How UK startups convert contractors to employees safely under IR35: five-step guide

Converting UK Contractors: An IR35-Safe Process

For many UK startups, particularly in sectors like SaaS, Biotech, and Deeptech, relying on contractors is standard practice for getting off the ground. It offers flexibility when cash flow is tight and project needs are fluid. However, as a contractor becomes more integrated into daily operations, their role can blur into that of an employee, creating significant compliance risk under IR35 legislation. The transition from a flexible workforce to a stable team often brings the challenge of how to move contractors to employees under IR35 without triggering financial penalties or legal missteps. This is not just a compliance issue; it’s a crucial step in building a scalable, fundable company, directly impacting your runway and operational stability.

The Litmus Test: Is Your Contractor Actually a 'Deemed Employee'?

Before you can solve an IR35 problem, you need to know if you have one. IR35, also known as the off-payroll working rules, is designed by HMRC to ensure that individuals who work like employees are taxed like them. If a contractor's working relationship with your company mirrors that of an employee, they are considered a 'deemed employee' for tax purposes. The responsibility for this determination lies with you, the hiring company. Misclassifying contractors exposes the company to back taxes, penalties, and even personal liability for founders, presenting a major legal risk of misclassification.

The critical distinction to make is between the wording of a contract and the actual working reality. HMRC will always prioritise the day-to-day facts of the relationship over contractual terms. The three primary tests for determining UK employment status rules are:

1. Control: How much say do you have over how, when, and where the contractor works? If you set their working hours, require them to be at daily stand-ups, and direct the specifics of their tasks rather than just the outcome, this points towards an employer-employee level of control. For a startup, this could mean dictating the coding standards and daily schedule for a freelance developer.
2. Right of Substitution: Does the contractor have a genuine right to send a qualified substitute to do the work in their place? If they must seek your permission, or if the reality is that you are hiring them for their specific personal skills, a genuine right of substitution does not exist. For a core developer in a Deeptech startup, this is rarely a practical possibility as their unique expertise is the reason for the engagement.
3. Mutuality of Obligation (MOO): Is there an ongoing obligation for you to offer work and for the contractor to accept it? If a contractor has worked exclusively for you for over a year on a rolling basis, a mutuality of obligation is likely to have been established. This moves the relationship beyond a simple project-based engagement into something that looks more like continuous employment.

If your relationship with a contractor ticks these boxes, you are likely facing an IR35 compliance risk. For companies with operations in the United States, see our guide on W-2 vs 1099 worker classification, as the rules differ significantly.

The Financial Reality Check: Contractor Day Rate vs. 'Fully Loaded' Employee Cost

The immediate obstacle for many founders is the perceived cost increase of conversion. The jump in payroll costs can strain cash flow if not budgeted for precisely. However, the financial difference between a contractor's day rate and the 'fully loaded' cost of an employee is often less than it appears when you analyse all the components.

A contractor's day rate is an all-inclusive figure that covers their own taxes, insurance, and benefits. An employee's cost, in contrast, is composed of their gross salary plus several mandatory on-costs. A scenario we repeatedly see is founders underestimating these additional expenses. The 'fully loaded' cost includes:

• Gross Salary: The agreed-upon annual pay before any deductions.
• Employer's National Insurance Contributions (NICs): For the 2024/25 tax year, this is 13.8% on most employee earnings above £9,100 per year. For a full breakdown, see this Deloitte analysis.
• Employer Pension Contributions: Under UK Auto-Enrolment law, the minimum employer pension contribution is 3% of qualifying earnings. Details can be found via The Pensions Regulator.
• Paid Leave: You must account for the cost of paid time off. The minimum statutory holiday entitlement for employees is 5.6 weeks per year under UK Employment Law.
• Other Costs: This category includes benefits like private health or life insurance, software licences, equipment provision, and potentially the Apprenticeship Levy for larger companies with a pay bill over £3 million a year, as specified by HMRC.

The basic formula to estimate this is: Fully Loaded Cost = Gross Salary + Employer's NICs + Pension Contributions + Other Benefits & Equipment Costs

To illustrate, let's compare a senior developer. As a contractor on a £600 day rate working 220 days a year, their total fee would be £132,000. Now, consider hiring them as an employee with a £100,000 gross salary. The 'fully loaded' cost would be approximately £117,816. This includes £12,544 in Employer's NICs, £2,772 in minimum pension contributions, and an estimated £2,500 for other benefits. In this common scenario, the permanent employee is more cost-effective annually, before even factoring in the long-term value of stability, team integration, and their eligibility for valuable incentive schemes like EMI options.

The 5-Step Playbook for How to Move Contractors to Employees Under IR35

Once you have determined a contractor needs to be converted and have budgeted for the cost, you need a watertight process. Translating complex IR35 rules into a clear contractor to employee transition is essential. Following these IR35 compliance steps provides a safe and structured pathway for onboarding employees from contractors.

