In Part I of the IR35 mini-series we talked about the current state of contracting and the IR35 mess. We covered some pros and cons of being a contractor and how it compares with being a permie.

It’s now time to talk numbers. The math will hopefully help you decide whether IR35 has made contracting worth continuing. The answer, as usual, is: it depends! Before we dive in, first some definitions. What do we mean by Outside IR35, Inside and Perm:

Outside IR35: The pre-2020 contracting landscape. You operate as a limited company that pays corporation tax and personal income tax. You have the freedom to choose your taxes based on how much you want to withdraw as salary/dividends from your company. Also, business expenses can be claimed.

Inside IR35 / Umbrella: You still operate as a contractor through your limited company or through an umbrella. The take-home pay amounts between inside IR35 and umbrella are very similar. You are taxed more than a permanent employee. That’s because you have to pay both yours and the Employer’s National insurance. 

You’re not paid while drinking Pina Coladas on the beach or when sick (except a small amount of Statutory pay).

Your gross pay is usually higher than a perm to compensate for these plus all other minuses that come with contracting, like void periods, short notice period, accounting, DIY pension etc. You don’t get to choose when to withdraw your profits, as everything is taxed at source and you must take all income home now.

Permanent employee (perm): The majority of the workforce belongs here. The usual employee of a company, who belongs to the company payroll, has a salary that lands in your bank account each month no matter what. Entitled to holidays, sickness pay, and potentially other benefits such as pension, training and mandatory performance reviews.

How much will IR35 cost me Inside IR35 or Umbrella?

This is the most common question. People switching from Outside IR35 to Inside or Umbrella want to know how much income they will lose.

For starters, we assume that the Outside IR35 contractor takes all income home and leaves nothing in the company.

Taking all income out is not the most tax-efficient way to deal with your company money. But it’s a good baseline so let’s start with that. The following graph shows the take-home pay Outside IR35 compared to Inside IR35/Umbrella at the same rate.

The higher the rate the more it will cost you to transition from outside IR35 to inside IR35. But it’s not that bad. (hint: it gets worse).

So in most cases, a contractor will lose anywhere between 15% to 20% of their take-home income. Here’s a graph, showing the percentage difference for the given rates.

Punchline: For tax-inefficient contractors who take all money home, the difference between Outside IR35 -> Inside IR35 (or Umbrella) is between 15-20%.

What if you switch to perm, instead? Let’s see how an Outside IR35 compares to the same gross income taken as a perm employee.

Cost of moving from Outside IR35 (All Out) to Perm

But a few people I know have abandoned contracting altogether and want to switch to perm. What would the impact be if we take the same gross income as a perm?

Here’s the take-home pay when taken as an Outside IR35 contractor vs the equivalent gross pay as a perm employee. I’ve used the salary calculator (link) to calculate the take-home pay of all perm salaries.

As you can see, going perm doesn’t make much of a difference. On £600 per day, for which the equivalent annual gross is £132,000, the difference is just £6,000 per year.

However, here’s the catch:

It is really hard to achieve the same gross income as a perm. Here is a table outlining the equivalent gross amount of a daily rate when charged annually (44 working weeks. 5w hols, 8d bank hols, 7d sick/void):

Do you see the problem? In my experience, a contractor on £300/day will find it really hard to find a job at £66,000. Similarly, one who earns £600/day won’t easily find a £132,000 perm salary, even if you account for things like pension and bonus.

And it makes sense from a risk point of view. As we explained in Part I of this IR35 series, as a contractor your client doesn’t provide months of leave notice, job security or any perks. You provide a service at a cost. You are a Capital Expenditure (CapEx budget).

As a perm, the company makes commitments to you which is why the equivalent gross pay is unrealistic. I don’t know exactly what the equivalent “discount” we need to apply here when switching from Outside IR35 to Perm. But I do know there is one. So the percentage difference is higher than the table above suggests – to some extent.

The difference is BIG when the contractor is tax-efficient

The gap between Outside IR35 and all the other options widens further if you’re a tax-efficient contractor.

I’m sure you know a lot of people who don’t take all the money home.

Most contractors I know will at least take advantage of the minimum salary/dividends payout. So they all withdraw a minimum salary and dividends up to the point that doesn’t cross the higher taxpayer threshold (£50,000 as of 2020).

I think we can all agree this is a good tax strategy assuming you have no other (unsheltered) income outside your LTD affairs. Why take more £50,000 a year and pay higher taxes if you can just leave the money in the company and just pay corporation tax? Assuming, of course, you can live on this amount.

To the extreme end of this spectrum, there are people like myself who invest their company money. I consider my LTD money as “take-home” because it can provide income for years to come when invested. Others just leave it in there in cash and at some point, they claim “Entrepreneur’s Relief” (if this is not scrapped soon). This means they will only pay 10% tax to take it out of the company.

This all means the take-home pay for Outside IR35 contractors can be different from person to person despite having the same daily rate.

