If your agency engages contractors, freelancers, or interim staff, IR35 is the single biggest tax risk on your balance sheet. Get the determination wrong and you inherit the tax bill. Get the process wrong and HMRC can issue a penalty regardless of the underlying status.
This is the definitive guide to IR35 for agencies. It covers the off-payroll working rules as they stand in the 2025/26 tax year, the obligations on fee-payers, the limits of the CEST tool, and the practical steps you need to protect your agency. We work with 73+ UK and UAE agency founders, many of whom run marketing, digital, creative, and recruitment agencies that rely on contractor talent. This guide draws on that experience.
As ICAEW qualified accountants, we do not deal in generalities. You will find specific HMRC forms, named software, real-world numbers, and worked examples throughout. The rules change. The principles do not.
What IR35 Actually Means for Your Agency
IR35 is not a tax. It is a set of rules designed to determine whether a contractor is genuinely self-employed or should be treated as an employee for tax purposes. If a contractor falls inside IR35, the fee-payer must deduct income tax and National Insurance Contributions (NICs) before paying the contractor's intermediary, typically their personal service company (PSC).
For agencies, the stakes are higher than for most businesses. You are often the fee-payer. You issue the Status Determination Statement (SDS). You carry the liability if HMRC disagrees with your assessment.
The off-payroll working rules (Chapter 10, Part 2, ITEPA 2003) shifted responsibility from the contractor's PSC to the end-client for medium and large organisations. But for agencies, the rules create a chain of liability that many founders do not fully understand.
The Chain of Liability
When a contractor works through their PSC, the contractual chain typically looks like this:
- End-client engages your agency
- Your agency engages the contractor's PSC
- The contractor works at the end-client's site (or remotely)
Under the off-payroll rules, the end-client must determine the contractor's status and issue an SDS. If the end-client fails to do so, or does so incorrectly, the liability transfers to the fee-payer, which is often your agency. The fee-payer is the entity that pays the contractor's PSC. That is usually you.
If you are a recruitment agency placing contractors with clients, you need to understand where you sit in this chain. If you are a creative or digital agency engaging freelancers directly for client work, the end-client may be your client, and you are the fee-payer. Different scenarios produce different obligations.
Inside IR35 vs Outside IR35
A contractor inside IR35 is treated as a deemed employee. The fee-payer must:
- Deduct PAYE income tax
- Deduct employee NICs (Class 1, currently 8% on earnings above £12,570)
- Pay employer NICs (13.8% on earnings above £9,100)
- Pay the Apprenticeship Levy if total pay bills exceed £3M
- Issue a P60 at year end
A contractor outside IR35 is genuinely self-employed. The contractor's PSC invoices your agency, usually without VAT (if below the threshold) or with VAT (if registered). The contractor handles their own tax through salary, dividends, and corporation tax on their PSC's profits.
The difference is material. A contractor billing £500 per day outside IR35 might net around £400 after their PSC's tax costs. Inside IR35, that same £500 per day costs the fee-payer approximately £569 once employer NICs and pension contributions are added. The contractor nets around £320.
When the Off-Payroll Rules Apply to Your Agency
The off-payroll working rules apply when a contractor provides services through an intermediary (usually a PSC) to a client that is medium or large. The size of the end-client determines whether the rules apply at all.
Size Tests for End-Clients
An end-client is medium or large if it meets two of the following three conditions in the current or previous financial year:
| Condition | Small | Medium | Large |
|---|---|---|---|
| Annual turnover | £10.2M or less | £10.2M to £36M | Over £36M |
| Balance sheet total | £5.1M or less | £5.1M to £18M | Over £18M |
| Number of employees | 50 or fewer | 51 to 250 | Over 250 |
If the end-client is small, the off-payroll rules do not apply. The contractor remains responsible for their own IR35 status. If the end-client is medium or large, the client must issue an SDS and the fee-payer (often your agency) must operate PAYE on payments to the contractor's PSC.
This creates a practical problem for agencies. You need to know the size of every end-client you work with. Many small end-clients will tell you they are small. Some will be wrong. HMRC does not accept ignorance as a defence.