Step 1: Conduct and Issue a Status Determination Statement (SDS)

Before making any changes, you must formally assess the contractor's employment status for tax purposes. The Status Determination Statement (SDS) is a legal document that declares your decision and the reasoning behind it. This assessment should be based on the tests of Control, Substitution, and MOO. This isn't just an internal memo; it's a critical piece of evidence demonstrating you have exercised 'reasonable care', which is vital for UK employment status rules. You must provide a copy of the SDS to the contractor, as it formalises your position.

Step 2: Have a Commercial Conversation and Agree on New Terms

The next step is a transparent conversation about the future. This is a negotiation, not a directive. You should discuss the new role, which will now be a permanent position, and agree on a salary and benefits package. Use your 'fully loaded' cost analysis to frame the salary negotiation, showing how the gross salary figure relates to their previous day rate. You will also need to agree on a start date for the employment contract and a corresponding end date for their existing contractor agreement. Be prepared to explain the benefits of employment, such as paid holiday, sick pay, pension contributions, and potential equity.

Step 3: Formalise the Legal Documentation

This is where legal precision is key. You must terminate the existing contract for services correctly, adhering to its notice period to create a clean break. Simultaneously, you must issue a bona fide employment contract, known as a 'contract of service'. Do not simply re-badge the old agreement. A proper employment contract includes clauses on duties, place of work, hours, holiday entitlement, and disciplinary procedures that are fundamentally different from a service agreement. Using compliant templates from providers like SeedLegals can help ensure you meet UK startup requirements. Getting this distinction right is central to a successful transition.

Step 4: Execute Payroll Setup for Former Contractors

Operationally, you must add the individual to your company's payroll system before their first payday as an employee. This involves registering them with HMRC through the PAYE (Pay As You Earn) system. Your payroll software, whether it's the payroll module in Xero or a dedicated platform like Pento, will handle the necessary calculations for income tax and National Insurance. This information must be submitted to HMRC via Real Time Information (RTI) reporting on or before each payment date. This marks the practical difference between processing a contractor's invoice and an employee's payslip. For businesses considering outsourcing this function, our PEO guide offers relevant insights, though it focuses on US options.

Step 5: Adjust Day-to-Day Working Practices

This final step is arguably the most important for cementing the new relationship in HMRC's eyes. The individual must now be treated like any other employee. This is not just a paperwork exercise. This means including them in performance reviews, all-hands meetings, benefits programmes, and internal communication channels. For example, instead of submitting a monthly invoice for approval, they will now receive a monthly payslip and be added to the company-wide holiday booking tool. This change in daily operations is the ultimate proof that the conversion is genuine, completing the process of how to move contractors to employees under IR35.

Practical Takeaways for Startups by Funding Stage

Proactively managing the contractor to employee transition is a sign of operational maturity that derisks your business for future funding rounds and protects it from HMRC scrutiny. Your approach should be tailored to your startup's stage.

For Pre-Seed to Seed Stage Startups

At this stage, your focus is on awareness. You might only have a few core contractors, but the legal risks of misclassification still apply. The key is to regularly review these relationships against the IR35 tests. If a contractor has been with you for over six months and is integral to your MVP development or initial go-to-market strategy, start planning for conversion. Build a 'fully loaded' cost estimate into your 18-month financial forecast in an accounting tool like Xero. While the immediate risk of an HMRC investigation is lower, misclassification can become a significant due diligence issue in your next funding round.

For Series A and B Startups

For most startups at this stage, proactive conversion becomes non-negotiable. Investors and their legal teams will scrutinise employment arrangements during due diligence. A clear process for onboarding employees from contractors should be in place and well-documented. Your payroll systems should be robust, and you should have a clear understanding of your total payroll liabilities. At this scale, the financial and legal exposure of getting it wrong is significant. Having a clean, compliant team structure is table stakes for securing growth-stage funding. Ignoring IR35 is no longer an option; it's a liability on your balance sheet.

Ultimately, this transition is about more than just compliance. It's about building a committed, integrated team to scale your business. For broader guidance on this topic, visit our contractor classification hub.

Frequently Asked Questions

Q: What if a contractor refuses to become an employee?
A: If your IR35 assessment determines they are a 'deemed employee', you cannot continue the engagement on a contract basis without significant risk. You must either negotiate new terms for a compliant arrangement, such as a true business-to-business service, or end the relationship, adhering to the contract's notice period.

Q: Is there a time limit for using a contractor before IR35 applies?
A: No specific time limit, such as six or twelve months, automatically triggers IR35. Status is determined by the reality of the working relationship, not its duration. However, a long-term engagement often leads to deeper integration and mutuality of obligation, increasing the likelihood of falling inside IR35.

Q: Can we keep a contractor if we just change the contract terms?
A: Amending a contract is insufficient if the day-to-day working practices remain unchanged. HMRC prioritises the actual working reality over the written agreement. For a genuine contractor relationship, the individual must have real autonomy, the right of substitution, and no mutuality of obligation in practice, not just on paper.

Q: Does providing a laptop automatically make someone an employee?
A: Not in isolation, but it contributes to the overall picture. Providing essential equipment is a factor that points towards employment. If you also dictate working hours, manage tasks closely, and integrate the person into your team structure, providing equipment strengthens HMRC's case for 'deemed employment'.