Limited company contractors whose contracts are inside IR35 and who pay themselves via a deemed payment calculation will end up paying 14% more tax than a permanent employee on an equivalent gross salary.
However, unlike an employee, even if a contractor is found to be inside IR35, and must therefore pay tax like an employee as the legislation requires, they still don’t gain employment rights or benefits from their clients, an employee would.
Contractor financial profile outside of IR35
A typical IT contractor trading through a limited company on about £340 a day, working for 220 days a year will earn approximately £75,000 in gross fees. Their income and expenses would look like this:
- Revenue of £75,000 per year
- Legitimate expenses of £500 per month, or £3,000 per year
- A salary of £640 per month, which is £7,680 per year
- No income splitting with a spouse.
Although a contractor’s personal allowance is £9,440 (2013-14 tax year), paying a salary above £7,680 per year, or £640 per month, would incur National Insurance Contributions (NICs), as the NIC thresholds have not kept pace with the rising personal allowance.
In this scenario, using Contractor Calculator’s Contractor Financial Profile calculator shows that the financial profile of a contractor outside IR35 would look like this:
- Deducting expenditure of £10,680 gives a profit of £64,318
- Corporation tax is therefore £12,863
- Income tax on dividends is £5,263
- The total tax burden is £18,126
- The contractor’s net monthly income is £4,489, which is 71% of the contractor’s gross income.
Contractor financial profile inside of IR35
If all of the contractor’s contracts that year were inside IR35, then according to Contractor Calculator’s IR35 calculator, the contractor’s financial profile would look like this:
- Under IR35, to calculate the deemed payment you allow 5% of the gross fees of £75,000 for ‘unspecified expenses’ (£3,750) and then deduct employee expenses (eg travel and subsistence), and then the salary paid by the limited company (£7,680), which gives you the ‘deemed payment’ on which income tax and NICs are calculated = £60,570
- PAYE income tax is £14,180
- Employers NICs are £7,300
- Employees NICs are £4,402
- The total tax burden is £25,956
- The contractor’s net monthly income is £3,524, which is only 56% of the contractor’s gross income. Or, to put is another way, the contractor pays an astonishing 44% of gross income in tax.
Needless to say, IR53 causes a sharp rise in the contractor’s tax rate, resulting in a hefty fall in the contractor’s income – by £965 a month, or 27%.
IR53 causes a sharp rise in the contractor's tax rate, resulting in a hefty fall in the contractor's income, by 27%
Permanent employee profile – earning the same as the deemed payment
An employee earning the same as the deemed payment, £60,570, pays rather less of their gross income in tax. Here’s how it works out, using Contractor Calculator’s Permanent Employee Financial Profile Calculator:
- Employee gross salary of £60,570 (same as contractor’s deemed payment)
- PAYE income tax is £14,046
- Employees NICs are £4,426
- The total tax burden is £18,472
- The employee’s net monthly income is £3,508, which is 70% of gross salary, or put another way, the permanent employee pays 30% of their income in tax.
The cost to the employer is of course greater than the gross salary of £60,570, as employer’s NICs of £7,300 have to be added. When other costs of employment are factored in, such as holiday pay, statutory pension contributions, training and other benefits, the £60,570 a year employee probably costs their employer not far off the costs of the contractor’s £75,000 gross fees.
IR35 contractors pay 14% more tax but get nothing in return
What these calculations show is that a contractor being taxed and paid according to IR35 actually pays 14% more tax than an employee on an equivalent salary. The Treasury also gains greater tax revenue, although the cost to clients/employers is not significantly different.
Employees also benefit from employment rights and protection, which at the very least include paid holidays, pension contributions, redundancy pay and possibly pay for time off sick. They may also receive many other perks, such as higher pension contributions, death in service benefits, medical insurances, subsidised canteens, and so on. And their employer funds their ongoing training.
But the contractor enjoys none of the employment rights and protections that the employee receives. Contractors have to fund all of these ‘benefits’, including training and development, from the fees their contractor limited company generates.