Public Sector Contracts
The off-payroll rules have applied to public sector engagements since April 2017. If your agency places contractors with NHS trusts, local authorities, central government departments, or any public body, the rules apply regardless of the body's size. Public sector engagements are always in scope.
We have seen agencies caught out by this. A digital agency in Bristol Harbourside took on a contract with a local authority. The authority was small in headcount but public sector. The agency assumed the rules did not apply. They did. The agency inherited a £47,000 tax bill for a six-month engagement.
The Status Determination Statement (SDS)
The SDS is the document that records the end-client's decision on whether the contractor is inside or outside IR35. It is not optional. It is a legal requirement under the off-payroll rules.
What the SDS Must Contain
HMRC has not prescribed a specific format for the SDS, but it must include:
- The name and address of the end-client
- The name and address of the contractor's intermediary (PSC)
- The name of the contractor (if known)
- The date the determination was made
- The conclusion (inside or outside IR35)
- The reasons for the conclusion
- Details of any appeal process
The SDS must be provided to the contractor and the fee-payer (your agency) within a reasonable time. HMRC recommends within 31 days of the engagement starting.
We recommend using a standardised SDS template. Many agencies use Qdos or IR35 Shield for this. Others build their own in-house process. The key is consistency. If HMRC challenges your determinations, they will look at your process first and your individual decisions second.
Who Issues the SDS
The end-client issues the SDS. But the end-client can delegate the process to your agency. Many do. If your agency takes on the responsibility of making the determination, you must have the expertise to do so correctly. You cannot simply ask the contractor what they think.
If the end-client fails to issue an SDS, the liability transfers to the fee-payer. That is your agency. This is the most common trap we see. An end-client tells your agency "we don't do IR35 assessments, you handle it." Your agency takes on the risk without realising it.
If you are a recruitment agency placing contractors, you should have a written agreement with each end-client that specifies who issues the SDS and who bears the liability if HMRC challenges the determination. We cover this in our agency accounting services.
The CEST Tool: What It Can and Cannot Do
HMRC's Check Employment Status for Tax (CEST) tool is the official online assessment tool. It is free to use. It produces a determination that HMRC says it will stand by, provided the answers given are accurate.
But CEST has limits. Understanding them is critical.
How CEST Works
CEST asks a series of questions about the engagement. It covers:
- Substitution (can the contractor send someone else?)
- Control (who decides what, when, and how the work is done?)
- Mutuality of obligation (is the client obliged to offer work, and the contractor obliged to accept it?)
- Financial risk (does the contractor bear any financial risk?)
- Part and parcel (is the contractor part of the client's organisation?)
The tool uses a rules-based engine to produce a determination. It works well for straightforward cases. It struggles with complex or hybrid arrangements.
When CEST Fails
CEST cannot handle:
- Engagements where the contractor works through an umbrella company
- Engagements with multiple end-clients simultaneously
- Engagements where the contractor provides their own equipment but the client provides the workspace
- Engagements where the contractor has a right of substitution that is never exercised
- Engagements where the contractor is a director of the end-client
In these cases, CEST may produce an "unable to determine" result. That is not a green light. It means you need a more detailed assessment, usually from a qualified professional.
We have seen CEST produce "outside IR35" determinations for engagements that were clearly inside. The tool relies on the accuracy of the answers. If the end-client or contractor provides answers that reflect the ideal arrangement rather than the reality, the determination is worthless.
CEST and HMRC's Compliance
HMRC has stated that it will stand by CEST determinations if the answers are accurate. But this is not a guarantee. HMRC can still challenge the underlying facts. If they find that the answers did not reflect reality, they will disregard the CEST result.
We recommend using CEST as a first pass. If it produces a clear "outside IR35" result, document the answers and keep the output. If it produces "inside IR35" or "unable to determine", escalate to a professional review.
Working Examples: Inside and Outside IR35
Let us look at two realistic scenarios. Both involve agencies we have worked with. The names are fictional but the numbers are real.
Example 1: Inside IR35, The Embedded Developer
BrightSpark Digital is a 15-person marketing agency in Shoreditch. They win a six-month contract with a large retail client. The client insists on a senior developer working on-site five days a week. BrightSpark engages Sarah, a contractor through her PSC, at £600 per day.
