Why Don't Inside IR35 Contractors Put Up and Shut Up?
I imagine that's a question many HR and compliance decision makers and hiring managers ponder. After all, most contractors earn well, right? Often substantially more than many senior employees? Why should they also get away with paying less tax? Why should companies bear that IR35 compliance risk our BIG 4 consulting partners have warned us so severely about, just so contractors pay less tax? If you care at all, you can find out later that the 'less tax' bit is massively exaggerated and NOT the main financial benefit of contracting, especially after huge hikes in dividend income tax. And in my next blog you can find out why Big 4 might be advising clients to pursue inside IR35 in the major conflict of interest unleashed by the government's woefully stifling, unjust stagnation-inducing reforms of 2017 and 2021. If you LET that impact happen. You don't have to.
Let me deal with the compliance risk point first, because it's quicker and easier than the other bit. Why? Because companies can eliminate the compliance risk without penalising their engaged contractors. If your contractors qualify to sell their services Outside IR35 and if you qualify to procure them in that way, which is the case in most scenarios where a work contribution is time-boxed and specific-change-related, there is no compliance risk. Compliance is straightforward and can take minimal effort with the right assistance. 34square, for example. And by the way, HMRC has engaged hundreds, perhaps thousands of contractors outside IR35 themselves and continues to do so. They are FINE with outside IR35 as long as it isn't pseudo-employment.
Now to the first point about how wonderfully cushy it is to be a contractor and how they should all put up and shut up. Difficult to properly establish the percentages, but freelance contractor resources might represent between 1% and 3% of working people. So, if it's so cushy, why does the vast, vast majority, in fact almost everyone NOT do it? I've done both extensively i.e. contracting and being employed. I prefer contracting. But I know PRECISELY why the vast majority don't. The benefits come at a cost.
So, let's tackle the tax point. Contractors operating through their own limited companies are subjected to precisely the same tax bands and percentages as employees. I feel duty-bound to mention this after the recent ridiculous... no... farcical BBC Question Time exposure of a tax advisor, yes... a tax advisor... revealing her colossal misapprehension that all that contractors pay is just the 19% corporation tax, on prime time national TV. Genius.
Now, contractors can choose to take some or most of their income in dividend and probably many believe that's lucrative tax avoidance. Tax avoidance is legal by the way, unlike tax evasion. The thing is, if they DO choose to take some or most of their income as dividend, thereby saving on employee and employer's National Insurance (NI) contributions, they actually pay 7.5% MORE of that income in tax. That's right. HMRC charges an extra 7.5% tax on dividends. This goes a long way to displacing the NI savings. And there are some things NI pays for that contractors don't get; guaranteed statutory redundancy and job seeker's allowance to name two.
Contractors, much more so than employees, face uncertain and sometimes fluctuating income. Imagine a highly-paid contractor on perhaps £600 per day, works for 12 months from April to March and could take earnings of £120K from their business profits. Imagine they're then out of work for, say, 4 months, and can take £80K the next year. Were they taxed as an employee and forced to pay tax on all income in a given period, they would pay £73K in tax and NI across the two years. Were they to be able to spread their income evenly through their limited company and take their income as if it were PAYE, they would pay £69K. In other words, in that example scenario, pushing them inside forces them to pay at least an extra 2% tax for two years. It's a 3% reduction in net income. And they have to do that whilst facing the stress and risk of being a contractor and having the constant threat of no income and no redundancy payout safety net. Is THAT fair?
So yes, there is some tax efficiency which surely SHOULD be possible, when they spread uneven income as they see fit. There are also financial, partly cash-flow benefits from being able to immediately offset business costs against turnover. Utilising all of the financial flexibility and other benefits of selling services through a limited company might increase a contractor's net income by 7% to 10%. That may or may not be life-changing but is certainly sufficient to have a significant impact on financial security and lifestyle. Most employees might consider it life changing if there boss came to them one day and said they were reducing their net income by 10%.
But it's even much worse than 10% loss of income in many cases. Unless companies substantially increase a contractor's rate to cover the umbrella company employer's NI costs, those costs will essentially be borne indirectly by the contractor, and yet they are supposedly an employee now, NOT an employer. Which pushes the income drop closer to 25%. So yes, contractors want to be outside IR35 because inside IR35 has the hugely unjust potential to destroy a livelihood they might have spent decades building.
Possibly a minor point here, but there will be many contractors that can take income in the region between £100K and £125K. That's about the least tax efficient income number you can have. Did you know that HMRC starts to reduce your personal allowance by £1 for every £2 you earn over £100K. I only found this out recently. So what that means is that a great many contractors will be paying a disguised but nevertheless absolutely real 60% tax and up to an extra whopping £5K on that last £25K of earnings. Work it out. It means they pay 40% tax on an amount they didn't earn that is half of that income i.e. an extra 20%.
So in the end, it isn't really tax efficiency that is the main financial benefit of contracting. It is in fact the higher gross earnings potential, higher for more successful and consistently in work contractors of course. Which seems fair to me. BUT... it comes at two major costs. Firstly, no security at all and extremely short notice periods, therefore zero safety net. What that means is that contractors must, if they are sensible, build up and maintain a large financial buffer to cover periods with no revenue. That can take a lot of doing, and when it erodes in periods of zero revenue, it needs to be built back up again.
Secondly, they live with that constant threat. Every time a contract end draws near, they need to find another one to follow it, often every year or even more than once a year. Maybe as a contract end draws near, they are apprehensive about time off, because when they take time off, they don't get paid. And they might have lots of unpaid time off soon involuntarily. That financial uncertainty and potential source of real emotional stress is something not everyone is comfortable with. For those that are, and I count myself as one of them, they are likely ONLY comfortable with it because of the potential financial reward of being successful. Part of that reward is legally avoiding paying more tax than they need to.
When you add everything up, probably being inside IR35 versus outside, with the tax system as it stands today, reduces net earnings for most contractors by somewhere between 10% and 25%. It's likely only as low as 10% if the client does pay perhaps a 15% higher rate for inside versus outside IR35. Many clients do pay more, whilst still actually paying contractors a lot less, at the behest of their compliance and legal experts. Perhaps those Big 4 experts in that obvious conflict of interest. Even at the low end of that scale of reduced income, which the increase in corporation tax next year will push many outside IR35 contractors towards, that has a profound impact on financial security and lifestyle. At the higher end, it is absolutely crippling and has forced many contractors to take their business abroad or go permanent, both of which reduce the income to the Treasury.
So yes, contractors really aren't happy with inside IR35. Of course many of them will be putting up and shutting up when they have to, but the reality is that the companies and the relevant decision makers within them that see sense the fastest, will get the highest quality of contribution from their critical contractor resources. Why not steal a march on your competition, do what the government u-turned on, and get the most value out of your investment in those resources that so very often, are by definition making a time-boxed, critical contribution to your not time-boxed but indefinite potential for success? The only winners with inside IR35 are umbrella companies. EVERYONE else loses. Unless you count the Big 4 consulting firms that the government gave the weapon to put a massive dent into one of their biggest competitors. Quite a lot of freelance contractors threw in the towel and went to work for consulting firms as permanent employees. So there's a solid case that even HMRC loses too when you consider how much income they are losing because of the dramatically shrunken contractor numbers.
Compliance. Don't park up, get out of your car and walk when you see the 30mph sign. Just drive at 30mph. It really is as simple as that. Especially don't do it if it's the company selling walking shoes that advised you to do so.