Understanding Employment Status and IR35: A Practical Guide for Freelancers and Small Businesses

Introduction 

If you run a small business or work as a freelancer, one of the trickiest areas of tax and employment law is understanding when someone is self-employed and when they’re an employee, and how the IR35 rules fit into that picture. 

This confusion isn’t just academic – it affects how you pay tax, how much National Insurance you owe, and the legal rights and responsibilities on both sides of the working relationship. 

In this guide, I’ll explain in plain language how HMRC and employment law treat freelancers, consultants, and contractors – both when they work directly with clients and when they work through a personal service company (PSC). We’ll also look at the April 2021 IR35 reforms, why they matter, and what both clients and contractors should be doing now to stay compliant. 

Section A: Employment or Self-Employment – Why It Matters 

When you engage a freelancer, it’s tempting to assume that calling someone “self-employed” or using a contractor agreement automatically makes it so. Unfortunately, that’s not how the law sees it. 

In the eyes of HMRC and employment tribunals, the reality of the relationship matters more than the label. A written “contract for services” helps, but it won’t override the facts on the ground if the working arrangement looks and feels like employment. 

Key Legal Distinction 

• An employee works under a contract of employment – they’re part of the organisation, subject to control, entitled to holiday pay, sick pay, and other employment rights. 
• A self-employed contractor works under a contract for services – they run their own business, control how and when they work, and bear some financial risk. 

Why It Matters for You 

1. Tax and National Insurance:
   Employees have tax and NIC deducted at source through PAYE. Self-employed individuals pay their own tax under Self Assessment and usually pay lower NICs. HMRC is alert to “false self-employment” – especially where the freelancer has only one client. 
2. Employment Rights:
   Employees enjoy protections like unfair dismissal rights, paid holidays, redundancy pay, and pension access. Freelancers don’t – though equality laws and health & safety protections may still apply. 
3. Legal Liability:
   Even if you classify a worker as “self-employed,” you could still be responsible for their actions or face tax liabilities if HMRC later decides they were effectively an employee. 

How to Tell the Difference 

There’s no single test, but tribunals and HMRC typically look at three key indicators: 

1. Control and Mutual Obligations

If you tell the worker when, where, and how to work – and you’re obliged to provide work that they’re obliged to do – that points to employment. 

2. Personal Service

If the individual must personally carry out the work and can’t send a substitute, that also suggests employment. If they genuinely can send someone else (and have done so before), that leans towards self-employment. 

3. Business Risk and Independence

Self-employed workers are more likely to: 

• Provide their own tools or equipment 
• Set their own hours and pricing 
• Work for multiple clients 
• Be responsible for fixing unsatisfactory work at their own cost 
• Make a profit or a loss 

If most of that applies, the worker is probably self-employed. 

A Quick Comparison 

Indicator	Employee	Self-Employed Contractor
Must perform work personally	✅	❌ (can send substitute)
Controlled by client	✅	❌ (decides how/when work is done)
Provides own equipment	❌	✅
Bears financial risk	❌	✅
Paid by time worked	✅	❌ (paid per project)
Works for multiple clients	❌	✅
Can profit or lose money	❌	✅

Employee Rights (If They Apply) 

If someone is found to be an employee, they’re automatically entitled to: 

• Paid annual leave 
• Sick pay and maternity/paternity rights 
• Redundancy and unfair dismissal protections 
• Notice of termination 
• Minimum wage compliance 
• Health and safety protection 
• Statutory pension contributions 

Even if you meant to hire a freelancer, HMRC or an employment tribunal can retrospectively impose these obligations if the working relationship looked like employment in practice. 

Section B: Working Through an Intermediary – Understanding IR35 

IR35 is HMRC’s shorthand for the “intermediaries legislation”, first introduced in 2000. It’s designed to stop people avoiding employment taxes by working through a company they control – typically a Personal Service Company (PSC). 

What’s a Personal Service Company? 

A PSC is usually a limited company set up and controlled by the contractor (often as sole director/shareholder) to supply their services. The PSC invoices clients and then pays the contractor a small salary and larger dividends – reducing PAYE and NIC liabilities. 

What IR35 Does 

If, ignoring the PSC, the contractor would realistically be treated as an employee of the client, then IR35 applies. The engagement is then deemed to be “disguised employment,” and PAYE and NIC must be operated as if the worker were employed. 

Put simply: 

If it walks like employment and talks like employment, HMRC will tax it like employment. 

