IR35 and Software Development: What UK Businesses Need to Know Before Hiring

Software development is one of the sectors most exposed to IR35, because contract engineering has always been common practice. If your business engages individual contractors directly rather than through an agency, IR35 status is not paperwork you can skip — getting it wrong carries real financial and legal risk that sits with your business, not the contractor. This guide covers what the rules actually mean in plain English, and what changes if you use an agency instead.

What IR35 actually is

IR35 (formally the “off-payroll working rules”) exists to stop a specific pattern: someone working like an employee — set hours, direct supervision, no real business risk of their own — while being paid through a personal service company (PSC) to get more favourable tax treatment than employment would give them. If a contractor’s actual working relationship looks like employment, HMRC expects PAYE tax and National Insurance to be paid as if it were, regardless of the contractual paperwork.

What changed in April 2021

Before April 2021, contractors themselves assessed their own IR35 status. Since then, for medium and large private-sector businesses, that responsibility moved to the client — the business engaging the contractor. This is the change that catches most businesses out: if you engage a contractor directly and get the status determination wrong, HMRC can pursue your business for the unpaid tax and National Insurance, not the contractor. “Medium and large” is defined by the Companies Act — broadly, businesses exceeding two of: £10.2m turnover, £5.1m balance sheet, or 50 employees. Small businesses are currently exempt from this responsibility, though the contractor’s own determination still applies.

Inside vs outside IR35, in practice

• Inside IR35 means the engagement is treated as employment for tax purposes — PAYE tax and NI apply, usually deducted by the fee-payer (often an umbrella company or agency in the chain). Take-home pay for the contractor drops significantly versus an equivalent outside-IR35 engagement, which is reflected in day rates.
• Outside IR35 means HMRC accepts the engagement is genuinely a business-to-business arrangement — the contractor carries real business risk, controls how the work is done, and is not treated as part of your workforce in the way a regular employee would be.
• The determination is not optional and not just about the contract wording. HMRC looks at the actual working relationship — supervision, direction and control; whether the contractor could send a substitute to do the work; whether they carry financial risk. A well-written contract that does not reflect reality will not protect the business in an enquiry.

The risk of getting it wrong

• Backdated PAYE tax and employer National Insurance on the full value of every engagement HMRC deems misclassified — sometimes going back several years.
• Penalties on top of the backdated tax, scaled by whether HMRC considers the error careless or deliberate.
• The administrative burden of running a Status Determination Statement (SDS) process properly for every contractor engagement, and defending it if challenged.
• Reputational and relationship cost if a contractor disputes their determination — CEST (HMRC’s Check Employment Status for Tax tool) does not have final legal authority, and its outputs are frequently disputed.

Why engaging an agency sidesteps this entirely

When you engage a software house or agency for a genuine services contract — the agency decides who does the work, manages quality, and delivers an outcome rather than supplying labour hours under your direction — the engagement sits outside the off-payroll working rules altogether. There is no personal service company in the chain to assess, because the contract is business-to-business: you are buying a deliverable, not directing an individual’s day-to-day work. The agency employs its own engineers and carries their tax status as a normal employer, which is its problem to manage, not yours.

This is one of the practical, often-overlooked reasons UK businesses choose an agency over direct contractor engagement even when the headline day rate looks higher — the IR35 administrative and financial risk simply does not exist in the agency relationship.

If you are still using contractors directly

• Run a proper Status Determination Statement for every engagement, not a one-off blanket assessment — status can genuinely differ between projects with the same person.
• Keep documentation of the actual working relationship, not just the contract — direction and control, substitution rights, and financial risk in practice, not on paper.
• Review status periodically, especially if the nature of the engagement changes — a contractor who starts out clearly outside IR35 can drift inside as the relationship becomes more like ongoing employment.
• Take professional advice for anything ambiguous — CEST’s binary output does not cover every real-world scenario, and getting a specialist opinion is far cheaper than an HMRC enquiry.

Common myths about IR35

• “A limited company automatically means outside IR35.” No — trading through a personal service company is a precondition for IR35 to apply at all, not a way to avoid it. Status depends on the actual working relationship.
• “If HMRC’s CEST tool says outside IR35, we are fully protected.” CEST is HMRC’s own tool and its outputs carry weight, but it does not have final legal authority, and it is known to struggle with ambiguous or complex engagements — a determination should be documented, not just screenshotted.
• “Using an umbrella company for the contractor solves the problem.” It changes who processes PAYE, but the underlying status determination and the client’s responsibility for making it correctly still apply.
• “This only matters for big companies.” The client responsibility applies to medium and large businesses under the Companies Act definition — many growing SMEs cross that threshold sooner than they expect.

A quick self-check

If you engage software contractors directly, it is worth honestly answering these before your next engagement:

• Do we know whether our business currently meets the “medium or large” threshold under the Companies Act?
• Do we have a documented Status Determination Statement for every current contractor, not just a verbal understanding?
• Could the contractor genuinely send a substitute to do the work without our approval, in practice, not just on paper?
• Do we supervise and direct this person’s day-to-day work in a way that looks like managing an employee?
• If HMRC opened an enquiry tomorrow, do we have the documentation to defend our determination?

A “no” or “not sure” to more than one of these is worth resolving before the next engagement starts, not after HMRC asks.

Frequently asked questions

Does IR35 apply if the contractor works through their own limited company but we treat them like an employee?

Yes — this is exactly the scenario the rules target. The contract type does not override the reality of how the work happens; if it looks like employment in practice (set hours, direct supervision, no substitution rights, no real financial risk), it is likely to be judged inside IR35 regardless of the paperwork.

Who actually pays if we get a status determination wrong?

For engagements since April 2021 where your business is the client and also the fee-payer, your business is liable for the unpaid PAYE tax and National Insurance, plus potential penalties — not the contractor.

Does engaging an agency really remove all IR35 risk?

For a genuine services contract — where the agency controls how the work is delivered and is not simply supplying an individual’s time under your direction — yes, there is no personal service company in the chain for IR35 to apply to. The key word is genuine: an “agency” that is really just a single contractor’s personal service company operating under a different name does not change the underlying analysis.

The practical takeaway

IR35 does not make hiring contractors impossible, but it does add a genuine compliance burden and financial risk that a lot of businesses underestimate until they are inside an HMRC enquiry. If your priority is getting software built without taking on that administrative exposure, an agency engagement removes the question entirely — which is one reason it is worth weighing against a direct contractor hire even before you compare day rates.

We engage as an employer, not a chain of personal service companies, so there is no IR35 determination for your business to make when you work with us. If you want to talk through the right structure for a build you are planning, get in touch.