As a contractor starting to build your consultancy business, it's crucial to consider IR35 compliance from day one to avoid significant issues. This guide explains how contractors can capitalise on the IR35 small companies exemption and build a valuable consultancy business, as well as highlighting what can go wrong if IR35 is not appropriately handled.
IR35 and Small Companies
IR35 originally started with the Intermediaries Legislation (Chapter 8 ITEPA 2003) and is designed to ensure contractors are taxed like employees if the relationship between the worker and the engager is determined as "deemed employment." In 2017, reforms to IR35, under new and separate legislation called Off-Payroll Working ("OPW"), shifted IR35 compliance from contractors to medium and large private sector businesses.
However, small companies are exempt from the off-payroll working rules. Contractors who work for small companies can continue to be responsible for correctly assessing their status and paying the correct taxes.
The small companies exemption applies to firms that meet two of the three small company criteria:
- Turnover under £10.2 million
- Balance sheet total under £5.1 million
- 50 or fewer employees
What advantages do small consultancies have?
Contractors who build small consultancies have a significant advantage compared to recruitment agencies and are attractive suppliers to medium and large firms – because OPW does not apply.
A contractor who expands their operation to include outsourcing work to more associate contractors can do so without being responsible for determining their IR35 status or deducting taxes. The liability remains with contractors' limited companies.
Most small consultancies can stay exempt for years by remaining lean on employees and extracting profits. The structural advantages are why building a consultancy is an appealing option for entrepreneurial contractors.
Building your consultancy
To build a successful consultancy business that remains compliant with the IR35 rules, follow these key steps:
Step 1: Get your paperwork right
Use proper commercial contracts that demonstrate you provide services, not just individuals. Avoid cheap templates, and avoid rehashed agency-like contracts. Where your clients provide agreements for you to sign, always have them reviewed by IR35 legal experts to ensure you don't have problems. Robust agreements are essential to demonstrate that you operate a legitimate consultancy.
Step 2: Assess all contractors for IR35
Even though it is not mandatory, assess all contractors upfront for IR35 as if the new reforms applied to your company. Relying on contractors to self-assess often leads to non-compliance – as history demonstrates. Use IR35 Shield to determine the status of their engagements and demonstrate due diligence.
If you want to hire a contractor and have ultimate control over them, engage them on payroll. Do not attempt to cheat and dress anything up – because it will haunt you when you come to sell your company.
Step 3: Ensure contractors have IR35 protection
Require contractors to become members of a service like IR35 Shield for Contractors, including a tax investigation service if HMRC queries their IR35 status later. This precaution helps to prevent issues cascading across your business if one contractor's IR35 compliance is challenged. It also demonstrates that you take IR35 seriously, but more importantly, you don't want a contractor trying to wing their defence against HMRC.
By following these three steps from the outset, you will build an IR35-compliant consultancy right from the start. You'll have evidence of due diligence if HMRC investigates and should prevent contagion if contractors get into hot water.
Value in your business
Paying careful attention to IR35 compliance also maximises your firm's value and risk when the time comes to sell. The attractive attributes buyers will seek are:
- Many happy clients
- Strong industry reputation
- Consistent revenue streams
- Evidence of robust compliance
Company valuations typically use EBITDA (earnings before interest, taxes, depreciation and amortisation), which means gross profit for most consultancies. Common multiples of valuation range from 4-5x EBITDA but can go higher.
For example, a consultancy profiting £200K could be worth circa £1 million or more. Savvy contractors will expand their businesses with an eye on this end valuation.
Also, don't forget, under Business Asset Disposal Relief, you will only pay a 10% tax on the first £1m of the sale price. This incentive is in place for entrepreneurs like you, who are likely to make considerable sacrifices, not just financial, to build and grow businesses that contribute significantly to UK Plc.
Selling and due diligence - where it can go wrong
When selling your consultancy business, IR35 compliance will be heavily scrutinised by buyers during due diligence. If found non-compliant, you risk:
- A massively reduced valuation if contractors should have been inside IR35
- Your buyer walking away if deemed an agency acting unlawfully
- Negligence claims down the road from clients
Due diligence aims to identify any tax liability you created that still sits on the books. You'll likely need to sign warranties agreeing to cover such costs and may even be required to put a portion of the sale fee in Escrow for several years. Worse case – the buyer walks away.
Once acquired, your consultancy will often expand beyond the small company definition, particularly if it becomes part of and associated with a larger group. At that point, the Off-Payroll reforms will soon apply. So, if you've been running a flawed business model because the contractors are really "Inside IR35", it won't work anymore – killing your valuation.
Summary: Building a valuable consultancy
- By making a small effort from day one, getting IR35 right, you ensure a smooth sales process and realise your hard work's total rewards. Don't let tax liability derail your exit plan.
- Follow the steps outlined here to build an IR35-compliant consultancy business from scratch. Get the paperwork right, assess contractors properly, and require your contractors to protect themselves with membership of IR35 Shield for Contractors.
- Do this, and you can construct a valuable firm without tax risks undermining your success.
If you’d like to utilise our services and expertise to build your consultancy safely and compliantly, please book a consultation.