How IR35 Is Tested 

The same principles apply as above: control, personal service, and mutual obligation. If the worker is required to do the work personally, under direction from the client, with no business risk, IR35 likely applies. 

A genuine right of substitution, a project-based fee structure, or use of own tools may indicate the opposite. 

Section C: The 2021 IR35 Reforms 

The biggest shake-up came in April 2021, shifting the responsibility for determining IR35 status away from the contractor’s company and onto the client – except where the client is “small.” 

Who Makes the Call Now 

• Public Sector: Since 2017, public bodies (not the PSC) have been responsible for assessing IR35 and deducting PAYE where necessary. 
• Private Sector (post-2021): Medium and large private companies must now also make this determination and, if IR35 applies, operate PAYE when paying the PSC. 

Small Company Exemption 

Private-sector clients are exempt if they meet two or more of the following: 

• Turnover under £10.2m (rising to £15m for the 2026 tax year) 
• Balance sheet under £5.1m (rising to £7.5m) 
• Fewer than 50 employees 

For “small” clients, the responsibility to apply IR35 stays with the contractor’s PSC. 

The Status Determination Statement (SDS) 

Medium and large businesses must issue a written Status Determination Statement to both the contractor and any agencies involved, explaining whether IR35 applies and why. 

They must: 

• Make determinations individually (no blanket rulings) 
• Take “reasonable care” (typically involving professional advice) 
• Provide a process for contractors to dispute the decision (a “status disagreement process”) 

If they fail to follow the rules, liability for PAYE and NIC can fall back on them – even if payments were made through another intermediary. 

Key Impacts of the 2021 Changes 

For clients: 

• More admin – you must identify PSCs in your supply chain and issue SDSs. 
• Potential tax risk – errors can lead to PAYE liabilities. 
• Possible renegotiation of rates, as gross pay becomes net of tax. 

For contractors: 

• Less flexibility – some clients no longer engage PSCs at all. 
• Lower take-home pay where IR35 applies. 
• Need for open discussion with clients and clear contract wording. 

Section D: Practical Steps for Businesses and Freelancers 

Whether you’re hiring freelancers or working as one, it’s vital to review your setup and paperwork. Here’s how to stay on the right side of both employment law and HMRC. 

If You Engage Freelancers 

1. Identify how they operate: Are they sole traders, agencies, or PSCs? 
2. Review each engagement individually: The same person could be outside IR35 for one project but inside for another. 
3. Use robust contracts: Avoid employment-style terms (e.g. fixed hours, holiday pay). Focus on project outcomes, substitution rights, and independence. 
4. Issue SDSs if you’re medium or large and engage PSCs. 
5. Keep records: Contracts, SDSs, and correspondence should be retained in case of HMRC review. 
6. Consider legal advice: The cost of a short consultation is far less than the risk of backdated tax and NIC. 

If You’re a Freelancer or Contractor 

1. Understand your clients: If they’re small, the IR35 risk remains with you; if large, they must assess you. 
2. Check contracts: Ensure they’re written as “contracts for services” with real autonomy and a genuine right of substitution. 
3. Use the HMRC CEST Tool cautiously – it’s not foolproof but can help guide you. 
4. Keep evidence: Multiple clients, your own equipment, insurance, and invoicing all support a genuine business relationship. 
5. Review your PSC setup: Consider salary/dividend balance, expenses, and professional indemnity cover. 

Common Mistakes to Avoid 

• Assuming a contract label decides status – it doesn’t. 
• Ignoring IR35 because “we’re small” – confirm that exemption applies every year. 
• Using old templates – contracts written before 2021 often miss new IR35 obligations. 
• Failing to issue or challenge an SDS – HMRC can reassign liability for tax to you. 

The Bottom Line 

Employment status and IR35 sit at the intersection of tax and employment law – complex, often confusing, and constantly evolving. But the core principle remains simple: 

If a working relationship looks like employment, HMRC will treat it like employment. 

With the 2021 reforms now well embedded, both contractors and businesses need to make compliance part of their normal onboarding process, not an afterthought. 

Call to Action 

At CCM | Carter Collins & Myer, we help small businesses and freelancers navigate employment status and IR35 with clear, practical advice – reviewing contracts, identifying risks, and setting up compliant processes that protect you from future tax surprises. 

Get in touch if you’re unsure whether your freelance arrangements pass HMRC’s tests, or if you’d like us to review your contracts and IR35 policies before the next financial year.