If your agency engages contractors who work through their own limited company, you are responsible for determining their IR35 status. This is not optional. Since April 2021, medium and large agencies in the UK have been legally required to issue a Status Determination Statement (SDS) to every contractor before they start work. Get it wrong, and HMRC can come after you for the unpaid tax and National Insurance, not the contractor.

This article is written specifically for IR35 agency founders who need to understand the process from the agency side. Not from the contractor's side. Not from a generic employer perspective. From your position as the intermediary that engages the contractor and pays their limited company.

Why IR35 Matters for Your Agency

IR35 is tax legislation designed to catch what HMRC calls "disguised employment". A contractor who works like an employee but takes income through a limited company to pay less tax and NI. When IR35 applies, the contractor's limited company pays roughly the same tax as if the contractor were on payroll.

For agencies, the risk is financial. If HMRC determines a contractor was inside IR35 and you did not operate PAYE and deduct employer NI, you become liable for the full amount. Backdated. With interest and penalties.

We have seen cases where a single contractor engaged for two years generated a six-figure HMRC bill for the agency. That is not a theoretical risk. It happens.

Under the off-payroll working rules (commonly called IR35), your agency is the "fee-payer". That means you are responsible for:

  • Determining the contractor's employment status before work begins
  • Issuing a Status Determination Statement (SDS) to the contractor and the client
  • Operating PAYE and deducting tax and NI if the contractor is inside IR35
  • Keeping records of your determination and the reasoning behind it

These rules apply if your agency meets two or more of these criteria: turnover over £10.2 million, balance sheet over £5.1 million, or more than 50 employees. Most agencies reading this will qualify. If you are smaller, the responsibility shifts to the end client, but you still need to know the rules because the client will ask you for information.

The Three Factors That Determine IR35 Status

HMRC looks at three main areas when deciding if a contractor is inside or outside IR35. These are not a checklist you tick. They are a holistic assessment of the working relationship.

Substitution and Personal Service

Can the contractor send someone else to do the work? A genuine right of substitution is the strongest indicator that the contractor is outside IR35. If the contract says the contractor must personally perform the work, that points towards inside IR35.

We see agency founders get this wrong by including a substitution clause in the contract but never intending to allow it. HMRC will look at what happens in practice, not just what the contract says. If your contractor has never substituted and you would not allow it, the clause is meaningless.

Control

Who decides what work gets done, when, where, and how? If your agency or the end client controls these things, the contractor looks like an employee. If the contractor decides their own methods, hours, and location, that points towards self-employment.

For agency contractors, control is often blurred. A contractor might work on your premises, use your equipment, and attend your team meetings. That looks like control. But if they also work for other clients, set their own schedule, and use their own tools for parts of the work, that weakens the control argument.

Mutuality of Obligation (MOO)

Is your agency obliged to offer work, and is the contractor obliged to accept it? If yes, that is an employment relationship. If the contractor can turn down work and you can stop offering it without penalty, that points towards outside IR35.

MOO is often the deciding factor. A contractor on a rolling monthly retainer with no end date and no right to refuse work is almost certainly inside IR35. A contractor engaged for a specific six-week project with a fixed scope and no expectation of further work is likely outside.

How to Issue a Status Determination Statement

The SDS is a formal document you must provide before the contractor starts. It must state:

  • Whether the contractor is inside or outside IR35
  • The reasons for that determination
  • The key facts that led to the decision

You can use HMRC's Check Employment Status for Tax (CEST) tool to help, but be careful. CEST gives directional guidance only. It is notoriously unreliable for complex arrangements, especially where the contractor works across multiple clients or has a genuine substitution right.

We recommend using CEST as a starting point, not a final answer. For any borderline case, take professional advice from an accountant or employment tax specialist. As ICAEW qualified accountants, we handle IR35 determinations for agency clients regularly. The cost of advice is small compared to the cost of getting it wrong.

Common Mistakes Agency Founders Make

We see the same errors repeatedly. Here are the ones that cause the most damage.

Relying on the Contract Alone

HMRC ignores contracts that do not reflect reality. If the contract says the contractor has control but they actually take direction from your account manager every day, the contract is worthless. HMRC will look at what happens on the ground.

Review your working practices alongside your contracts. If they do not match, fix the practices or change the contracts. Do not leave a mismatch.

Treating All Contractors the Same

Every contractor relationship is different. A graphic designer who works from home, uses their own software, and takes briefs from multiple clients is different from a developer who sits in your office 40 hours a week using your equipment and attending your standups. You cannot apply a blanket determination to all contractors.

Not Keeping Records

HMRC can ask for your IR35 determinations up to six years after the engagement ends. If you cannot produce the SDS and the reasoning behind it, HMRC will assume you did not do the work. That presumption works against you.

Keep a file for each contractor with the SDS, the working practices review, and any correspondence about the determination. Store it securely and keep it for at least six years after the contractor leaves.

What Happens When a Contractor Is Inside IR35

If you determine the contractor is inside IR35, you must operate PAYE on their fees. That means:

  • Deducting income tax and employee NI from each payment
  • Paying employer NI at 13.8% on top
  • Reporting through RTI (Real Time Information) each month
  • Issuing a P60 at year end

The contractor's limited company invoices you for the gross amount. You then calculate the deemed employment payment, deduct the tax and NI, and pay the net amount to the contractor personally. The contractor's company does not pay itself a salary or dividend from that income. You handle it through payroll.

This is administratively heavier than paying a contractor outside IR35. But it is cheaper than the alternative of getting it wrong and facing a retrospective bill.

What Happens When a Contractor Is Outside IR35

If you determine the contractor is outside IR35, you pay their limited company the full invoice amount. No PAYE, no NI. The contractor handles their own tax through their company.

You still need to issue the SDS and keep records. The determination is not permanent. If the working relationship changes, you must reassess.

A contractor who starts outside IR35 but later becomes more integrated into your team may move inside. Revisit determinations at least annually, or whenever the working arrangements change significantly.

Practical Steps for Agency Founders

Here is a workflow that works for most agencies.

Step 1: Assess Before Engagement

Before the contractor starts, review the proposed working arrangements. Use CEST as a first pass. If CEST gives a clear answer and the facts are straightforward, proceed with that determination.

Step 2: Document Your Reasoning

Write down the key facts that led to your decision. Include the substitution right, control factors, and MOO analysis. Save this alongside the SDS.

Step 3: Issue the SDS

Send the SDS to the contractor and the end client before work begins. Keep proof of delivery.

Step 4: Set Up Payroll for Inside IR35 Contractors

If the contractor is inside IR35, add them to your payroll software. Most accounting packages like Xero, QuickBooks, or FreeAgent can handle deemed employment payments. Set up the right tax codes and NI categories.

Step 5: Review Annually

Set a calendar reminder to review every contractor's IR35 status at least once per year. If anything changes in the working relationship, review sooner.

When to Take Professional Advice

If any of these apply, speak to an accountant or tax specialist before making your determination:

  • The contractor works across multiple clients simultaneously
  • The contractor has a genuine substitution clause that they have used
  • The contractor provides their own equipment and workspace
  • The contractor has their own insurance, marketing, and business structure
  • You are unsure about the CEST result
  • The contractor has been with your agency for more than 12 months

Our team at Agency Founder Finance handles IR35 determinations for agencies regularly. If you want to check whether your current determinations would hold up under HMRC scrutiny, get in touch.

The Cost of Getting It Wrong

Let us put a real number on this. Suppose you engage a contractor on a two-year project at a day rate of £500. They work 220 days per year. Total fees: £220,000 over two years.

If HMRC determines they were inside IR35, you owe:

  • Employer NI at 13.8% on the deemed employment payment: roughly £26,700
  • Interest on late payments at 7.75% per year
  • Potential penalties of up to 30% of the tax due

That is a £30,000 to £40,000 bill on a single contractor. For an agency with five contractors engaged on similar terms, you are looking at £150,000 to £200,000 in retrospective tax, interest, and penalties.

Getting the determination right upfront costs a fraction of that.

Final Thoughts

IR35 is not going away. HMRC has increased enforcement in the creative and digital sectors specifically. Agency contractors are a target because the working relationships often blur the line between employment and self-employment.

The key is to take the process seriously. Issue the SDS. Keep the records. Review the working practices. And when in doubt, ask someone who does this for a living.

If your contractor mix has changed in the last 12 months, ask your accountant before year-end. A quick review now could save you tens of thousands later.