Contractors vs. Employees: Who Really Pays More in Taxes Now?

In today’s blog post, I investigate an intriguing comparison: how the tax burden for contractors has evolved over the last 21 years and how it stacks up against the taxes paid by full-time employees. My curiosity stems from wanting to uncover whether contractors actually faced lighter taxation two decades ago compared to the present day and whether IR35 is now more bark than bite.

Key Blog Points

• 21 years ago, a limited company contractor paid less tax than an equivalent full-time employee. In 2024 this is now reversed.
• Limited company contractors now pay 49% more in tax compared to 21 years ago on an inflation-adjusted business income basis.
• Equivalent full-time employees now pay 15% less in tax compared to 21 years ago on an inflation-adjusted gross annual salary basis.
• Overall, limited company contractors still have a higher net take-home pay than a full-time equivalent, which reflects the higher risks and associated extra costs of running their own business. And while the scenario we illustrate here is straightforward, a good contractor accountant will be able to help you squeeze a little more from every pound of income.
• IR35 is now much less potent than it was 21 years ago. In fact, it would now be fair to say that IR35 now has a vastly reduced impact on tax revenue for the HMRC than was the case 21 years ago. Risks to end clients engaging limited company contractors is also significantly reduced now that the IR35 offset mechanism is in place (and backdated to 2017). With numerous firms now advising end-clients on how to streamline an IR35 friendly environment, the risks associated with engaging limited company contractors are now at an all-time low.

Let’s Go Back in Time

We started our contractor accountancy firm back in 2005, and I have managed to find some old tax calculations that we used for some initial clients for the 2003/04 tax year. Back when we started our business, the term “tax motivated incorporation” was common, and there was certainly a very distinct advantage for workers to move from employment to self-employment via a limited company in terms of taxes paid.

Only a few years earlier, IR35 was introduced to effectively prevent the scenario where an employee was P45’d on a Friday and came back contracting on the Monday through their own limited company.

Things have changed a lot since then and the HMRC now have much better access to real time information. Also, the Off Payroll rules have moved the liability for ltd company contractors “caught” by IR35 from the limited company itself to the end client that engaged the contractor. This has made end-clients more wary of engaging contractors and having the HMRC pursue IR35 investigations with high profile contractors like Kay Adams and Gary Lineker (HMRC failed in both) can cause some end clients to think the engagement of ltd company contractors is not worth the hassle. IR35 however mostly works as a deterrent, and in fact most end clients are capable of offering a IR35 friendly environment for contractors.

So, I have been wondering lately, with all the tax changes introduced over the past 20 years, is there such a thing as ‘tax-motivated incorporation’ anymore, and is IR35 still relevant in today’s contracting market?

Let’s look at a really simple contractor scenario, where we have a limited company contractor working for a fixed daily rate, working 48 weeks of the year, and where they have business expenses totalling 5% of their turnover. Let’s keep VAT out of the scenario for simplicity, and we’ll have the contractor draw all available funds from their business using the most tax efficient ratio of salary and dividends of the day. We’ll also assume that the contractor has no other sources of income.

In our first scenario the contractor will be on a fixed daily rate of £200 per day for the year ended 31 March 2004.

Using the Bank of England inflation calculator, £200 in 2004 is worth £345.60 in February 2024. I want our second scenario to cover year ended 31 Mar 2025, so lets make the contractors rate of pay £350 per day. Of course, the wage inflation could run at a different rate for the role our hypothetical contractor is in, but the general rate of UK inflation seems fair for our analysis.

I also want to look at what a full-time employee would have been paying in taxes under each scenario. We know that contract rates tend to be higher than a full-time employees salary to account for things like lack of benefits, no holiday pay, no sick pay, lack of job security, and that contractors must pay for their own training, insurances, and accounting. The amount appears to be variable across sectors and job types, but a common rule of thumb that keeps popping up is a contractor’s rate of pay is often 50% higher than a full-time employee. So I will use this in my analysis.

Scenario 1 – Earnings for period to 31 March 2004

Here we have a contractor earning £200 per day, for 48 weeks of the year. This equates to an overall business income of £48,000 per year. The business has expenses at 5% of turnover, so total expenses are £2,400.

The optimal salary for the contractor to take is £4,615 per annum, so total business profit is (48,000 – 2,400 – 4,615) = 40,985.

The corporation tax calculation was different back then. If your business had profits of less than £10,000 per annum you paid 0% corporation tax and then the small companies tax rate of 19% kicked in for profits over £50,000 (and up to £300,000). Back during these years, the vast majority of our clients paid a corporation tax rate somewhere between 0% and 19%.

For the year ended 31 Mar 2004, the corporation tax due on company profits in this scenario is £7,359.

This leaves a total of (40,985 – 7,359) = £33,626 available for dividends. As I mentioned above let’s say the contractor takes all available funds as dividends, so for the year ended 31 March 2004 total dividends paid to the contractor is £33,626. 

Dividends were also taxed a lot differently in 2004. Effectively the first £30,500 in dividends paid were completely tax free, and any dividends over that threshold were taxed at an effective rate of 25%. Back then dividends were paid with a nominal tax credit of 10%, and the tax calculation was a bit different. In this case, dividends paid of £33,626 attracted a dividend tax of £1,544.

So in summary our contractor pays (7,359 + 1,544) = £8,903 in taxes across to the HMRC. As a percentage of business income this is (8,903 / 48,000) = 18.5%

They also get a net income of (4,615 + 33,626 – 1,544) = £36,697. As a percentage of business income this is (36,697 / 48,000) = 76.5%.