Putting it all together we have the following groups:

1. All Out:  Some other people say I want all my capital in my pocket, therefore I’m happy to pay the extra dividend tax to do that. This means I’ll have to apply a 32.5% dividend tax on the money before it becomes “take-home”. All-out approach
2. Leave Surplus In strategy: Some, like me, consider the LTD surplus cash as “take-home” pay. Since you can invest the company money, the income/dividends will keep coming and I don’t need to (ever?) withdraw this surplus. So for the purposes of providing me income, the money is effectively take-home although it still belongs to the company. This is mathematically the most tax-efficient way.
3. Entrepreneurs Relief approach: Some others take an accumulative approach but with ER in mind. They say, I will only withdraw a minimum salary and dividends as everybody else does and I will leave the rest of the money in the company. When the sum is big enough, I will close the company down and claim Entrepreneur’s Relief by paying only 10% tax to make the money mine. I will call this approach the ER approach.

So for an Outside IR35 contractor who takes a £50,000 take-home and leaves the surplus in the company (on 10% tax, Entrepreneurs Relief) here is the difference in take-home:

That’s a BIG difference. So if you leave some money in the company, moving from Outside IR35 to inside IR35 is going to cost you 30% loss of income on £650 per day. It’s “just” 15% on £200 per day but can go up to 33% loss on £1000 per day.

A bit depressing if you’re an Outside IR35 on a high rate. The data don’t lie!

Putting it all together: Outside IR35 vs Inside IR35 & Umbrella vs Perm

If we put all possible options in one single graph, it looks like this:

And that’s all on the same gross pay!!!

So when people ask me whether converting from contracting to perm has a difference, the answer is: It depends on how well you handle your taxes. If you’re wise with taxes, then it makes a massive difference. As you can see, an Outside IR35 contractor on £500 per day, who Leaves Surplus In goes from £87,000 down to £70,000 (perm) or £62,400 (Umbrella). That’s a 30% drop in take-home income!

If you want to have a detailed look at the exact numbers, here’s the full table:

Even if you’re not working exactly 44 weeks and make the same assumptions as I do, the above table gives you a good indication. Here is a link to my spreadsheet which I used to calculate all the Outside IR35 take-home options. Use File -> Make a copy to edit the file, please do not request access to edit mine.

You may be wondering:

How can I improve my take-home pay if I cannot continue contracting Outside IR35? 

There are a few things you can do to improve your take-home pay.

1. Negotiate a rate increase
2. Contribute to your pension

Negotiating a rate increase can work sometimes but it’s a bit futile. If everyone is running around like a headless chicken, why would companies offer more? It’s a question of supply and demand really because I’m sure companies still need some flexible workforce to scale up and down quickly.

So we shall wait and see who needs who more :)

Contributing to your pension is a sure win from a tax point of view and makes the transition much smoother. That’s because your pension contributions are income-tax-free, NI-free and corporation tax-free. In the next article we are going to answer the following questions:

• How can I increase my take-home pay inside IR35, Umbrella or Perm?
• How much do I need to increase my rate inside IR35 to match my Outside IR35 take-home?

Calculation Notes:

1. A contractor works approximately the same weeks as a perm employee. Takes 5 weeks holidays, 8 days bank holidays, 7 days sickness/void periods between contracts. Total: 44 working weeks. 
2. All calculations were done for the Financial tax year 2019/20
3. No pension was added to either perm or contract. It can save both perm and contractors a lot of tax. Pension deserves its own chapter, which is why we’re going to have another article just on how to use pensions to extract more out of your salary.
4. Perm calculations include ALL benefits, bonus, overtime etc except pension.
5. Used my Outside IR35 Contractor calculator (Google Sheet) to calculate all take home styles
6. Inside IR35 calculations provided by Contractor Calculator – link
7. Salary (perm) calculations by The Salary Calculator – link

Contracting from April 2020 and beyond

You don’t have to be a contractor to realise the mess IR35 has recently caused to companies and people. The number of emails asking me what my plans are for 2020 confirms that. The government last year announced that in April 2020 the IR35 legislation will come into effect in the private sector.

What this means is that people who work through their limited companies will now pay higher taxes, as if their temporary employment is not really temporary (but PAYE). HMRC wants contractors (often called Personal Services Companies – PSC) to pay income tax, in fact, more tax than a permanent member of staff. (I promise the acronyms stop here :) ).

The tricky bit is that there are no clear guidelines as to what is a legitimate company or not. If I’m someone working 7 years in the same position in the office for a “client” you’d think I should be an employee, right? I should be in the company’s payroll.

If I’m a person who works for a week to build a logo for you from my own office am I an “employee” or not? You’d think no, right? What if I’m working in your office for 1 month on that? Now things get trickier. Things like mutuality of obligation, the substitute rule and statement of work come into play, which I will tackle another time.

The truth is, it’s not so straightforward.

Previously, the call on whether you fall outside or inside IR35 legislation was on you, the contractor. So everybody thought they’re a legit company. Money talks ;) But now the check must be done by the end-client. In other words, the company to whom you provide the work.

From now on, if I’m a designer building something for Lloyds, it’s Lloyds who should determine what tax I should pay for the engagement with them.

