IR35 Compliance for UK Startups: Complete Guide to Assessments, Payroll, and Risk

Understanding IR35 Compliance for UK Startups

Hiring specialist contractors is often the only way a startup can access the skills needed to build an MVP, find product-market fit, or scale a go-to-market team. It's a flexible, capital-efficient way to grow. Yet, for UK-based companies, this flexibility comes with a significant compliance challenge: the off-payroll working rules, commonly known as IR35. For more background, see our hub on contractor classification. Getting this wrong can lead to unexpected tax bills, interest, and penalties from HMRC, creating a serious risk for a startup managing its runway.

The reality for most pre-seed to Series B startups is more pragmatic: IR35 isn't an obstacle to be feared, but a process to be managed. This guide explains how to comply with IR35 as a UK startup, protecting your cash flow and satisfying investor due diligence without needing an in-house tax expert.

First, Do You Even Need to Worry? The Small Company Exemption

Before diving into complex assessments, the first question is whether the off-payroll working rules apply to your startup. Many early-stage businesses are exempt under the 'small company' exemption. If your startup qualifies, the responsibility for determining IR35 status remains with the contractor's limited company, not with you as the client.

So, what defines a small company for IR35 purposes? According to UK law, a company is classified as small if it meets at least two of the following criteria for two consecutive financial years:

• Turnover of £10.2 million or less
• Balance sheet total of £5.1 million or less
• 50 or fewer employees

This definition comes from the Companies Act 2006, Section 382. For most pre-seed and seed-stage startups, this exemption provides crucial breathing room. However, it is vital to monitor these figures as you scale, especially at the end of each financial year. Rapid growth in a SaaS or E-commerce business can quickly push you over these thresholds.

Planning Your Transition

The rules don't switch on overnight. The off-payroll working rules apply from the start of the tax year after your company has met the medium or large size criteria for two consecutive years. This means you have a grace period to prepare your systems. For example, if your startup first exceeds the small company thresholds in your financial year ending 31 December 2024, and again in the year ending 31 December 2025, the rules will apply to you from the start of the next tax year, which is 6 April 2026.

Use this time to establish an internal process for assessment and adapt your payroll systems. Planning for this transition is a key part of managing your approach to hiring contractors UK wide and preventing future compliance headaches.

The Core IR35 Determination Process: Creating a Defensible Record

Once your startup no longer qualifies for the small company exemption, the legal responsibility for determining a contractor's employment status for tax purposes shifts to you. This is the core of how to comply with IR35 as a UK startup. You cannot simply ask the contractor for their opinion. You must conduct an objective assessment and produce a formal document called a Status Determination Statement (SDS).

The SDS is more than a simple declaration; it is your evidence that you have taken 'Reasonable Care' in making your decision. It must state whether the contractor is 'inside' IR35 (treated as an employee for tax) or 'outside' IR35 (a genuine business-to-business service) and clearly outline the reasoning behind that conclusion. This document is your primary defence against penalties by creating an auditable record of your IR35 determination process.

To make a determination, you must consider the reality of the working relationship. HMRC IR35 guidance focuses on three key tests of employment status.

1. Control: Who Directs the Work?

Control refers to who directs what, when, where, and how the work is done. If your startup exercises significant control over the contractor, it points towards an employment-like relationship ('inside IR35'). Ask yourself:

• Do you set fixed working hours or require them to work from your office?
• Do they need to seek permission for time off?
• Do you manage their day-to-day tasks with detailed instructions, rather than providing a high-level brief?
• Are they required to attend mandatory company meetings or training?

If you provide a high-level brief and the contractor determines their own methods, tools, and schedule to deliver the agreed outcome, that suggests a genuine contractor relationship ('outside IR35').

2. Right of Substitution: Can Someone Else Do the Job?

Does the contractor have a genuine, unfettered right to send a qualified substitute to perform the work in their place? This is a strong indicator of being a separate business. While many startups hire a specific individual for their unique skills, the contractual right must exist and be plausible. If the contract explicitly forbids substitution, or if the reality of the role makes it impossible, it points towards an 'inside IR35' employee status assessment.