Sarah works 9 to 5, Monday to Friday, at the client's office. She uses the client's equipment. She reports to the client's head of digital. She cannot send a substitute. The client provides her with a company email address and laptop.
This is inside IR35. The client should issue an SDS confirming this. If they do not, BrightSpark as the fee-payer is liable.
The cost to BrightSpark: £600 per day plus employer NICs at 13.8% (£82.80) plus pension contribution (3% minimum, £18) = £700.80 per day. Over 130 working days (6 months), that is £91,104. Sarah nets approximately £416 per day after PAYE and employee NICs.
Example 2: Outside IR35, The Specialist Consultant
Curate Creative is a 30-person PR agency in Manchester's Northern Quarter. They win a project to rebrand a fintech startup. They engage Tom, a brand strategist through his PSC, at £750 per day.
Tom works remotely from his own studio. He uses his own equipment. He has a right of substitution (he can send a colleague if he is unavailable). He attends weekly calls but sets his own hours. The project has a defined scope and deliverable. Tom bears financial risk, if the project overruns, he absorbs the cost.
This is outside IR35. The client issues an SDS confirming this. Tom invoices Curate Creative £750 per day plus VAT. Curate Creative pays the invoice. Tom's PSC handles the tax.
The cost to Curate Creative: £750 plus VAT (if Tom is VAT-registered) = £900 per day. Over 60 working days (3 months), that is £54,000. Tom's PSC nets approximately £600 per day after corporation tax and dividend tax.
IR35 for Recruitment Agencies
Recruitment agencies face unique IR35 challenges. You are typically the fee-payer in the chain. You pay the contractor's PSC. You carry the liability if the end-client gets the determination wrong.
The Recruitment Agency's Obligations
If you place a contractor with an end-client that is medium or large, you must:
- Obtain a copy of the SDS from the end-client before the engagement starts
- Check that the SDS is reasonable (you cannot simply accept it without review)
- Operate PAYE on payments to the contractor's PSC if the SDS says "inside IR35"
- Keep records of all SDSs for at least six years
If the end-client fails to provide an SDS, you must not pay the contractor's PSC until you have one. If you pay without an SDS, you assume the liability.
We have seen recruitment agencies in Leeds and Edinburgh caught out by this. A contractor starts work on Monday. The end-client promises the SDS "by Friday." The agency pays the contractor's PSC on Thursday. The SDS never arrives. HMRC later challenges the arrangement. The agency is liable for the unpaid tax and NICs.
Umbrella Companies and IR35
Some contractors use umbrella companies to manage their tax affairs. The umbrella company employs the contractor and handles PAYE. This removes the IR35 liability from your agency, but it creates other risks.
Not all umbrella companies are compliant. Some engage in tax avoidance schemes. If your agency refers contractors to a non-compliant umbrella, HMRC can pursue you for facilitating tax avoidance.
We recommend using only umbrella companies that are members of the FCSA (Freelancer and Contractor Services Association) or equivalent accreditation bodies. Check their compliance status before referring any contractor.
IR35 for Creative and Digital Agencies
Creative and digital agencies often engage freelancers for specific projects. A web designer for a two-week sprint. A copywriter for a campaign. A videographer for a shoot. These engagements are usually outside IR35 because they lack the control and mutuality of obligation that characterise employment.
But not always.
When Freelancers Become Deemed Employees
If your agency engages the same freelancer repeatedly, the relationship can drift into IR35 territory. A copywriter who works for you three days a week, every week, for 18 months, using your briefs and your tools, is likely inside IR35 regardless of the contract terms.
HMRC looks at the reality of the relationship, not the paperwork. If the freelancer is effectively part of your team, working alongside your employees, taking direction from your creative director, and using your equipment, they are a deemed employee.
We have seen this happen at a web design agency in Leeds. They engaged a developer on a rolling contract for two years. The contract said "outside IR35." The reality was inside. HMRC assessed the agency for £63,400 in back taxes and NICs.
If you regularly engage the same freelancers, review the arrangement annually. Consider whether the relationship has changed. If it has, adjust the determination or bring the freelancer onto payroll.
