tax consequences of hiring an employee or a contractor
News, Tax & Accounting

Tax Implications of Hiring Employees vs. Independent Contractors

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As a business owner contemplating a new hire, you may be wondering which way to go – with an employee or an independent contractor. While both may offer the skills and services you need, when it comes to your tax obligations, there are substantial differences between the two. Understanding these differences helps prevent unexpected costs and ensures you meet your tax duties.

Here’s what business owners need to consider when choosing between hiring employees or independent contractors:

What’s the difference between an employee and a contractor?

The Australian Taxation Office (ATO) outlines specific criteria for determining whether a worker is an employee or works as an independent contractor.

The table below illustrates the key differences:

When you hire an employee
When you hire a contractor
  • They work within your business under a contract of employment
  • Have regular working hours
  • Are paid a wage or salary
  • Are entitled to any employee benefits programs you have in place
  • Are entitled to annual and personal (sick) leave
  • Are entitled to superannuation
  • May work at your office or remotely (as set out in the employment contract)
  • Employers have greater control over their employees’ workloads – i.e. they will carry out tasks under your direction and guidance, during hours set out by you
  • They have their own business
  • They may offer their services to multiple clients, including you (which means you will join the queue when needing work done)
  • They have control over the hours they work, where they work and what their schedule looks like.
  • Work will be invoiced (i.e. no fixed wage and benefits)

 

It’s important to classify your workers correctly, as it affects your tax responsibilities, superannuation obligations, and potential liabilities.

Tax withholding obligations for employees vs. contractors

One key distinction between hiring an employee and an independent contractor lies in how taxes are handled and reported. Refer to the table below for a concise overview of your responsibilities for each

When you hire an employee
When you hire a contractor
  • Employer will need to withhold PAYG (Pay As You Go) withholding tax from employees’ wages and remit it to the ATO on their behalf
  • Employer is responsible for submitting regular payroll tax reports
  • Employer is responsible for issuing payment summaries
  • Employer will need to meet all ATO requirements
  • Employers generally don’t need to withhold tax from contractor payments unless the contractor does not provide their ABN, in which case employers must withhold 47% of the payment.
  • Contractors are responsible for managing their own tax obligations and paying their own income tax
  • Contractors may need to make quarterly PAYG instalments if required by the ATO

 

Superannuation obligations for employees vs. contractors

Superannuation requirements vary for employees and contractors, and the regulations are not always clear-cut.

When you hire an employee
When you hire a contractor
  • Employers must pay superannuation at the Superannuation Guarantee rate (currently 11.5%)
    • For employees over 18 superannuation is paid on ordinary earnings
    • For employees under 18 superannuation is paid if they work more than 30 hours in a week
  • The abovementioned contributions must be made to the employees nominated super fund at least quarterly.
  • Contractors are generally responsible for their own super contributions

 

Note: If a contractor is engaged mainly for their labour, they could be treated as an employee for superannuation purposes, and you may need to make super contributions on their behalf. This can be complex, so seek professional clarification if you’re unsure.

 

 

Leave entitlements and worker’s compensation for employees vs. contractors

One of the key distinctions between employees and contractors is that you can provide employees benefits such as annual leave, personal leave, and long service leave. This can help attract talent during the hiring process.

When you hire an employee
When you hire a contractor
  • Employers are required to provide paid leave entitlements in line with the National Employment Standards (NES) and their applicable award or enterprise agreement
  • Employer must have workers’ compensation insurance to cover employees in case of injury or illness at work
  • Contractors do not receive paid leave entitlements
  • Contractors manage their own insurance cover, including income protection and public liability insurance

Note: If a contractor is misclassified as an independent contractor when they should be an employee, you may be liable for back pay of leave entitlements and other benefits, as well as fines.

You may also need to include contractor payments on your workers compensation insurance. Check with your provider as requirements can change for each State

 

Payroll Tax for employees vs. contractors

Payroll tax is a tax imposed on businesses with total taxable wages surpassing a specific threshold, which differs across states and territories.

When you hire an employee
When you hire a contractor
  • Wages paid to employees are subject to payroll tax if total national wages (including superannuation) exceed the threshold for your business within the relevant state or territory that individuals are employed.
  • Payroll tax is calculated based on the total wages you’ve paid for a month. If you surpass the threshold, you must register for payroll tax.
  • Payments to independent contractors are generally not subject to payroll tax.
  • Depending on where you live, payroll tax might be necessary for payments made to contractors who exclusively work for your company or under certain conditions.

 

Fringe Benefits Tax (FBT) for employees vs. contractors

When you provide non-cash benefits to staff (e.g. company cars, health insurance or accommodation), you incur Fringe Benefits Tax (FBT).

These benefits are taxed separately from income tax.

When you hire an employee
When you hire a contractor
  • FBT applies to employees if you provide them with fringe benefits
  • Employers are responsible for calculating and paying FBT
  • FBT generally does not apply to contractors, as they are not considered employees.
  • Any non-monetary benefits offered to a contractor are usually regarded as part of their compensation package and will be subject to income tax by the contractor.

 

Risk of incorrectly classifying employees and contractors

The ATO and Fair Work Ombudsman closely monitor worker classification. Misclassifying employees as contractors can result in serious consequences, such as having to pay back wages, superannuation, leave benefits, and fines.

Here are some common risks associated with misclassification:

  • Superannuation shortfall: Not providing superannuation contributions for employees classified as such may lead to the ATO imposing a superannuation shortfall charge.
  • Unsettled entitlements: If an employee is mistakenly classified as a contractor, they could request reimbursement for unpaid leave, overtime penalties, and other entitlements they missed.
  • Penalties and interest: Businesses that do not fulfill their PAYG, superannuation, and other tax obligations due to misclassification may face penalties and interest charges from the ATO.

To Summarise…

Determining whether to hire employees or engage independent contractors carries significant tax and legal implications. Employees offer stability and the ability to provide benefits, while contractors provide flexibility and potential tax and superannuation savings. However, misclassifying workers can lead to severe financial penalties, so accuracy is crucial.

If you’re unsure about the best choice for your business or want to ensure compliance, seek professional advice. At Lemonade Beach Accounting, we provide general guidance on the different options and considerations. We recommend consulting specialist HR and Employment Law advisers to confirm your contracts and terms of engagement meet legal requirements.

Contact us today for tailored advice on worker classification and tax planning strategies designed for your business.

 

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