How It Works When You're Inside IR35

When your contract falls inside IR35, everything changes about how you take money from your company. You can't take dividends anymore. Instead, you're paying yourself through PAYE (Pay As You Earn) the same system that taxes every employed person in the UK.

For contractors who've spent years optimising their tax through limited company structures, PAYE feels restrictive. You're paying more tax, losing flexibility, and dealing with monthly deductions instead of managing your own tax liability.

But PAYE under IR35 isn't quite the same as standard employment PAYE. There are specific calculations, allowances, and requirements that apply only to contractors deemed inside. Understanding exactly how it works—and how much you'll actually take home matters whether you're already inside IR35 or trying to work out if a contract's financially worthwhile.

What PAYE Actually Is

PAYE is the system HMRC uses to collect Income Tax and National Insurance from employees. Instead of paying tax annually in one lump sum, it gets deducted from your salary every time you're paid.

Your employer calculates how much tax and NI you owe based on your tax code and how much you earn. They deduct it from your gross pay before you receive anything. Then they send that money to HMRC on your behalf, usually monthly.

By the time money hits your bank account, the tax is already gone. You never see it, never handle it, never make a conscious decision to pay it. It's automatic.

For standard employees, this is straightforward. For contractors inside IR35, there's an extra layer of complexity because your limited company is both the employer and, in effect, the employee.

The Deemed Payment Calculation

When you're inside IR35, HMRC doesn't just tax your contract income as though it were salary. First, they apply what's called the deemed payment calculation to work out what should be taxed.

Here's how it works. Start with your contract income—everything your limited company invoices the client. From that, deduct 5% as an expense allowance. This is meant to cover costs you incur that aren't reimbursed.

Then deduct employer's National Insurance at 13.8% on everything above the secondary threshold, currently £9,100 per year. This is the bit that really hurts—it's tax coming straight off your income before you even calculate what you owe personally.

Finally, deduct any employer pension contributions your company makes.

What's left is your deemed payment. That's the figure that gets treated as employment income and taxed through PAYE.

How the Numbers Actually Work

Abstract percentages don't mean much. Let's look at a real example.

You invoice £100,000 through your limited company. Your contract's inside IR35.

The calculation works like this. Contract income is £100,000. Less 5% expense allowance of £5,000 leaves £95,000. Less employer's NI of £11,854—that's 13.8% on £95,000 minus the £9,100 threshold—leaves a deemed payment of £83,146.

That £83,146 then gets taxed like employee salary. You'll pay roughly £20,460 in Income Tax after the personal allowance, and roughly £5,940 in employee's National Insurance. Your take-home is approximately £56,750.

Compare that to operating outside IR35 where you'd typically take home around £70,000 from the same £100,000 contract. You're losing over £13,000 in tax.

Employer's vs Employee's National Insurance

One of the most confusing aspects of PAYE under IR35 is understanding the difference between employer's and employee's National Insurance.

Employer's National Insurance is what companies pay on top of employee salaries. It's currently 13.8% on earnings above £9,100 per year. Normal employees never see this—it's a cost to the business that comes from company funds, not their salary.

When you're inside IR35, your limited company pays this employer's NI, but it comes from your contract income. It reduces the deemed payment before any other calculations happen.

Employee's National Insurance is what gets deducted from your salary. It's 12% on earnings between £12,570 and £50,270, then 2% on everything above that. This comes directly off your take-home pay.

You're paying both. Employer's NI reduces what goes through PAYE in the first place. Employee's NI then reduces what you actually receive. It's double taxation on the same income, which is why inside IR35 is so much more expensive than taking dividends.

The 5% Expense Allowance Explained

The 5% allowance is automatic. You don't need receipts, you don't need to justify it, you don't need to document anything. It just comes off your contract income before the deemed payment calculation starts.

On a £60,000 contract, that's £3,000. On £120,000, it's £6,000.

It's meant to acknowledge that contractors have business expenses that aren't reimbursed—accountancy fees, insurance, equipment, workspace costs. The reality is 5% doesn't come close to covering actual business expenses for most contractors, but it's better than nothing.

You can't claim the 5% allowance and then itemize specific expenses on top. It's one or the other. For almost all contractors, the 5% allowance is simpler and works out better than trying to claim specific expenses under employment expense rules.

Tax Codes and How They Work

When you operate through PAYE, you need a tax code. This tells your company's payroll software how much tax-free income you're entitled to before deductions start.

The standard tax code for 2024/25 is 1257L. This gives you the full personal allowance of £12,570—you don't pay Income Tax on the first £12,570 you earn.

If you have other income—maybe from a pension, rental properties, or another job—your tax code might be adjusted to collect tax on that income too. HMRC might reduce your personal allowance by issuing a different code.

If you're only working through one limited company on one inside IR35 contract, you'll probably get the standard code. If you're juggling multiple income sources, HMRC might issue a BR code (basic rate, 20% on everything with no allowances) or a different adjustment.

Check your tax code when you set up payroll. Wrong codes mean wrong deductions, which means either underpaying tax all year and facing a bill later, or overpaying and waiting months for a refund.



Monthly PAYE vs Annual Income

PAYE operates on a cumulative basis throughout the tax year. Each month, your payroll calculates what you should have paid in tax from April to date, works out what you've already paid, and deducts the difference.

This matters when your income varies. Maybe you work eight months of the year and take four months off. Maybe you start a contract halfway through the tax year. Maybe your day rate changes.

In the months you earn more, you'll pay proportionally more tax. In months you earn less, you might pay very little. By the end of the tax year, it should all balance out to the right total tax on your annual income.

But it can create cashflow surprises. A particularly high-earning month might push you into the higher rate tax band for that month's PAYE calculation, even if your annual income wouldn't normally reach that threshold.

Setting Up PAYE for Your Limited Company

If you're moving from outside to inside IR35, your limited company needs to become a registered employer. This involves several steps.

First, register as an employer with HMRC. You'll get an employer PAYE reference number. This is separate from your company's corporation tax reference.

Second, set up payroll software or use an accountant who handles it for you. You need something that calculates PAYE, National Insurance, and pension deductions correctly every time you pay yourself.

Third, operate Real Time Information (RTI). Every time you make a payment to yourself, you must submit a Full Payment Submission to HMRC within 24 hours. This tells them what you've paid and what tax you've deducted.

Fourth, pay HMRC monthly. The tax and NI you've deducted must reach HMRC by the 22nd of the following month (or 19th if paying by post, though nobody does that anymore).

This is substantially more admin than paying yourself dividends. Monthly submissions, monthly payments to HMRC, monthly record-keeping. It's one reason some contractors switch to umbrella companies when they're inside IR35—let someone else handle the PAYE headache.

What Gets Deducted When

Every time you pay yourself through PAYE, several deductions happen in a specific order.

First, employer's National Insurance gets calculated and set aside. This isn't deducted from your payment—it comes from company funds and goes straight to HMRC.

Then from your gross pay: Income Tax based on your tax code and earnings, employee's National Insurance on earnings above the threshold, pension contributions if you're making them, and student loan repayments if applicable.

What's left is your net pay. That's what hits your personal bank account.

The tax, NI, and other deductions sit in the company account until the monthly HMRC payment date. You're holding their money temporarily, not yours.

How This Differs From Taking Dividends

Outside IR35, most contractors pay themselves a small salary (often around £12,570 to use the personal allowance) and take the rest as dividends from company profits after corporation tax.

Dividends are taxed differently. They have their own allowance (currently £500 per year) and their own tax rates—8.75% for basic rate, 33.75% for higher rate, 39.35% for additional rate. No National Insurance applies to dividends.

This structure is significantly more tax-efficient than PAYE. On £100,000 of profit, you'd pay corporation tax of £19,000 at 19%, leaving £81,000. After taking optimal salary plus dividends and personal tax, you'd have roughly £70,000 take-home.

Under PAYE inside IR35, the same £100,000 results in about £57,000 take-home. That's a £13,000 difference.

The dividend route only works outside IR35. Inside, HMRC treats everything as employment income and you're stuck with PAYE rates.

Student Loans and PAYE

If you have a student loan, PAYE deductions include loan repayments once your income exceeds the threshold for your plan type.

Plan 1 loans start repayments at £24,990. Plan 2 at £27,295. Plan 4 at £31,395. Postgraduate loans at £21,000.

These repayments get deducted automatically through PAYE at 9% of income above the threshold (6% for postgraduate loans).

When you were outside IR35 taking dividends, you probably weren't making student loan repayments because dividends don't count for student loan purposes. Switch to PAYE inside IR35 and suddenly 9% of your income above the threshold vanishes every month.

For contractors with student debt, this is an additional hit on top of the increased tax and NI. It's worth factoring into your take-home calculations when deciding if a contract's worthwhile.

Pension Contributions Through PAYE

One of the few tax advantages remaining inside IR35 is employer pension contributions. Your limited company can contribute to your pension before calculating the deemed payment.

These contributions reduce your taxable income and don't attract employer's or employee's NI. They're deducted from your contract income before the PAYE calculation even starts.

On a £100,000 contract, if your company contributes £15,000 to your pension, the deemed payment drops to roughly £68,000. Your Income Tax and employee's NI reduce accordingly. Your pension grows by £15,000. The effective tax saving is around £6,500.

You can't access pension money until you're 55 (rising to 57 in 2028), but if you're building retirement funds anyway, this is substantially more efficient than taking everything through PAYE.

What Happens at Year End

When the tax year ends on April 5th, your company must complete several tasks.

Submit a final Full Payment Submission showing the total pay and deductions for the year.

Provide P60s to anyone who received PAYE income. If you're the only employee, that's just you. The P60 shows total pay and tax for the year.

