Disclosure: This article is not intended to replace in any way professional accounting advice.
When it comes to hiring, a common area of confusion for startup founders is whether their new hire is in fact a contractor or an employee.
It’s important to get the distinction right. Hiring contractors and employees each comes with different responsibilities for you as a startup founder. While this is generally an area touched on by HR and employment law experts, it also crosses over to incorporate different tax requirements.
From a tax angle, it’s important you (1) first work out whether a hire is a contractor or an employee and (2) understand the different tax requirements for hiring contractors vs employee:
(1) Is your new hire a contractor or an employee?
The ATO lists six factors which need to be considered in determining if your hire is a contractor or an employee:
— Is your hire able to sub-contract/delegate? A contractor is able to sub-contract/delegate and pay someone else to carry out the work, whereas an employee is not.
— What is the basis of payment? A contractor is paid for achieving a result, whereas an employee is based on hours worked/commission/price per item.
— Who provides the equipment, tools and other assets? A contractor provides the majority of the equipment, tools and other assets they use and doesn’t get paid an allowance for these. Whereas, an employee does not provide the majority of equipment, tools and other assets and in instances where the do, they are reimbursed for these costs.
— Who takes the commercial risk? Contractors take on the commercial risks, being legally responsible for their work. An employee on the other hand does not take on the commercial risks which are borne by your startup instead.
— Who has control over your hire’s work? Contractors, subject to the terms in your agreement with them, can exercise freedom in the way they carry out their work. Whereas, workers are more bound by the employment terms of your startup.
— Is there independence? Contractors operate independently from your startup whereas employees are part of your startup.
You may also find using the ATO’s online Employee/contractor decision tool useful in reaching a decision on the above.
(2) The different tax requirements for hiring contractors vs employees
When hiring contractors vs employees, there are four key differences when it comes to tax which you need to be on top of:
Unlike employees, with contractors you don’t need to worry about withholding tax from payments. You only need to withhold tax if your contractors don’t quote an ABN when they invoice you or if they ask you to withhold tax from their payment (known as a voluntary agreement). This means that contractors need to remember that when they get paid the amount received is the gross amount, so a portion of it will need to be set aside to cover their income tax.
You are not required to pay GST on employees wages. If you contractor is registered for GST, you will be required to pay GST as part of the work they charge. If you are registered for GST, you will be able to claim the GST back in your BAS.
Employees are entitled to receive superannuation (subject to certain provisions). However, a common error startups make is thinking that they do not need to pay superannuation to contractors. This is wrong. If you hire an individual contractor and more than 50% of the value of their contract is for their own labour then you are liable to pay superannuation.
However, superannuation is only calculated on the labour component of their payment. Explaining this, if the contractor invoiced $1,000 and $600 was for labour and 40% was for tools, you would only pay superannuation on the $600. More information on the superannuation rules around contractors can be found here.
Contractors, unlike employees, are not subject to leave entitlements such as sick leave, annual leave and compassionate leave. This is important to be aware of from a tax perspective as entitlements to employees forms part of their pay or, depending on the type of leave, their payout at termination of their employment.