The tax implications of choosing employees or contractors

What’s the difference between hiring an employee and engaging a contractor? And what are the tax implications? It’s vital small businesses know the difference.

Running a startup or small business and need someone to work for you? Knowing the difference between hiring an employee and engaging a contractor – and the tax and superannuation implications of each – is crucial.

Assuming someone can be classified as a contractor just because they have an Australian Business Number (ABN), or are hired on a short-term deal, can be a big mistake.

In simple terms spelled out by the Australian Tax Office (ATO), the essential difference between an employee and a contractor is this:
an employee works in your business and is part of your business;
a contractor is running their own business.

Easy enough, right? Well, sometimes. It’s not always that clear cut.

“To check if your worker is an employee or contractor, you need to consider the whole working arrangement,” an ATO spokesperson says. “There are a number of factors that need to be considered, not just the terms of the employment contract.”

These factors include whether the worker can subcontract/delegate the work, who’s providing any tools or equipment, and whether the worker is taking any commercial risks. The ATO has come up with a table that lists six factors that need to be weighed up.

“We consider the entire working arrangement in the decision-making process,” the spokesperson says. “There isn’t one factor that makes this determination on its own.”

The ATO also provides an online decision-making tool that walks you through the process, and the ATO recommends you keep a copy of its decision for your records.

Know your tax obligations

The ATO doesn’t mind if you hire employees or engage contractors, as long as you meet the relevant tax and super obligations:

• If your worker is classified as an employee, you must withhold and remit pay-as-you-go (PAYG) tax on their behalf and make superannuation guarantee contributions
• Workers engaged as independent contractors manage their own income tax arrangements. If you make payments to independent contractors in ATO-specified industries (such as building, cleaning and IT services), you need to lodge a Taxable Payments Annual Report (TPAR) each year to help the ATO identify contractors who are not paying as much tax as they should
• You may have to make super contributions for individual contractors if the contract is principally for their labour. The ATO’s decision-making tool can help you work out whether this applies

Avoid sham contracting

Beware: it’s against the law to treat an employee as a contractor. If this is done knowingly or recklessly, it’s regarded as ‘sham contracting’ – and the ATO doesn’t like it one bit.

“Where we identify employers or businesses that deliberately misclassify their workers to gain an unfair advantage, we can take firm action, which includes the imposition of tax and super penalties,” the ATO spokesperson says.

Beyond tax and super, sham contracting also has implications for workplace health and safety, award wages and leave. It’s a contravention of the Fair Work Act and can be investigated by the Fair Work Ombudsman, ultimately leading to court-imposed fines – so do your best to get it right.

Understanding the difference between employees and contractors is not only good business practice and might have tax implications, but it will also help keep you on the right side of the law.

This information is general in nature and does not constitute professional advice. For guidance specific to your situation, MYOB suggests engaging a specialist advisor near you ASAP.