It is a well-known fact that Limited Company contractors have significant tax advantages when compared to full-time employees. However, if contractors are caught by IR35 rules, there can be a major impact on their take-home pay.
In this article, we look how IR35 affects contractors. We continue to use the example of a fictitious individual Tim, who chooses to become a Limited Company contractor only for saving taxes.
We look at different scenarios, and how Tim’s annual take-home pay is impacted by being outside or inside of IR35.
In this example, we will look at the difference in Tim’s annual take-home pay by being outside IR35 and inside IR35, assuming that Tim’s business is not eligible for VAT.
Let’s say Tim works for 40 hours every week for 48 weeks in a year. At his usual hourly rate of £40, this results in gross annual earnings of £76,800. Tim pays himself a salary of £7,000 every year and has annual business expenses of £12,000.
Tim’s net profit after deducting all expenses is £57,914.72 (£76,800 less £7,000 less £12,000 plus £114.72 of Employer’s National Insurance). He paid a corporation tax of £11,582.94 on this profit (20% of £57,914.72) and declared the remaining £46,331.78 as dividends.
Taking into account his dividends and salary, Tim’s gross income was £58,479.75, which resulted in a personal income tax of £3,738.32.
Based on this, Tim’s annual take home pay was £61,708.18 (net salary of £7,114.72 plus net dividends of £46,331.78 plus expenses of £12,000 that can be claimed back, minus £3,738.32 of personal income tax). This worked out to an average monthly income of £5,142.35. Out of his total revenues of £76,800, Tim got 80.35% as take-home pay.
What if Tim is caught inside IR35 with similar gross earnings of £76,800? Being inside IR35, Tim will have to pay for both Employer’s and Employee’s National Insurance Contributions (NICs). After deducting an employer NIC adjustment of £3,840, Tim’s net turnover is £72,960. On this turnover, there will be an employer NIC contribution of £7,417.08.
Under IR35 rules, Tim is allowed to deduct 5% as administration expenses if he’s caught inside IR35. After deducting the employer contribution and administration expenses of £3,840 (5% of £76,800), Tim is left with a salary of £61,702.92. On this salary, there is a deduction of £10,308.17 towards income tax and £6,449.63 towards Employee’s NIC, resulting in a net salary of £44,945.12.
The amount of £3,840 deducted above towards employer’s NIC adjustment is considered as net profit before tax. Therefore, this amount will not be charged at normal income tax rates, but at corporation tax rates of 20%, resulting in a corporation tax of £768. After deducting corporation tax, Tim is left with £3,072, which he will declare as a dividend. The total tax on dividends is £5,231.53.
Factoring in all these income and expenses, Tim’s annual take-home pay works out to £46,625.59 (net salary of £44,945.12 plus net dividends of £3,072 plus £3,840 of expenses which can be claimed back less tax on dividends of £5,231.53).
As you can see, Tim’s annual take-home pay when inside IR35 is only £46,625 as compared to £61,708.18 of pay outside IR35. And out of the total annual income of £76,800, Tim can take only 60.71% as take-home pay inside IR35 as opposed to 80.35% outside IR35. In terms of taxes, Tim pays £30,175 inside IR35, which is almost double the £15,092 outside IR35.
We look at how IR35 affects Tim’s income if he is registered for VAT. After adding VAT of 20% to Tim’s annual revenues of £76,800, Tim earns £92,160. Assuming he is registered for a flat rate VAT scheme of 11%, Tim gets VAT savings of £5,222.40. Including VAT savings, Tim’s total earnings are £82,022.
Continuing with the above example, Tim pays himself an annual salary of £7,000 and his administration expenses are £12,000. After deducting salary and administration expenses and adjusting for employer NIC of £114.72, the net profit before tax is £63,137.12.
Taking into account a corporation tax deduction of £12,627.42 (20% of £63,137.2), Tim declares a dividend of £50,509.70. The total tax on these dividends is £4,782.80.
So after accounting for VAT, Tim’s annual take-home pay outside IR35 is £64,841.62 or 84.43% of the total revenues of £76,800.
With the same total earning of £82,220 as above, (after adjusting VAT savings gained from the flat rate VAT scheme) and an employer NIC adjustment of £4,101.12, Tim’s net turnover is £77,921.28. After deducting employer’s NIC of £7,925.58 and administration expenses of £4,608, Tim receives a salary of £65,387.70. On this salary, Tim has to pay an income tax of £11,782.08 and employee NIC of £6,449.63, resulting in a net salary of £47,155.99.
As in the example of inside IR35 without VAT, the employer’s NIC adjustment of £4,101.12 is considered as net profit before tax and is subject to 20% corporation tax. After deducting a corporation tax of £820.22, Tim gets a dividend of £3,280.90. After adding salary to this dividend amount, the tax on dividends is £6,112.
So with VAT, this results in an annual take-home pay of £48,932.06 inside IR35 against £64,841.62 outside IR35. The take home pay with VAT inside IR35 is only 63.71% of the total revenues of £76,800, against 84.43% outside IR35. And with VAT, Tim pays a tax of £27,867.94 inside IR35, which is more than double of £11958.38 or the tax paid outside IR35.
As can be seen from the example, being inside IR35 can mean a significant reduction in take-home pay. The biggest incentive for individuals to take up contracting is tax savings, and IR35 simply negates the advantage. If you are inside IR35, you will end up paying the same or even more tax than you would be paying as a full-time employee.
To avoid such losses, it is important that your contract should always be outside IR35. Before starting as a contractor, you should find out your IR35 status. You can use our Business Entity test and get an IR35 risk score for your contract.
If you want to know the difference in take-home pay between inside IR35 and outside IR35, the calculations are quite complex and involve a lot of different numbers. Our IR35 calculator can be of help to contractors who want to understand how IR35 impacts their taxes and take-home pay. All the calculations in the example above have been completed using our IR35 calculators: