Contractor vs employee: employment and tax implications
Depending on the nature of your business, you may have workers who are employees or contractors, or you may have both. Each has their merits, but it’s important to review which are which in order to meet your tax obligations.
When you have an employee, you must withhold income tax as well as report on additional benefits. Contractors generally look after their own tax obligations but in some cases employers may have to withhold tax from payments.
Contractor vs employee definitions and obligations
It’s against the law to treat an employee as a contractor. Significant penalties apply if you do, so it’s important to get it right. The simplest way to remember is:
An employee works in your business and is part of your business.
A contractor is running their own business.
Employment NZ states that:
- Contractors are self-employed and earn income by invoicing the principal for their services. A contractor pays their own tax and ACC levies.
- Contractors aren’t covered by most employment-related laws. This means they don’t get things like annual leave or sick leave, they can’t bring personal grievances, they have to pay their own tax, and general civil law determines most of their rights and responsibilities. Businesses don’t have to hold contractor records.
- An employee is a person employed to do any work for hire or reward under a contract of services (an employment agreement).
- Employees have minimum employment rights under employment laws such as the right to take a personal grievance. the minimum wage, holiday and leave entitlements and a written employment agreement.
But how can you be sure that you’ve got an employee or a contractor on your hands, especially with remote work blurring the lines between employees and contractors? Does there come a point that you should actually be hiring a worker as an employee, when you thought they were a contractor? There are six factors to consider:
1. Ability to subcontract or delegate
An employee is not able to subcontract or delegate the work. They must perform the outlined tasks themselves. If they can’t do the work themselves for any reason, say a prolonged illness, and someone else does it, this is substitution. Your business would then pay the other person to carry out those activities.
A contractor can delegate the work as long as they’re not obligated to do it themselves as per the contract. If your contractor can’t work, they would arrange for another qualified person to do it. You would pay your contractor as usual, who would then pay their subcontractor.
2. Basis of payment
An employee is paid a set amount per period of time. The most obvious example would be an annual salary or hourly wage. Some employees are paid piece-work rates. They receive an amount per successful sale, or per the number of pieces produced. A commission basis would be a price per item structure.
A contractor, however, is paid an agreed-upon price in exchange for a predetermined result. Some contracts may specify the amount to be paid in increments as stages of the project are completed. But the key takeaway is that a contractor is paid when the agreed-upon result is achieved.
3. Equipment, tools, and other assets
If your business is responsible for providing the equipment, tools, and other assets required to perform the job, that’s characteristic of an employee.
If the worker is providing these items, they are likely a contractor.
4. Commercial risks
Employees do not bear commercial risk and they are not liable for correcting any defects in the work at their own expense. Instead, your business takes this responsibility. The worker will be paid for the time required to perform the task to completion.
A contractor assumes the commercial risk. They are responsible for fixing any mistakes on their own time. This extra work would fall under the umbrella of the terms set at the beginning of the project. Your business does not have to pay for any extra time taken or materials used, unless otherwise specified in the contract.
5. Control over the work
Employees have to complete the work the way the employer specifies. What work is done, where it’s done, how it’s done, and when it’s done are all up to the employer. The employee then completes the work as required.
Contractors are not subject to the same rules. They decide when and how the work is done, so long as it meets the obligations laid out in the contract. For example, a contractor could choose to work three 10-hour days to complete a job, rather than working four 8-hour days.
An employee works within a business. They complete tasks as required until they leave the job.
A contractor operates independently and may have any other number of contracts on the go with other companies. They can freely accept and refuse other work. Their obligation is complete when they deliver the specified outcome.
In the case of an employee/employer relationship, the employer pays PAYE tax and ACC on the employee’s behalf, and the employee is paid net wages or salary.
Self-employed people (contractors) are responsible for their own tax. This means they must:
- declare to Inland Revenue they are in business
- complete an individual tax return (IR3) each year
- budget to make regular payments of provisional tax and end-of-year income tax
- register for GST if turnover was over $60,000 in the last 12 months or will be over $60,000 in the next 12 months.
Schedular payments are made to contractors who perform certain activities such as:
- an IT project manager contracted by a recruitment agency (labour hire business) to one of the agency’s clients
- a builder contracted to a labour hire business
- a freelance journalist paid to write a magazine article.
In most cases tax will need to be deducted from payments and employment information filed with Inland Revenue.
It can be confusing to make the determination between an employee and contractor, but it’s important that you do so in order to meet your tax obligations and play by the rules. Contact us to learn more about your tax obligations for employees and contractors.