If your agency uses freelancers — developers, designers, copywriters, project managers, anyone working through their own limited company — IR35 is your problem to manage. HMRC’s off-payroll working rules have been in force for medium and large private sector businesses since April 2021, and they shift the responsibility for determining a contractor’s employment status firmly onto the agency engaging them, not the contractor themselves.
For a typical UK digital agency running on a mix of permanent staff and flexible freelance capacity, this creates a compliance obligation that many owners still haven’t fully got their heads around. A wrong determination — classifying someone as outside IR35 when HMRC would say they’re inside it — can result in a backdated tax bill for your agency, plus interest and penalties. This isn’t a hypothetical: HMRC has been actively investigating agencies and their supply chains, and the “small business exemption” that once protected most agencies is narrower than many assume.
This guide covers what IR35 actually means for digital agencies, how to determine status correctly, what your contractual and process obligations are, and where the real risk sits. It is not a substitute for accountancy or legal advice, but it will give you a clear framework so you know exactly what questions to ask.
What IR35 Actually Means (And What It Doesn’t)
IR35 — formally, the “off-payroll working rules” — is designed to ensure that contractors who work in a way that is substantively equivalent to employment pay broadly the same income tax and National Insurance contributions as employees, even if they operate through a personal service company (PSC). The legislation has existed since 2000, but the 2021 reforms fundamentally changed who is responsible for making the determination. Previously, it was the contractor’s responsibility to assess their own IR35 status. Now, for medium and large businesses, it is the responsibility of the “end client” — the agency engaging the contractor — to issue a Status Determination Statement (SDS) and to ensure the correct tax treatment is applied.
What IR35 does not mean is that you can never use contractors, or that all contractors must be put on the payroll. It means that for each contractor engagement, you must make a considered, documented determination of whether that engagement — if the PSC wrapper were stripped away — looks like employment or genuine self-employment. If it looks like employment (inside IR35), you must either hire the person as an employee, engage them via an umbrella company, or if they invoice you directly through their PSC, you become responsible for deducting income tax and National Insurance before paying them.
The rules apply to medium and large businesses. A company is classed as medium or large if it meets two of the following three criteria: annual turnover above £10.2m, balance sheet total above £5.1m, or more than 50 employees. Most established digital agencies of ten or more staff will cross at least one of these thresholds if they have grown steadily — particularly on the turnover measure. If you are genuinely small (under £10.2m turnover, fewer than 50 staff, and under £5.1m on the balance sheet), the pre-2021 rules still apply: the contractor remains responsible for their own IR35 assessment. But it is worth confirming your size classification with your accountant, because the threshold is based on the previous financial year’s figures and can catch agencies that grew quickly by surprise.
The Three Tests That Determine IR35 Status
HMRC’s assessment of whether an engagement falls inside or outside IR35 rests on a body of employment law case history, but in practice it distils down to three core tests. No single factor is determinative — HMRC looks at the overall picture — but these three carry the most weight.
Substitution
Can the contractor send a substitute to do the work, and would your agency accept that substitute without needing to approve them personally? Genuine self-employment typically allows for substitution — a plumber can send a colleague to finish a job. If the contract says substitution is possible but in practice you would never accept it, that is a “sham” clause that HMRC will disregard. However, if the contractor does genuinely send substitutes, or if the contract makes clear that the agency is engaging a service rather than a specific person, this points strongly towards outside IR35. For digital agencies, this is often the weakest test — most agencies engage specific people for their particular skills and would not accept an unknown substitute on a client project.
Control
Does your agency control how the work is done, or just what the end result should be? If the contractor turns up at your office, works your hours, uses your equipment, follows your processes, sits in your stand-ups, and is line-managed by one of your permanent staff, that looks a great deal like employment. If they work their own hours from their own location, use their own tools, set their own working methods, and are simply accountable for delivering a defined outcome, that points towards genuine self-employment. Many agency engagements sit uncomfortably in the middle — contractors embedded in client delivery teams often have a level of day-to-day direction that HMRC would view as control.
Mutuality of obligation
Is your agency obliged to offer ongoing work, and is the contractor obliged to accept it? In a genuine employment relationship, there is an expectation that the employer offers work and the employee shows up for it. In genuine self-employment, the contractor completes a defined piece of work, and there is no obligation on either side beyond that. Long-running engagements where the contractor has been working essentially full-time for your agency for two or more years — even on technically separate contracts — are the ones that most commonly fail this test. HMRC is particularly alert to what they call “disguised employment” in long-term contractor relationships.