HMRC provided employment status tool so that companies start using this to assess their workers’ statuses for tax purposes.

But guess what. Companies are just too afraid to start assessing thousands of contractors. If they get it wrong the blame is on them. So with banks on the front row, they’ve gone: “Sorry, everyone. We can either hire you as perm or here’s the door”.

It kind of makes sense. When you’re a big place you have dozens of projects that you want to kick off and shut down quickly. You want to hire/fire in a few months and make no investment to train or move existing employees around. Managing a big flexible workforce is a big benefit because it allows you to move quickly, despite the higher cost.

But now you have to manage this risk of dealing with employment status. It’s not only the financial risk but also the reputational if you get it wrong.

No surprise the majority of Outside IR35 contractors are now Inside IR35. If you don’t believe me count the red dots on the excellent OffPayroll.org.uk website.

Some say that this is an effort coming from big consultancies (think Accenture, KPMG etc) who want to oust solo consultants stealing their profit share. Others say contractors should pay the same tax as an employee. But regardless of whether these statements hold true or not, this is the name of the game from now on.

Why I Like Contracting over Perm

I have been both a contractor and a permanent employee in my career. The reason I like contracting is that if you’re a skilled person, you can jump from project to project earning very good money while also building a decent network of people.

There are some minuses – you’re not paid holidays, sick leave, training courses, you’re the first to fire having often one or two weeks of notice. Finding another contract can result in some void periods between contracts and you generally take more risk. You have to prove yourself again and again in new projects and interviews.

You’re also left behind when it comes to climbing the career ladder and managing people. You have to do your own tax planning, waste some time managing invoices, explain business transactions and make sure you get paid on time.

All of the above goes to show why not everyone who says “contracting is so much better” becomes one 😉 
It also explains why the free market (without much government intervention) has decided that the pay must be higher than an employee to compensate for the minuses and that’s where we are now.

Especially for those of us on the FIRE trajectory, it can help. The money is better and allows you to defer taxes for the period where your income will be lower. Avoiding taxes (not evading) is perfectly legal and it’s what you’re doing when you put money in an ISA or a pension.

Contracting is not for everyone and here’s an article I wrote in 2017 which gets lots of hits again lately:

Why I like Perm over Contracting

As I said before, contracting is not for everyone which explains why most people prefer to stay a perm employee.

As a permanent employee, you just get paid every month a salary. A paycheck on a particular date of the month is a great feeling. Especially when others depend on you.

Paycheck stability is underrated. I cannot stress this point enough.

You don’t care if next week you’re sick. You just stay at home, recover and get paid.

Financial planning gets easier too. You can plan better if you know how much you will get paid 6-12 months down the line. It’s why banks prefer to give mortgages to permanent employees better than contractors.

You’re probably going to have contract work 3-6 months later, I’m not saying you won’t. But the psychological pressure takes its toll on some people. Whereas as a perm employee, you know you will be employed.

As a regular employee, you don’t have to stay up to date with new industry standards. Of course, you may want to do so for career development, personal interest and because you like it. Some companies will also push you and pay you to attend conferences and training just because it’s a win-win situation! But you don’t have to interview every 6-12 months and prove it.

As a matter of fact, I know a few people who prefer to stay in the same position for 10 years. And that’s fine. In the contracting space, this is less likely and not fine at all. I’m sure you know a few contractors who do this. But they’re part of the problem of why we ended up here in ‘disguised employment’ land.

As a perm employee, you need to interview only when you want to change a job or become redundant. The former is up to you but the latter is not in your control. Lots of people will moan about contractors getting paid £500 per day but only a few will factor in wasted time to find jobs, talk to recruiters, prepare and go to interviews every year or so.

Being too comfortable is, of course, a dangerous game to play. We often talk about financially independent people getting depressed because they don’t challenge themselves enough. The same applies to people and organizations too. I’ve seen permanent people become too comfortable on a good enough salary. They would only do the bare minimum to not get fired. And if shit hits the fan, good luck firing me and paying me garden leave and redundancy.

Of course, I don’t advise anyone to do that, but all I’m saying is that perm employees can get away with more comfort if they want to.

What about me in April 2020 and beyond?

I have already transitioned to permanent employment ahead of the IR35 changes of April 2020. I plan to keep my company open for the foreseeable future mainly because the market situation is very fragile at the moment and prefer to keep my options open. There are outstanding loans to my investment company which I plan to keep open for investing purposes.

I know a lot of people (including myself) want to talk about money. In the next posts of the IR35 series I’m going to talk about:

• How much should I ask if I’m going perm?
• Should I consider contracting as a perm after the IR35 changes?
• How much will it cost to transition from Outside IR35 to Inside IR35 (or Umbrella) to Perm?
• How much do I need to increase my daily rate to earn the same take-home pay Inside IR35?
• As a perm employee, how much would I need to earn if I switch to contracting to earn the same take-home pay?

It’ll be a data-intensive post and the findings are very interesting, I promise!

A Question to you: How does your company handle the April 2020 IR35 changes? Do you prefer perm or contracting?