Now let’s also look at the equivalent full-time employee. Using the rule of thumb mentioned earlier, a full-time employee in the same role was paid is (48,000 / (1 + 50%)) = £32,000 per annum. If we assume the normal tax code of 461L, they will have a total of £5,789 in PAYE and £2,907 in employees NIC deducted from their pay. Total net pay after taxes would have been (32,000 – 5,789 – 2,907) = 23,304. As a percentage of gross salary income, this is (23,304 / 32,000) = 72.8% (making the overall employee tax rate 100 – 72.8 = 27.2%).

And total taxes paid to the HMRC would have been £5,789 in PAYE, £2,907 in employees NIC, and £3,505 in employers NIC, which totals £12,201.

2004 Pay Summary

In 2004, for a limited company contractor with business income of £48,000 per year, the HMRC gets £8,903 in taxes, and the contractor gets a net pay after all taxes of £36,697.

For the full-time employee paid £32,000 per year, the HMRC gets £12,200 in taxes, and the employee gets a net pay after all taxes of £23,204.

Scenario 2 – Earnings for period to 31 March 2025

Now zoom forward to today. Here we have a contractor earning £350 per day (equivalent to 2004 after inflation), for 48 weeks of the year. This equates to an overall business income of £84,000 per year. The business has expenses at 5% of turnover, so total expenses are £4,200.

The optimal salary for the contractor to take is £9,096 per annum, so total business profit is (84,000 – 4,200 – 9,096) = 70,704.

The corporation tax calculation has now changed. Profits under £50,000 are now taxed at 19%, and profits over £250,000 are taxed at 25%. The starter rate of 0% from 20 years has now gone. Nowadays most of our clients pay a corporation tax rate somewhere between 19% and 23%.

For the year ended 31 Mar 2025, the corporation tax due on company profits in this scenario is £14,987.

This leaves a total of (70,704 – 14,987) = £55,717 available for dividends. As a mentioned above let’s say the contractors takes all available funds as dividends, so for the year ended 31 March 2025 total dividends paid to the contractor is £55,717.

Dividends are now taxed a lot more aggressively than in 2004. You now get just £500 of dividends tax free (compared to £30,500 in 2004), and the top tax rate for dividends is 39.35%. Dividends also no longer carry a tax credit (this was dropped from the 2016/17 tax year onwards), and now other than the first £500, dividends attract a tax charge ranging from 8.75% to 39.35% depending on your tax band. In this case, dividends paid of £55,717 would attract a dividend tax of £8,163.

So in summary our contractor pays (14,987+ 8,163) = £23,150 in taxes across to the HMRC. As a percentage of business income this is (23,150 / 84,000) = 27.6%

They also get a net income of (9,096 + 55,717 – 8,163) = £56,650. As a percentage of business income this is (56,650 / 84,000) = 67.4%.

Now let’s also look at the equivalent full-time employee. Using the rule of thumb mentioned earlier, a full-time employee in the same role is paid (84,000 / (1 + 50%)) = £56,000 per annum. If we assume the normal tax code of 1257L, they will have a total of £9,828 in PAYE and £3,130 in employees NIC deducted from their pay. Total net pay after taxes will be (56,000 – 9,828 – 3,130) = £43,042. As a percentage of gross salary income this is (43,042 / 56,000) = 76.9% (making the overall employee tax rate 100 – 76.9 = 23.1%).

And total taxes paid to the HMRC would have been £9,828 in PAYE, £3,130 in employees NIC, and £6,473 in employers NIC, which totals £19,431.

2025 Pay Summary

For the year to 31 March 2025, for a limited company contractor with business income of £84,000 per year, the HMRC gets £23,150 in taxes, and the contractor gets a net pay after all taxes of £56,650.

For the full-time employee paid £56,000 per year, the HMRC gets £19,431 in taxes, and the employee gets a net pay after all taxes of £43,042.

Analysis of Results

The table below summarises the tax position for both scenarios. In 2004, the contractor paid less tax to the HMRC. In 2025 this has now reversed, and the equivalent employee now pays less tax.

	Mar 2004	Mar 2025
Overall taxes paid by Contractor *	8,903 (18.5%)	23,150 (27.6%)
Overall taxes paid by Employee **	12,200 (27.2%)	19,431 (23.1%)
Difference in tax paid	3,297	3,719

Overall Summary

It’s evident that the tax landscape for limited company contractors and full-time employees has significantly evolved over the past two decades. While contractors face increased taxation compared to 21 years ago, their capacity for higher take-home pay through tax-efficient strategies remains advantageous. This reflects the inherent risks and overheads of managing their own business. With IR35 becoming less of a threat and more manageable, the contracting environment appears more stable now. It is important for both contractors and those engaging them to stay informed and proactive about the latest tax laws and optimization strategies to ensure they navigate these financial waters successfully and continue to benefit from the flexible work arrangement that contracting offers.

A good contractor accountant, such as No Worries Accounting 😁, can help ensure that contractors make the most of their hard-earned money and enjoy the flexibility, freedom, higher earning potential, and entrepreneurial growth that comes from contracting through their own limited company.

We think now is a good time to sit back and reflect on why IR35 was introduced and to consider if this kind of legislation is suited to modern work practices, which have significantly transformed since 1999. In the press release from HMRC dated 23 September 1999, it introduces what is now known as IR35:

New rules to tackle tax avoidance using personal service companies and similar intermediaries were published today.

The rules, which were developed following extensive consultation, ensure that the legitimate use of service companies can continue, but they will no longer provide a means to avoid paying a fair share of tax and National Insurance Contributions.

Our analysis here now shows that in 2024, if an employee is issued a P45 on a Friday and returns on a Monday as a limited company contractor, HMRC would collect more in tax. It’s a reversal from 2004 and certainly doesn’t sound like tax avoidance to us.