3. Mutuality of Obligation (MOO): Is There an Ongoing Commitment?

Mutuality of Obligation assesses whether there is an ongoing obligation for you to offer work and for the contractor to accept it. In a true contractor arrangement, the relationship is project-based and ends when the specific deliverables are complete. There is no expectation of further work. If the engagement feels like a rolling contract with no clear end date, resembling a permanent role, MOO likely exists. This strongly suggests an 'inside IR35' status.

IR35 Determination Process Examples

Here are two contrasting scenarios to illustrate the employee status assessment in practice:

• 'Outside IR35' Scenario (Deeptech Startup): A company hires a specialist machine learning engineer for a six-month project to develop a specific algorithm. The contract features a clear statement of work, defined deliverables, and a project-based fee. The engineer uses their own high-powered laptop, works remotely on their own schedule, and has the contractual right to bring in a colleague to assist. This combination of low control, a defined project scope, and a right of substitution points strongly to an 'outside IR35' status.
• 'Inside IR35' Scenario (Professional Services Startup): A consulting firm brings on a project manager for an open-ended engagement to manage a key client account. They are given a company laptop, a company email address, and are required to be on-site at the client's office three days a week. They manage a team of the firm's junior employees and report to a Partner. This high degree of integration, control, and ongoing obligation makes this an 'inside IR35' role.

While HMRC provides an online tool (CEST) to help with assessments, it is merely a guide and has been criticised for its limitations, particularly regarding MOO. A scenario we repeatedly see is startups relying solely on a CEST result without documenting the 'why' in a detailed SDS, which leaves them exposed during an inquiry.

Payroll and Budgeting for 'Inside IR35' Contractors

Once you determine a contractor is 'inside IR35', your operational and financial processes must adapt. You can no longer pay the gross invoice from their limited company via accounts payable. Instead, you must process this payment through your payroll as a 'deemed employment payment'. This is a critical part of startup payroll compliance where mistakes can be costly.

For a founder or operations lead using accounting software like Xero, the workflow looks like this:

1. Onboarding: You add the contractor to your payroll system, selecting the specific 'off-payroll worker' category. This flags them for the correct tax treatment.
2. Invoice Processing: The contractor submits their monthly invoice as usual, for example, for £6,000.
3. Payroll Calculation: Instead of paying the full £6,000, you input this gross figure into the payroll run. The system automatically calculates and deducts PAYE (income tax) and Employee's National Insurance contributions.
4. Payment & Reporting: The net amount after deductions is paid to the contractor's personal bank account, not their business account. You then submit this information to HMRC via your standard payroll filing (RTI).

Budgeting for the True Cost of Contractor Tax Obligations

The most significant financial impact comes from a cost your startup must bear directly. On top of the contractor's fee, you are liable for Employer's National Insurance Contributions (NICs). "Employer's National Insurance is currently 13.8%." This is not deducted from the contractor's fee; it is an additional cost to your business and a direct hit to your cash flow if unplanned.

For a £6,000 invoice, the total cost to your business is actually £6,000 + (£6,000 x 13.8%) = £6,828. For a startup focused on runway, this unexpected 13.8% can be a serious problem. Proper budgeting for these contractor tax obligations is a non-negotiable part of IR35 compliance. When modelling your finances, always add this cost for any role you anticipate will be inside IR35. Founders of US companies managing UK contractors should also familiarise themselves with these rules, which differ significantly from the US framework discussed in our W-2 vs 1099 guide.

Managing Risk: What 'Reasonable Care' Looks Like

Compliance is not just about getting the determination right; it is about proving you took the process seriously. HMRC's standard for this is 'Reasonable Care'. Demonstrating reasonable care is your primary defence against penalties if a determination is later challenged and found to be incorrect. An honest mistake made with a robust process is viewed far more leniently than a determination made carelessly or to deliberately avoid tax.

