What is IR35 and Why Should Agency Founders Care?
IR35 is the set of tax legislation designed to stop workers from operating as limited company contractors when they are effectively employees. HMRC calls them "disguised employees." If you run an agency and hire contractors through their own limited companies, IR35 determines whether you pay them gross or whether you must deduct PAYE and National Insurance.
For agency founders, this is not a theoretical tax problem. It is a real cost and compliance issue that affects every contractor engagement you make. Get it wrong and you could be liable for backdated tax, interest, and penalties stretching back years.
Since April 2021, the responsibility for determining IR35 status shifted from the contractor to the hiring organisation. For agencies, that means you are responsible for issuing a Status Determination Statement (SDS) before the contractor starts work. And you are on the hook if HMRC disagrees with your determination.
This guide covers the practical implications of IR35 for agency founders, including how to make determinations, what happens if you get it wrong, and how to structure contractor engagements to reduce risk.
The 2021 Rule Change: What Changed for Agencies
Before April 2021, contractors assessed their own IR35 status. HMRC could challenge them individually, but the agency had limited exposure. The off-payroll working rules (often called IR35 for the public sector) were extended to medium and large private sector organisations in April 2021.
If your agency meets two of these three criteria, you are a medium or large organisation:
- Annual turnover of £10.2 million or more
- Balance sheet total of £5.1 million or more
- 50 or more employees
If you are below those thresholds, the contractor still determines their own status. But most agencies grow past those numbers quickly. Once you cross them, the rules apply to every contractor you engage through their own limited company.
The key change is this: you must now issue an SDS to every contractor before they start, and you must take reasonable care in making that determination. HMRC can challenge your determination and, if they find it wrong, hold you responsible for the unpaid tax and NI.
How IR35 Actually Works for an Agency
Imagine you run a 15-person digital agency in Manchester Northern Quarter billing £1.2m per year. You hire a senior developer through their own limited company for a six-month project. They work from your office four days a week, use your equipment, and report to your technical director. They do not have the right to send a substitute.
In that scenario, HMRC would almost certainly deem that contractor inside IR35. That means you must treat them as an employee for tax purposes. You deduct PAYE and employee NI from their invoices, and you pay employer NI on top. The contractor's limited company effectively becomes irrelevant for tax purposes on that engagement.
Now contrast that with a specialist UX consultant who works for three different agencies simultaneously, sets their own hours, uses their own equipment, and can send a substitute if they are unavailable. That contractor is likely outside IR35. You can pay them gross, and they handle their own tax through their limited company.
The difference is not about job titles or contract wording. It is about the reality of how the working relationship operates. HMRC looks at the actual working practices, not the contract terms.
The Three Key Tests HMRC Uses
HMRC applies three main tests to determine IR35 status. Understanding these helps you make better determinations for your agency.
Substitution
Can the contractor send someone else to do the work? If the contract says they must do the work personally, and in practice they always do, that points to employment. If they can and do send substitutes, that points to self-employment.
Control
Who decides what work is done, how it is done, and when it is done? If your agency controls the contractor's schedule, methods, and priorities, that looks like employment. If the contractor decides how to deliver the outcome, that looks like self-employment.
Mutuality of Obligation
Is the agency obliged to offer work, and is the contractor obliged to accept it? Ongoing engagements with no right to refuse work point to employment. Fixed-term projects with no ongoing obligation point to self-employment.
These are not the only factors, but they are the most important. HMRC also considers financial risk, equipment provision, integration into the business, and whether the contractor is in business on their own account.
Issuing a Status Determination Statement (SDS)
You must issue an SDS to every contractor you engage through their own limited company. The SDS must state whether the engagement is inside or outside IR35 and give the reasons for that determination.
You must issue the SDS before the work starts. If you do not, the contractor can treat the engagement as outside IR35 by default. That creates significant risk for your agency because HMRC can still challenge the arrangement and hold you liable.
The SDS should include:
- The contractor's name and limited company details
- The engagement start date
- Whether the role is inside or outside IR35
- The reasons for the determination, referencing the specific tests
- The date of the determination
You must also have a process for the contractor to challenge the determination. If they disagree, you must respond within 45 days. If you change your determination, you must issue a new SDS.
Using the CEST Tool: Helpful but Not Enough
HMRC provides the Check Employment Status for Tax (CEST) tool online. You answer questions about the engagement and it gives a determination. Many agencies use CEST as their primary assessment tool.
CEST is free and gives you HMRC's view of the status. But it has limitations. It does not handle complex arrangements well. It relies on honest answers about working practices. And HMRC have said they will stand by CEST determinations only if you answer all questions accurately and the tool gives a clear result.
