Limited company contractors vs sole traders: What UK businesses need to know

If your business engages contractors, the way they operate matters, not just commercially, but for tax. Get it wrong and you could end up liable for unpaid PAYE and National Insurance. Here's a plain-English breakdown.

The two main ways to engage a contractor

Most contractors work in one of two ways: through their own limited company (sometimes called a personal service company or PSC), or as a sole trader in their own name. Both routes come with different rules, different legislation, and different obligations for your business.

When a contractor operates through a limited company, the IR35 and off-payroll working rules apply. When they contract in their own name as a sole trader, it's the PAYE regulations that govern the engagement. The starting question is the same in both cases: is this person genuinely self-employed, or does the arrangement look more like employment? But how you get to the answer, and who's responsible for getting there, differs depending on the structure.

IR35 and off-payroll: limited companies

Where a contractor works through their own limited company, IR35 applies. If your business is classed as medium or large under the Companies Act 2006, you're responsible for assessing whether the engagement reflects genuine self-employment or something closer to employment.

The assessment uses what's called a hypothetical contract, essentially asking: if there were no limited company in the middle, would this person be an employee? If the answer is yes, the payments are treated as deemed employment income and you need to operate PAYE and National Insurance on them, covering both the employee and employer contributions.

Small companies: If your business qualifies as small under the Companies Act, the responsibility for the IR35 assessment shifts to the contractor's own limited company, not you. That said, it's worth confirming your size status each tax year, as it can change if your business grows.

PAYE rules: sole traders

With a sole trader, there's no intermediary. You're contracting directly with the individual, so the actual contract is assessed rather than a hypothetical one. The core question is the same: employment or genuine self-employment? But the legislation is different, and there's no small company exemption here.

Every sole trader engagement needs to be assessed, regardless of your business size. If the working arrangement looks like employment when you examine it honestly, PAYE and National Insurance must be applied.

One important exception: if a sole trader is placed through a recruitment agency rather than engaged directly by you, the agency must apply Agency Legislation under Chapter 7 ITEPA 2003. That means operating PAYE regardless of employment status. This rule applies even if the worker would otherwise be considered self-employed. Only direct engagements avoid this.

The status tests are the same for both

Whether you're dealing with a limited company or a sole trader, the employment status tests themselves draw from the same body of case law, going back to the Ready Mixed Concrete case in 1967. Both the written contract and the actual working practices in day-to-day reality are considered. The legislation that follows once you've made a determination differs, but the underlying analysis is largely the same.

There's one technical distinction worth knowing: for limited company engagements under IR35, you assess a hypothetical direct contract between you and the worker. For sole traders, you assess the actual contract that exists. In practice this rarely changes the outcome, but it can matter in borderline cases.

What this means for your business

If you're a medium or large business, anyone working off-payroll needs to be assessed, whether they invoice through a limited company or operate as a sole trader. For limited companies, the off-payroll rules set out the process. For sole traders, there's no threshold or exemption: PAYE rules apply from the first engagement.

Getting this wrong can be expensive. HMRC's focus on off-payroll compliance has sharpened considerably, and the liability can sit with the client business. For sole traders in particular, because there's no exemption and no threshold, it's an area that's easy to overlook and easy to get caught out on.

If you're unsure how your current contractor arrangements stack up, it's worth reviewing them before HMRC does it for you.

Not sure where your engagements stand?

J-Benn Finance works with owner-managed businesses across Essex to review contractor arrangements and flag any exposure, before it becomes a problem.