For a startup without a dedicated finance team, reasonable care involves several key actions:

• Individual Assessments: Never apply a blanket policy like "all our developers are outside IR35." Each engagement is unique and must be assessed on its own specific facts and working practices.
• Documented Process: Create a simple, written policy for how you conduct an employee status assessment. It should outline who is responsible, the factors they consider, and where records are kept.
• Thorough Record-Keeping: For every contractor, maintain a dedicated file. This should contain the contract, the signed SDS, and any notes or evidence you used to reach your conclusion. This creates a clear audit trail.
• Appropriate Expertise: The person making the determination must have a solid understanding of the IR35 rules and the actual day-to-day work involved. This could be a founder or an operations lead, but they must be properly informed.
• Process for Disagreements: The law requires you to have a clear process for a contractor to challenge a determination they believe is incorrect. You must respond to a challenge within 45 days.
• Periodic Reviews: A contractor's working practices can change over time. A role that starts as 'outside IR35' can evolve into an 'inside IR35' position through scope creep. Review engagements periodically, such as upon contract renewal, to ensure the determination remains accurate.

Taking these steps is fundamental to how to comply with IR35 as a UK startup. The risk is not just financial. During fundraising, investor due diligence teams will scrutinise your contractor arrangements. A messy, undocumented approach to IR35 is a significant compliance red flag that can complicate or even derail a funding round.

Practical Takeaways for Founders

Navigating IR35 compliance can seem daunting, but it boils down to a manageable process. For founders focused on growth, getting this right is about building a scalable and resilient operational foundation.

1. Confirm Your Status First: Use the small company exemption criteria to determine if the off-payroll working rules apply to you yet. Check your turnover, balance sheet total, and employee count. If you are exempt, diarise to monitor these figures at the end of each financial year.
2. Build a Repeatable Process: If the rules apply, create a simple IR35 determination process. Document who is responsible and which factors they will consider based on the key tests of control, substitution, and MOO.
3. Budget for the True Cost: For any role you assess as 'inside IR35', immediately add at least 13.8% to the contractor's fee in your financial model to cover Employer's National Insurance. This avoids a nasty surprise to your cash flow.
4. Document Everything: The Status Determination Statement (SDS) is your most important piece of evidence. Ensure one is completed, signed by both parties, and stored for every contractor engagement, along with the corresponding contract.

For startups that prefer to outsource these complexities, engaging with a UK-based Professional Employer Organisation (PEO) can be an effective solution. Ultimately, hiring contractors remains a powerful tool for scaling your startup. By implementing a clear process, you can manage the risks effectively, satisfy investors, and focus on building your business. Continue your learning at our contractor classification hub.

Frequently Asked Questions

Q: What happens if a contractor disagrees with my IR35 determination?
A: The contractor has the right to challenge your Status Determination Statement (SDS). You are legally required to review their challenge and respond within 45 days, either by upholding your original decision with further reasoning or by issuing a new SDS. A clear, documented disagreements process is a key part of showing reasonable care.

Q: Can I just classify all contractors as 'inside IR35' to be safe?
A: While this may seem like a low-risk approach, it is not recommended. It can make it harder and more expensive to attract top contractor talent who expect to operate as a business. Furthermore, HMRC requires you to take reasonable care to make an accurate determination for each engagement, not apply a blanket policy.

Q: How often should I review a contractor's IR35 status?
A: It is good practice to review a contractor's IR35 status at key milestones, such as a contract extension or a significant change in their working practices or responsibilities. An engagement that started as 'outside IR35' can evolve over time, so periodic reviews help ensure your employee status assessment remains accurate.

Q: Does IR35 apply if my contractor works through an umbrella company?
A: If a contractor works through a compliant umbrella company, the IR35 rules typically do not apply to you as the end client. The umbrella company becomes their employer, handling all PAYE tax and National Insurance deductions. This can be a simpler administrative option for roles that are clearly 'inside IR35'.