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Contractors be warned: here are 5 tax headaches you need to avoid

Tax Time Text on Adhesive Note on Alarm Clock. Source: Getty Images
Tax Time Text on Adhesive Note on Alarm Clock. Source: Getty Images

It’s common in certain trades for people to be taken on as independent contractors rather than employees.

Independent contractors are in theory treated as small businesses, with all the tax implications that go with that, the most significant of which are a potential obligation to register and account for GST and to account for your own income tax (rather than having it deducted for you by the employer).

Deciding whether you’re a contractor or an employee can be a minefield, both for the individual and for the business taking you on.

Getting it wrong can have a big impact, with consequences both for you and for the business which has engaged your services.

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What is contracting?

Contractors (or consultants as they are sometimes called) are self-employed people engaged for a specific task, at an agreed price, with a specific goal in mind, often over a set period of time.

They set their own hours of work and take care of their own tax obligations.

Contractors are paid a fee for completing an assignment. They don’t receive a salary or wage.

Often, once an assignment is finished, the contractor will move on to a new assignment with a different business.

Contractors will often perform work for more than one business at a time.

Some myths dispelled

There are a series of common myths and misconceptions which are routinely trotted out by armchair tax experts which can lead you badly up the garden path.

So, if you’ve based any employee/contractor decisions on any of these myths, you might want to revisit those decisions:

Myth 1: If I have an ABN, I’m a contractor

Having an ABN makes no difference, and will not automatically make you a contractor for a job. If the working arrangement has all the hallmarks of employment, whether you have or quote an ABN will not make you a contractor.

Myth 2: If I only work for short periods, I’m a contractor

Just because work is short term or irregular makes no difference and will not make you a contractor for a job. The working arrangement determines whether you are an employee or a contractor, not the amount of time you work for an organisation.

Myth 3: If others in my industry are doing the same, then I’m a contractor

Industry practices make no difference and will not make you a contractor for a job. Don’t assume other businesses have worked it out correctly – it’s your working arrangement that determines if you are an employee or contractor.

Myth 4: If the contract or agreement says so, I’m a contractor

A contact or agreement makes no difference and will not make you a contractor for a job. If the working arrangement is employment based on the facts and circumstances of that arrangement, a contract or agreement stating you are a contractor won’t override this employment arrangement or change the obligations you need to meet.

Myth 5: If I submit an invoice, I’m a contractor

Submitting an invoice for work done makes no difference and will not make you a contractor for a job. The working arrangement determines whether you are an employee or a contractor, not whether you submit an invoice.

Why do businesses like contractors?

Many businesses like taking people on as contractors. It gives them the flexibility to ‘hire’ and ‘fire’ at will to cover peaks and troughs in the order book. It also generally saves on costs and red tape. Some people prefer the relative freedom of contracting, though others resent the lack of rights and job security.

Employee or contractor?

The basic rule is that if you are engaged just for your labour, you will be considered an employee rather than a contractor from a tax point of view.

Beyond that, it gets complicated. Here are the key attributes of an employee and a contractor, compared and contrasted.

Ability to sub-contract or delegate:

An employee cannot sub-contract or delegate the work - they cannot pay someone else to do the work.

A contractor is free to sub-contract or delegate the work - they can pay someone else to do the work.

Basis of payment:

An employee is paid:

  • for the time worked

  • a price per item or activity

  • a commission.

A contractor is paid for a result achieved based on the quote they provided.

Equipment, tools and other assets:

The business provides all or most of the equipment, tools and other assets required to complete the work, or the worker provides all or most of the equipment, tools and other assets required to complete the work, but the business provides them with an allowance or reimburses them for the cost of the equipment, tools and other assets.

The worker provides all or most of the equipment, tools and other assets required to complete the work. The worker does not receive an allowance or reimbursement for the cost of the equipment, tools and other assets.

Commercial risks:

An employee takes no commercial risks. The business is legally responsible for the work performed by the worker and liable for the cost of rectifying any defect in the work.

A contractor takes commercial risks, and is legally responsible for their work and liable for the cost of rectifying any defect in their work.

Control over work:

The business has the right to direct the way in which the worker performs their work.

A contractor has freedom in the way the work is done subject to the specific terms in any contract or agreement.

Independence:

An employee does not operate independently from the business. They work within and are considered part of the business.

A contractor is operating their own business independently from the hiring business. Services are performed as specified in the contract or agreement and they are free to accept or refuse additional work.

The tax obligations facing the two types of worker are very different. Employees have tax deducted at source from their salary and receive compulsory superannuation payments from their employer. Contractors have to pay their own tax from their gross earnings and also need to make their own superannuation contributions.

The burden of getting the decision right rests with the hiring business. If they incorrectly – based on the facts – deem you to be a contractor when you should be treated as an employee, that business should account for PAYG on your wages, pay you superannuation and give you annual leave and long service leave. Similarly, if you run a small business and hire someone as a contractor, those obligations could fall on your business.

Even if you are a genuine contractor, the business that has engaged you may still have an obligation to pay you superannuation.

The Fair Work Act prohibits "sham contracting arrangements", where an employer treats a worker as an independent contractor in an attempt to avoid meeting employee entitlements. It is illegal for a business owner to convert staff into contractors. Employers who try it can face prosecution for tax evasion and can be penalised for flouting superannuation laws and avoiding workers compensation laws.

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