If a contractor has been working for your agency for three years, works your hours, sits in your stand-ups, and you’d struggle to replace them with someone else at short notice — that is a very difficult IR35 case to defend as outside.
HMRC publishes a free online tool called CEST (Check Employment Status for Tax) that you can use to assess engagements. Its results are HMRC-binding if you answer the questions honestly and the circumstances don’t change — meaning if CEST says outside IR35 and you’ve recorded that assessment accurately, HMRC cannot later challenge it without demonstrating you misrepresented the facts. Using CEST and keeping a copy of the output is good practice for every contractor engagement.
Your Obligations as the Engaging Agency
If your agency meets the medium or large threshold, your obligations are specific and procedural. Getting the process right is almost as important as getting the determination right, because HMRC’s enforcement approach looks at both.
First, for every contractor engaging through a PSC, you must issue a Status Determination Statement (SDS) before the engagement begins, or as soon as the 2021 rules became applicable to an existing engagement. The SDS must state your determination (inside or outside IR35) and give your reasons. There is no prescribed format, but it needs to be in writing and it needs to be passed to both the contractor and any agency in the supply chain (if you’re using a recruitment agency to supply contractors, they need to know too).
Second, you must have a disagreement process. Contractors have the right to challenge your determination, and you must respond to any challenge within 45 days with either a revised determination or a reasoned explanation of why you’re maintaining your original position. Ignoring a challenge invalidates your determination and passes liability back to you.
Third, if you determine an engagement is inside IR35 and the contractor continues to invoice through their PSC, you become the fee-payer and must deduct income tax at source and pay employer’s National Insurance on top of the fee. This changes the economics of the engagement significantly — employer’s NI at 13.8% is a real cost that needs to be factored into rates. Many agencies find it simpler to either adjust the rate negotiation (expecting the contractor to absorb the change by moving to an umbrella company) or to formalise the relationship as employment if the engagement is genuinely ongoing.
Keep documentation for every determination you make. If HMRC opens an enquiry — which they most commonly do when a contractor complains about a determination, or during a wider PAYE audit of your agency — you will need to produce evidence that you undertook a genuine assessment of the facts, not just a blanket policy of treating everyone as outside IR35 to keep costs down.
Common Mistakes UK Agencies Make With IR35
Most IR35 problems at agencies aren’t the result of deliberate non-compliance — they’re the result of process gaps, misunderstanding the rules, or simply not having looked at contractor relationships closely enough. These are the mistakes that come up most often.
Blanket determinations
Issuing a blanket policy that all contractors are either inside or outside IR35 is explicitly disallowed. Every engagement must be assessed on its own facts. An agency that applies outside-IR35 status to everyone as a default — because it’s administratively simpler — is exposed to very significant liability if HMRC investigates. The determination has to reflect the actual working arrangements for each individual engagement.
Contracts that don’t match reality
A contract can say whatever you like. HMRC assesses the actual working arrangements, not just what the paperwork says. If the contract says there’s a right of substitution but the contractor has worked exclusively for you for 18 months without ever sending a substitute, the contract clause is worthless as a defence. The contracts you use with contractors should be drafted to reflect genuine working practices, not to create a paper trail that contradicts how the relationship actually works. Many agencies are using contract templates from years ago that were designed to look good rather than to reflect reality.
Failing to reassess when circumstances change
A determination made when a contractor starts working on a discrete six-week project is not automatically valid if that engagement extends to 18 months of ongoing embedded work. Your obligation is to reassess status if the working arrangements change materially — a new project, a new role, a change in the day-to-day control relationship. Treating the original SDS as a permanent record without review is a compliance gap.
Assuming the small business exemption applies
The exemption is based on the previous financial year’s figures. An agency that crossed the £10.2m turnover threshold in the 2022/23 financial year became a medium-sized business for IR35 purposes from April 2024. Many agency owners are not tracking this carefully. It’s worth confirming your classification with your accountant at the start of each financial year, before you engage new contractors.
Not telling recruitment agencies about the determination
If you engage contractors through a recruitment agency, the recruiter sits in the supply chain. You must pass the SDS to them, and they become responsible for implementing the correct tax treatment. If you fail to do this, liability can remain with your agency. The chain of communication matters — it’s not enough to make the determination internally and never inform anyone downstream.
When a Contractor Is Inside IR35: Your Practical Options
Discovering that an engagement falls inside IR35 doesn’t necessarily mean it ends. You have a few practical routes, and which one makes sense depends on the nature and duration of the relationship.
