Most founders could tell you headcount without hesitation, but far fewer could tell you, role by role, who's actually the legal employer across their whole team. Direct hires, contractors operating through personal service companies, agency workers, umbrella company arrangements, each carries a different set of obligations and a different level of risk, and 2026 has made getting that wrong considerably more expensive.
Why this matters more than it used to
The legal test for employment status hasn't changed. What has changed is the cost of getting it wrong. Since April 2026, Statutory Sick Pay applies from day one of employment with no lower earnings limit, meaning a misclassified worker can potentially claim unpaid sick pay stretching back through the whole engagement. From January 2027, the unfair dismissal qualifying period drops to six months, so a misclassified contractor who's actually been working as an employee for that long could acquire full unfair dismissal protection without either side realising it. And umbrella companies, widely used across the contractor and agency labour market, are being brought within scope of Fair Work Agency regulation as the definition of "employment business" is expanded, with enforcement expected as the framework phases in.
Layered on top of the existing off-payroll working (IR35) rules, which already require medium and large businesses to determine the correct employment status of anyone engaged through an intermediary, the practical result is straightforward: employment status errors that used to sit quietly for years now surface faster, and cost more when they do.
What goes wrong
Misclassification rarely happens through carelessness. It happens because a working relationship changes gradually, a contractor originally brought in for a fixed project ends up working exclusively for one business, taking direction day to day, and using company equipment, in ways that look far more like employment than genuine self-employment, regardless of what the original contract says. HMRC and employment tribunals look at how a relationship operates, not just what the paperwork claims, which means a status decision made a year or two ago can quietly become wrong without any contract ever being updated.
The financial exposure when this surfaces is real. A misclassified worker can bring claims for unpaid holiday pay, National Minimum Wage shortfalls, statutory sick pay and pension contributions, while HMRC can separately pursue unpaid PAYE and employer National Insurance, plus interest and penalties, from the business itself.
What the audit should actually cover
A useful version of this exercise doesn't need to be a full legal review, it needs to answer a few direct questions for every person doing work for your business: who employs them on paper, does that match how the relationship operates day to day, and if that person brought a claim tomorrow, would your paperwork hold up. For contractors specifically, it's worth checking whether the working pattern still matches the original IR35 assessment, since roles evolve faster than contracts get updated. For anyone engaged through an agency or umbrella arrangement, it's worth confirming exactly who is responsible for PAYE, holiday pay and pension contributions, rather than assuming the intermediary has it covered.
What this means for how you structure your team
Running this audit is worthwhile regardless of how you hire, but it also tends to make one thing obvious: the more intermediaries and arrangements sitting between you and the person doing the work, the harder this gets to keep track of. A model where one employer is clearly and contractually responsible for every compliance obligation removes this ambiguity entirely, which is exactly the appeal of an employer of record structure over a patchwork of direct hires, contractors and agency arrangements.
FAQ
Has the legal test for employment status changed under the Employment Rights Act 2025? No, the underlying test for determining employment status is unchanged. What has changed is the financial and legal consequence of getting that classification wrong.
What happens if a contractor is later found to have been misclassified? They may be able to claim unpaid holiday pay, National Minimum Wage arrears, statutory sick pay and pension contributions, while HMRC can separately pursue the business for unpaid PAYE and employer National Insurance.
Are umbrella companies being regulated under the Employment Rights Act 2025? Yes. The Act expands the definition of "employment business" to bring umbrella companies within scope of Fair Work Agency regulation, with implementation expected to follow a consultation period.
Do the off-payroll working (IR35) rules still apply alongside these changes? Yes, IR35 rules continue to apply to medium and large organisations engaging contractors through personal service companies, independently of the newer Employment Rights Act obligations.
How often should I review employment status across my team? At least annually, and whenever a contractor's working pattern changes meaningfully, since status is judged on how a relationship operates, not just what the original contract says.
Sources
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