When you’re acting as a sole trader, it’s vital that you have an in depth understanding of the legislation that applies to your business. This includes tax, VAT and other business legislation. With IR35 frequently hitting newspaper headlines, many business owners are left wondering the answer to the question ‘does IR35 apply to sole traders?’
In this article, we’ll explain exactly what IR35 is, whether it applies to sole traders and the other types of legislation that you’ll need to be aware of as a sole trader. After all, no business owner wants to get caught out by not complying with the relevant legislation.
Do sole traders need to worry about IR35?
IR35, otherwise known as off-payroll working rules, was introduced to close a loophole that formerly allowed contracted workers to pay less tax than employed and self-employed workers. For sole traders who contract their services to other organisations, this may leave them wondering whether IR35 regulations affect their business.
In the majority of cases, IR35 does not apply to sole traders. However, there could be a time where IR35 comes into play during your freelance career, so it’s worth being aware of it and ensuring that you have a good working understanding of when it might apply to you.
Read on to learn more about IR35 and how it applies to sole traders.
What is IR35?
You might have heard about IR35, but what exactly is it and who does it apply to?
IR35, formally known as the intermediaries legislation, was originally introduced in 2000. It was designed to prevent freelancers and contractors from avoiding paying tax through disguised employment.
Disguised employment involves an individual conducting work through an intermediary (usually their own limited company) to provide services to a client. The worker is treated as an employee but is engaged on a self-employed basis to ‘disguise’ their true employment status.
Employers benefit from disguised employment as they make significant savings. This is because they do not have to make national insurance contributions, pension contributions or provide the employee with rights such as holiday pay, sick pay or parental leave.
Workers also benefit from disguised employment. By working as a contractor through a limited company, the worker will pay corporation tax on any profits whilst claiming expenses against the tax bill. Not only that, but they can also avoid making National Insurance Contributions by taking dividends from the business instead of drawing a salary.
IR35 is designed to prevent this unfair advantage by clamping down on disguised employment. This means that businesses will need to employ workers directly if they fall into the IR35 regulations.
What is a sole trader?
Before we can discuss whether IR35 applies to sole traders, we first need to understand exactly what a sole trader is.
A sole trader is defined as a self-employed person who owns and runs their own business as an individual. This means that their business is not an incorporated company. Unlike a limited company, the business is not a separate legal entity from the sole trader – the sole trader is the business.
There are over 3.5 million sole traders in the UK, making it the most popular business structure. This is due to the simplicity of becoming a sole trader. You do not need to incorporate a company to become a sole trader – you simply register as self-employed with HMRC, begin trading and complete an annual self assessment tax return.
Does IR35 affect sole traders?
IR35 applies to anyone that offers services through their own intermediary. This is usually in the form of a Personal Service Company (PSC) – a limited company set up by an individual through which they provide services to clients.
Sole traders are not affected by IR35. This is because sole traders do not trade through a limited company – the sole trader and their business are legally the same entity. For this reason, IR35 is not a consideration for sole traders.
However, if you are considering turning your business into a limited company in the future, IR35 will then come into play. For this reason, it’s a good idea to ensure that you have a good understanding of IR35 and how it could impact your business if you do decide to incorporate as a limited company in the future.
How did IR35 change in April 2021?
IR35 was originally introduced in 2000 by Gordon Brown as a way to prevent employees from reducing the tax that they pay by working as contractors. When it was introduced, public sector employers were responsible for deciding whether contractors were genuine contractors or employees, whilst in the private sector it was down to the contractor themselves to make the decision.
Changes to IR35 were planned for 2020 but were pushed back as a result of the Covid-19 pandemic. These changes were finally made in April 2021, when the legislation was amended to alter who holds responsibility for checking whether a contractor is subject to IR35 regulations.
In April 2021 private sector employers also became responsible for making the judgement on whether IR35 applied to their contractors. This means that if a private sector employer deems that IR35 is applicable, they must treat the contractor as an employee for tax purposes.
By accepting that a contractor should be treated as an employee, the business must take on the additional costs and responsibilities that come with hiring an employee.
Is IR35 only for limited companies?
The IR35 regulations were created to tackle ‘disguised employment’ – that’s those who are providing services through a limited company to benefit from reduced income tax and National Insurance. If it wasn’t for this limited company, the individual would be deemed to be an employee of the client, therefore paying a higher level of tax and National Insurance, as well as benefitting from paid holidays, sick pay and parental leave.