Engage via an umbrella company. The contractor stops invoicing through their PSC and instead works through an umbrella company, which employs them and handles PAYE deductions. This is the most common route for genuinely flexible, project-based contractors who want to remain self-employed in practice. The cost typically comes out of the contractor’s gross rate — the umbrella takes a margin (usually £15–£30/week) and deducts tax and NI. You pay the umbrella company; they pay the contractor net. Your administrative burden is minimal. If you’re engaging contractors regularly, it’s worth having an umbrella company or two that you’ve vetted and can direct contractors to.
Employ them. If the engagement is effectively permanent — full-time hours, ongoing work, embedded in your team — employing the person properly is often cleaner than trying to structure a contractor relationship around IR35 compliance. The employment costs (salary, employer’s NI at 13.8%, pension contributions, holiday pay) need to be weighed against the cost and risk of maintaining a contractor arrangement. Many agencies that have taken a hard look at long-running contractor relationships have found that the contractor’s effective rate already made them more expensive than an equivalent employee once employment costs were added to the gross day rate.
Renegotiate the rate. If you’ve been engaging someone outside IR35 and a reassessment puts them inside, you’ll need to pay employer’s NI on top of their fee. That’s a meaningful cost increase. Some agencies absorb it; many renegotiate. The contractor may agree to a lower gross rate in exchange for the security of knowing their income tax is handled. These conversations are delicate but not unusual — most experienced contractors have been through them since 2021 and understand the landscape.
End the engagement. If the relationship was primarily structured for tax convenience rather than genuine operational need, this is sometimes the honest outcome. A contractor who has been embedded full-time for three years and whose working practices would clearly be deemed employment by any tribunal is a liability that the agency is carrying. Restructuring or ending that engagement, while potentially disruptive in the short term, removes a compliance risk that grows the longer it persists.
Keeping Records That Protect You
If HMRC opens an IR35 enquiry into your agency — which is more likely following a contractor complaint than a random audit, but both happen — you need to be able to demonstrate that you followed the correct process. The documentation that matters most is: the SDS for each contractor engagement, evidence that you used CEST or took professional advice in reaching your determination, any communications about the determination with the contractor and any recruitment agency, records of any disagreement process you went through, and evidence of how the contractor actually worked (timesheets, project briefs, communications showing working arrangements).
This is an area where having organised contractor records pays a real dividend. If your subcontractor management is spread across email threads and spreadsheets, pulling together evidence for an HMRC enquiry is time-consuming and stressful. Centralising contractor records — contracts, SOWs, SDS documents, communications, invoices — in a single place means you can respond to an enquiry quickly and confidently rather than spending a week reconstructing a paper trail.
Marque CRM’s contracts module lets you store signed contracts against contacts, with full version history and an audit log. For agencies managing a mix of employees, subcontractors, and freelancers, having client and supplier records in the same system — alongside project work and invoicing — removes the fragmentation that makes compliance evidence hard to produce. It’s not a substitute for specific IR35 documentation practices, but it creates the organisational infrastructure that makes those practices sustainable at scale. See how managing subcontractors as an agency connects to your wider operational setup.
Practical Steps to Take Right Now
If you haven’t reviewed your contractor relationships through an IR35 lens recently, here is a straightforward action plan.
- Confirm your size classification. Ask your accountant whether your agency met the medium or large criteria for the most recent financial year. If yes, the off-payroll rules apply to all your contractor engagements.
- List every active contractor engagement. Include anyone who invoices you through a limited company or PSC, regardless of what you call them. Day rate developers, freelance designers, consultants, part-time content writers working through their own company — all of them count.
- Run each engagement through CEST. Answer the questions based on how the work actually happens, not how the contract describes it. Save a copy of the output for each engagement.
- Issue or update Status Determination Statements. If you haven’t issued formal SDSs, do so now. If you have, check that they reflect current working arrangements — things may have changed since they were issued.
- Review your contract templates. Make sure substitution, control, and mutuality of obligation clauses reflect actual practice. If they don’t, update them — or ask a solicitor to.
- Set a review calendar. Commit to reassessing contractor status at the start of each new project or contract period, and whenever a contractor’s working arrangements change materially.
IR35 compliance is not a one-time exercise — it’s an ongoing responsibility that grows with the number of contractors you engage. The agencies that manage it well treat it as a routine part of contractor onboarding rather than a periodic scramble triggered by an accountant’s warning letter. Building the process into how you bring contractors on board — rather than retrofitting it afterwards — is considerably easier than the alternative.
For more on the operational side of running a compliant, profitable agency, the guide to running a profitable digital agency covers how IR35 fits into the broader picture of agency financial management. And if you’re thinking about how to structure client and contractor billing efficiently, our piece on retainers versus project pricing is worth reading alongside this one.