Submit P11D forms if you received any benefits in kind. Most contractors inside IR35 don't have these, but if your company provided you with a company car or private medical insurance, you'd need to declare it.

File your own Self Assessment tax return by the following January. Even though you've paid tax through PAYE, you still need to file because you have a limited company. This return includes your company income and any other personal income sources.

The P60 figure should match what appears on your Self Assessment return for PAYE income. If it doesn't, something's wrong with either the payroll or the tax return.

PAYE Mistakes and How They Happen

Common PAYE errors for contractors inside IR35 include several typical problems.

Using the wrong tax code happens when HMRC hasn't been notified about your employment. They might not issue a code, or they might issue the wrong one. Check your first payslip carefully.

Forgetting employer's NI is another mistake. Some contractors calculate their take-home based only on Income Tax and employee's NI, forgetting the employer's piece that reduces the deemed payment first.

Missing RTI deadlines creates automatic penalties. First late submission in a tax year gets you a warning. Second onwards costs £100 each time.

Paying HMRC late results in interest charges and potentially penalties. Set up a direct debit or standing order so it happens automatically.

Mixing PAYE and dividend payments causes problems. Once you're inside IR35, everything should go through PAYE. Taking dividends as well can trigger investigations because it suggests you're not properly applying the deemed payment rules.

When You're Part-Year Inside IR35

Not every contractor is inside IR35 for the full tax year. Maybe you had six months outside, then moved inside. Or you're inside for one contract but outside for another running simultaneously.

PAYE calculations handle this, but you need to track which income came from which source.

Outside IR35 income stays as company profit for dividend distribution. Inside IR35 income goes through PAYE. Each gets taxed differently.

Your personal allowance and tax bands are annual, not per-contract. If you've already used your personal allowance on income from your outside IR35 contract, your inside IR35 PAYE will all be taxed from the first pound.

Keep meticulous records. Which invoices relate to which contract? Which payments went through PAYE? Which were dividends? Come tax return time, you'll need to separate everything clearly.

PAYE Under IR35 vs Umbrella Companies

Many contractors inside IR35 consider switching to umbrella companies instead of running PAYE through their own limited company.

The tax outcome is similar—you're paying through PAYE either way. The difference is admin and a small margin.

Umbrellas charge around £100-150 per week or 2-3% of contract value. In exchange, they handle all the PAYE administration, RTI submissions, pension setup, and HMRC payments. You invoice the umbrella, they pay you a net salary.

For contractors who'll be inside IR35 long-term, umbrellas often make sense. The margin you pay is offset by saved accountancy fees, reduced admin burden, and not having to maintain your limited company.

For short-term inside IR35 contracts where you expect to move back outside, keeping your limited company and running PAYE yourself might be better. The admin's painful but temporary, and you're ready to switch back to dividends when the next outside contract arrives.

Documentation and Record-Keeping

HMRC requires specific records for PAYE.

Payroll records must show gross pay, deductions, and net pay for each payment period. Keep these for at least three years after the end of the tax year they relate to.

RTI submissions should confirm you've reported each payment. Your payroll software should store these automatically.

Payment records need to prove you actually paid the tax and NI to HMRC each month. Bank statements showing the payments going out are sufficient.

Tax code notifications from HMRC matter when they change your code mid-year. You need the letter explaining why.

P60s for each tax year prove what you earned and what tax you paid. Keep them indefinitely—you might need them for mortgage applications, benefits claims, or future tax queries.

Digital records are fine. You don't need physical paper. But they must be accessible if HMRC asks.

When PAYE Refunds Happen

Sometimes you'll overpay tax through PAYE. This typically happens in several situations.

Your income drops mid-year after you've been taxed on the assumption you'll earn consistently all year.

You have work gaps between contracts and the PAYE system over-collected in months you were working.

Your tax code was wrong and gets corrected later.

HMRC should automatically refund overpaid tax, usually within a few weeks of the tax year ending once they've reconciled everything. But sometimes they don't notice or the refund gets delayed.

If you're owed a refund, you can claim it through your Self Assessment tax return or by writing to HMRC with your P60 showing the overpayment.

Don't just wait and hope HMRC sorts it. They're slow, and your money's better in your account earning interest than sitting with them.

PAYE under IR35 means substantially higher tax than taking dividends outside IR35. You're paying employer's NI, Income Tax, and employee's NI on the same income that would have been taxed much more lightly as dividends. The deemed payment calculation reduces your contract income by 5%, then employer's NI, before PAYE even starts. What's left gets taxed like employment income with no flexibility to optimize.

You'll need proper payroll setup, monthly RTI submissions, and monthly payments to HMRC. It's more admin than dividends, more expensive, and less flexible.

The only silver lining is employer pension contributions, which still work tax-efficiently and can claw back some of what you're losing to increased tax.

Understand the numbers before accepting inside IR35 contracts. What looks like a decent day rate might deliver disappointing take-home once PAYE's taken its cut.