For this reason, IR35 only applies to those who trade through a limited company. Sole traders submit annual self assessment tax returns to HMRC, so this legislation does not apply to sole traders.
Can contractors operate through a limited company?
Many contractors choose to operate through a limited company to perform their freelance work. This is because many businesses are more reluctant to deal with sole traders. It’s perfectly legal for contractors to operate through a limited company, and this is often referred to as a Personal Service Company, or a PSC.
IR35 applies when the contractor operates through a limited company but is treated as an employee. If a contractor is seen to be working in the same way as an employee and holds similar obligations to a standard employee, HMRC state that the worker should be treated as an employee for tax purposes. This means that their employer will need to pay National Insurance contributions, as well as providing a workplace pension, sick pay, holiday leave and other benefits.
Is there anything else that sole traders should be aware of?
Whilst sole traders are not affected by IR35, they do need to be aware of their employment status, which is closely linked to IR35. Employment status is an important consideration for anyone that provides services to a client, whether they are trading as a sole trader or a limited company.
Ultimately, a worker who is self-employed will be paid on a gross basis, whilst an employee will have their income tax and National Insurance Contributions deducted from their salary by their employer. The self-employed individual will be responsible for submitting self assessment tax returns and paying their own income tax to HMRC.
The legal responsibility for deciding whether a worker is employed or self-employed rests with the employer. However, this is rarely clear cut and it can often be difficult to work out what the employment status should be. For this reason, HMRC has created an employment status checker known as CEST (Check Employment Status for Tax). This tool asks a series of questions to establish whether the individual should be categorised as self-employed or employed for tax purposes.
Employment status is designated based on the type of work that is carried out as well as the level of control that the sole trader has over their work. If HMRC later discover that a self-employed worker should have been treated as an employee for tax purposes, the company could be liable for an investigation by HMRC.
What are the tax obligations of a sole trader?
A sole trader is legally responsible for the finances, debts and taxes of its business. This is because there is no legal separation between a sole trader and their business – they are the same legal entity, unlike with a limited company.
As a sole trader, the self-employed person is able to keep any income generated by the business as personal income. This means that they can withdraw cash from the business at any time, without considering tax.
Sole traders are required to complete an annual self-assessment tax return, detailing the income and expenditure of the business.
The sole trader will then need to make payments to HMRC for the following:
Income tax on business profits (after expenses and personal allowance have been deducted)
Class 2 and class 4 National Insurance contributions
VAT payments if the business is VAT registered
Tax on any monetary gain from selling business assets or the business itself
Sole traders are able to claim tax relief on expenses that are incurred exclusively for the operation of the running of the business. This includes claiming tax relief on interest and charges related to a business bank account, providing it is completely separate to their personal bank account.
Sole traders are also able to employ staff. Any employees must be set up as PAYE, meaning that the sole trader will also need to make tax and National Insurance contributions on behalf of the employee.
Can a sole trader work outside IR35?
Sole traders are not impacted by IR35. This is because IR35 covers contractors who work through intermediaries – most commonly through their own limited company. This reduces the taxes that they are required to pay, as well as minimising the costs incurred by their employer. Sole traders pay tax through the self assessment process, so they are not subject to IR35 regulations.
Does IR35 only apply to UK companies?
IR35 applies to all UK resident contractors who trade through a UK based limited company. This means that wherever in the world they trade, or whatever location they are working in, IR35 regulations will still apply.
Who is not affected by IR35?
IR35 does not apply to sole traders, as the legislation is only applicable for limited companies. However, it is important to note that regulations around employment status are particularly relevant to sole traders who provide services to clients. If you’re unsure of your employment status, it’s always best to check with HMRC to ensure that you are complying with regulations and to avoid an unexpected tax bill later down the line.
Whether you’re a contractor that provides services to clients or a business that hires contractors, IR35 is likely to be on your mind. This regulation can be quite complex in nature, leaving many people with questions around it.
IR35 applies to contractors who are trading through an intermediary – most commonly a limited company. This means that IR35 does not apply to sole traders. However, sole traders need to consider whether they are truly a contractor or whether they may be acting as an employee in certain circumstances, or they could find themselves breaching employment status regulations.
This article has answered the main question ‘does IR35 apply to sole traders’, and provided an overview of what IR35 is and who it applies to, plus the changes that were made to the legislation in April 2021. If you’re unsure of your IR35 status, it’s always best to seek advice from a qualified accountant to avoid potentially costly mistakes.