Start-up legal basics: Hiring employees vs hiring contractors

StartupSmart is running a five-part series to help plug any potentially disastrous knowledge gaps that new entrepreneurs may have regarding legal issues.

Lachlan McKnight, CEO of LegalVision, has already covered off legal structures, lurking online pitfalls and the key documents you need to know. Today, McKnight talks hiring.

As the founder of a start-up, there will hopefully come a time when you need to increase your workforce.

You may have raised some capital, or signed up some new customers. In any case, you’ve got the cash to hire. The next question is whether you want to bring on board an employee, or hire a contractor.

What’s the difference?

It is important to note that the legal obligations of a business differ depending on whether they employ someone as an employee or engage a contractor.

An employee works in a business and is part of that business. A contractor, on the other hand, runs their own business, has an ABN and provides services to other businesses.

Why does it matter to me?

Generally, as an employer, you will have many more obligations towards an employee than you would a contractor.

For instance, an employer has a legal obligation to withhold pay-as-you-go tax from payments of salary and wages made to an employee.

An employer also has to make compulsory superannuation guarantee contributions to an employee’s nominated superannuation fund.

In addition, as an employer you will be responsible for work undertaken by your employees. If they make a mistake then you (or they) will need to fix it, but you will be paying for it to be fixed.

On the other hand, contractors are responsible for their own taxation and superannuation obligations and an employer is not required to deduct the relevant amounts from any payments made to contractors (unless they do not quote their ABN).

Working with a contractor is therefore a great option if you need a defined piece of work completed in a set time frame.

It also means that the contractor will generally be responsible for any work he/she/it undertakes so that they (not you) will need to fix any mistakes.

So what’s the catch?

It sounds like working with a contractor is the way to go then, right? Unfortunately, it’s not that simple!

As an employer, you can’t just designate an individual working for you as a ‘contractor’ in order to avoid the legal obligations associated with hiring an employee.

The ATO can rule that someone characterised as a ‘contractor’ is actually an employee, even if the employer did not intend to hire the employee but rather sought to set up a contracting arrangement.

The six basic differences between employees and contractors are set out below:

1. Delegation/sub-contracting

• An employee cannot delegate or sub-contract their work and/or pay a third party to perform their work.
• Unless otherwise agreed, a contractor can generally delegate or sub-contract their work and pay a third party to perform their work.

2. Payment

• An employee is paid a salary, hourly rate and/or commission.

• A contractor is generally paid based on a result achieved (e.g. completion of a task).

3. Equipment

• A business provides most, if not all, of the equipment for use by its employees. If an employee purchases equipment then the employer generally reimburses the employee for the cost of the equipment.

• A contractor supplies most, if not all, of their own equipment required to complete their work and is not reimbursed for the cost of the equipment.

4. Risk

• An employee takes no commercial risks and the employer is legally responsible for the acts of its employees.

• A contractor takes commercial risks and is legally responsible for their work.

5. Control over work

• An employer has the right to direct its employees in relation to the work that they perform.

• A contractor has freedom in performing work, subject to the terms of any contract.

6. Independence

• An employee does not work independently of his or her employer; their work is part of the employer’s business.

• A contractor is operating their own independent business, may accept or refuse to perform additional work (subject to contract) and may contract with third parties.

These factors are not determinative and the circumstances of each relationship must be carefully considered to determine the type of relationship that exists.

So which one is for you?

Before you ask someone to perform tasks for your business it is important to work out whether you want to hire an employee and enter into an employment contract or simply contract out.

Hiring an employee will usually be less expensive in the long-run, but you will be taking on a number of legal obligations that can be burdensome.

The terms and conditions of an employer-employee relationship should be documented in an employment contract.

Contracting out is simple, but generally more expensive. If you choose to contract out you must ensure your relationship with the contractor does not have the characteristics of an employee/employer relationship and that the rights and obligations of you and the contractor are clearly specified in a Contractor Agreement.

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