Project-Based Work and Scope Creep
Project-based work is generally safer from an IR35 perspective, but scope creep can change the nature of the engagement. A fixed-price project that expands into an ongoing retainer relationship moves the needle toward employment.
We recommend setting clear project boundaries in your contracts. Use a statement of work (SOW) for each engagement. If the scope changes, issue a new SOW rather than letting the original contract drift.
Fee-Payer Responsibilities and PAYE Operation
When a contractor is inside IR35, the fee-payer must operate PAYE on payments to the contractor's PSC. This is not optional. The fee-payer is responsible for deducting income tax and NICs and reporting them to HMRC through RTI (Real Time Information).
How to Operate PAYE on a Contractor's PSC
You need to:
- Register as an employer with HMRC (if you are not already)
- Add the contractor to your payroll software
- Calculate the deemed employment payment each pay period
- Deduct PAYE and NICs
- Report through RTI on or before the payment date
- Pay HMRC monthly (usually by the 22nd of the following month)
The deemed employment payment is the amount paid to the contractor's PSC, minus any allowable expenses. Allowable expenses are limited. You cannot deduct the contractor's travel and subsistence costs unless the contractor is working at a temporary workplace (which is rare for long-term engagements).
Most payroll software handles this automatically. We recommend BrightPay or Xero Payroll for agencies. Both handle deemed employment payments correctly.
The Apprenticeship Levy
If your agency's total pay bill (including deemed employment payments) exceeds £3M per year, you must pay the Apprenticeship Levy at 0.5% of the total pay bill. This catches many agencies that engage large numbers of contractors.
For example, a recruitment agency in Soho with 20 employees and 50 contractors inside IR35 could easily exceed the £3M threshold. The levy applies to the total pay bill, not just the employee portion.
IR35 Penalties and HMRC Investigations
Getting IR35 wrong is expensive. HMRC can assess back taxes, interest, and penalties. The penalties depend on whether HMRC considers the error to be careless or deliberate.
Penalty Tiers
| Error Type | Maximum Penalty | Typical Scenario |
|---|---|---|
| Careless | 30% of tax due | Honest mistake, no process in place |
| Deliberate but not concealed | 70% of tax due | Ignored advice, no SDS issued |
| Deliberate and concealed | 100% of tax due | Falsified records, hidden payments |
HMRC also charges interest on late-paid tax at the Bank of England base rate plus 2.5%. For a large assessment, interest alone can run into thousands.
What HMRC Looks For
HMRC's IR35 compliance teams focus on:
- Engagements where no SDS exists
- Engagements where the SDS says "outside IR35" but the reality looks like employment
- Engagements with the same contractor for more than 12 months
- Engagements where the contractor works exclusively for one client
- Agencies that use blanket "outside IR35" determinations
If HMRC opens an investigation, they will request:
- All SDSs for the period under review
- Contracts between your agency and contractors' PSCs
- Contracts between your agency and end-clients
- Timesheets and invoices
- Email correspondence about the working arrangements
- Your IR35 process documentation
We recommend keeping all IR35-related records for at least six years after the engagement ends. HMRC can go back further if they suspect deliberate non-compliance.
Action Checklist for Agency Founders
Here is what you should do this week, this quarter, and this year to protect your agency from IR35 risk.
This Week
- Review every contractor engagement currently active in your agency
- Confirm that an SDS exists for each engagement where the end-client is medium or large
- If no SDS exists, request one from the end-client immediately
- Do not pay any contractor PSC invoices until the SDS is received
This Quarter
- Document your IR35 process in writing
- Train your team on the off-payroll rules
- Review your contracts with end-clients to clarify who issues the SDS and who bears liability
- Review your contracts with contractors' PSCs to ensure they reflect the working reality
- Consider using IR35 insurance (available through Qdos, Kingsbridge, or Hiscox)
This Year
- Conduct a full IR35 audit of all contractor engagements from the past three years
- Review any long-term contractor relationships (over 12 months) for signs of drift into employment
- Update your processes for any changes in the off-payroll rules
- Speak to an ICAEW-qualified accountant about your specific situation
We help agency founders with IR35 compliance as part of our agency accounting services. If you need a review of your current contractor engagements, get in touch.