If CEST says "undetermined," you have no HMRC protection. In those cases, you need professional advice. As ICAEW qualified accountants, we see many agencies using CEST as a starting point and then reviewing borderline cases with a tax specialist.
For a 12-person agency billing £800k per year, CEST will handle most straightforward contractor engagements. But if you have contractors who work closely with your team, use your equipment, or have been with you for years, get professional input.
What Happens if You Get IR35 Wrong
HMRC can open an IR35 enquiry into your agency. They will ask to see your SDS records, your contractor agreements, and evidence of how you made your determinations. If they find you did not take reasonable care, they can issue a tax bill for the unpaid PAYE and NI, plus interest and penalties.
The tax bill can be substantial. A contractor billing £80,000 per year who should have been inside IR35 would mean roughly £24,000 in unpaid employer NI and employee NI, plus income tax. For three contractors over three years, that is over £200,000 before penalties.
Penalties can range from 15% to 100% of the tax due, depending on whether HMRC considers the error careless, deliberate, or deliberate and concealed.
There is also reputational risk. If HMRC publishes details of your enquiry, contractors may stop working with you. And your existing contractors may demand reassessments if they think you have been making incorrect determinations.
Practical Steps for Agency Founders
Audit Your Current Contractor Engagements
Start by listing every contractor you currently engage through their own limited company. For each one, document the working practices: do they work from your office? Do they use your equipment? Can they send a substitute? How much control do you exercise? This gives you a baseline for your IR35 risk.
Review Your Contract Templates
Standard contractor agreements from online sources often do not reflect the actual working relationship. Your contracts should match reality. If the contract says the contractor can send a substitute but in practice they never do, HMRC will look at the reality, not the contract. But having a contract that accurately reflects the arrangement is still important.
Build a Determination Process
Create a standard process for every new contractor engagement. Use CEST as a first pass. For borderline cases, get professional advice. Document every determination with the reasons and the evidence. Keep records for at least six years after the engagement ends.
Consider a Preferred Supplier List
Many agencies now work with umbrella companies for contractors who are inside IR35. The umbrella company handles the payroll and tax deductions, reducing your administrative burden. But be careful: some umbrella companies are not compliant. Use reputable providers and check they are making proper tax deductions.
Train Your Hiring Managers
Your account directors and project managers are the ones who decide how contractors work. They need to understand that the working practices they set determine IR35 status. If they treat contractors like employees, you create IR35 risk. Brief them on the key tests and the importance of letting contractors maintain their independence.
IR35 and Your Agency Structure
If your agency is structured as a group with multiple trading companies, IR35 applies to each entity separately. A holding company that does not engage contractors directly has no IR35 obligations. But each trading company that hires contractors must comply.
Some agency founders consider restructuring to avoid IR35. That is rarely advisable. HMRC has anti-avoidance rules that can recharacterise arrangements designed to circumvent IR35. Focus on compliance rather than avoidance.
If you are planning an exit, IR35 compliance matters. Buyers will due diligence your contractor arrangements. A history of incorrect determinations or unpaid tax liabilities will reduce your valuation or kill the deal entirely. Clean IR35 records are a selling point.
Common Mistakes Agency Founders Make
Treating all contractors the same. Some roles are inside IR35, some are outside. You cannot apply a blanket approach. Each engagement must be assessed individually.
Relying on contract wording alone. HMRC looks at reality, not paperwork. If your contract says the contractor has no fixed hours but they always work 9-5, the reality trumps the contract.
Ignoring long-term contractors. A contractor who has been with your agency for three years is much more likely to be inside IR35 than one on a three-month project. Long engagements create mutuality of obligation and integration into the business.
Not documenting determinations. If HMRC opens an enquiry and you cannot show how you made your determinations, they will assume you did not take reasonable care. Document everything.
When to Speak to an Accountant
If your agency engages any contractors through their own limited companies, you should review your IR35 position now. If you have not issued SDS documents for existing contractors, that is a priority. If you are unsure whether your determinations are correct, get professional advice before HMRC comes knocking.
We work with agency founders across the UK, from Shoreditch to Bristol Harbourside, helping them navigate IR35 compliance. If your contractor mix has changed in the last 12 months, or if you are taking on your first limited company contractor, ask your accountant before the engagement starts.
For more on how we support agencies with contractor compliance, see our services page. If you work with digital agencies or creative agencies, we understand the specific contractor patterns in those sectors.
IR35 is not going away. HMRC is actively targeting agencies. But with the right process, documentation, and professional support, you can manage the risk and keep your contractor model working for your business.