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Understanding the Difference Between Independent Contractor vs Employee

employee or contractor

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If you have decided to take on someone to work with you, should that person be an employee of your business or an independent contractor?

Emily Coltman ACA, Chief Accountant to FreeAgent – who provide an award-winning online accounting system for freelancers and small business owners – gives her top tips on the different financial and other issues you may encounter when working with employees as compared to contractors.

Independent Contractor vs Employee

1. Tax responsibilities

If you take on an employee, you must register as an employer, run their payroll and pay PAYE and NI, file the right forms with HMRC at the right time, and make sure you’re ready for RTI.

When you work with a contractor, you must be sure they really are independent.  If they are a sole trader and found to be an employee by HMRC, then it’s you who would be liable for the extra tax.  However, if they trade through their own limited company, then it’s that company that would be liable for any extra tax.

2. Paying them

For your employees, their wages will often be their only source of income, so even if business cash flow is tight, you can’t delay or avoid paying them!

With a contractor, you have more flexibility than with an employee to negotiate payment timescales and to pay less than the agreed fees if they don’t cut the mustard.  Also, you don't have to worry about providing benefits like whole life insurance or a matching 401K retirement account. But it’s important not to push them too far, or they won’t want to carry on working with you, and your relationship with them will be soured.

3. Legal

When you take on an employee, you must know your and their rights and responsibilities under employment law, which is a very complex area.  For example, you could have to pay statutory sick pay, or maternity or paternity pay.  You must give your staff paid time off, and put a contract of employment in place.  The list goes on. If you don’t have an HR department, consider using an outsourced HR service to help with this.  This is a very easy area to fall into a trap because as the proverb says, “You don’t know what you don’t know.”

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A contractor should have a standard contract for services, but again you should be aware of the ins and outs of this and what it would mean for you in the event of a dispute.  It might be as well to have the contract checked by a friendly solicitor or legal expert.

4. Work

You must give your employees work to do, and pay them their full salary even if they have a few tasks to do.  For example, in an accountancy practice, the months of February and March are often very quiet, because the key tax filing deadline of 31st January has passed and the new tax year has not yet begun.  Staff in the practice still have to be paid their salaries even if they are not carrying out chargeable client work.

But colleagues who worked as independent contractors often didn’t come in full-time during February and March.  You can ask a contractor not to come in, and not pay them if you don’t have any work for them to do.

5. Development

Relating to the above point, as a good employer you should give your employees regular appraisals and work with them to help them grow and develop their career path.

Although you should also review your contractors’ performances, their career growth is their own responsibility rather than yours.

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6. Involvement

With all these responsibilities why do business owners take on any employees, rather than simply staffing their business with contractors?

Firstly, because HMRC are on the alert for people avoiding tax by pretending to be independent when they’re actually not, and they will levy that extra tax.

Also, when you’re growing your business it’s important to build the right crew to work together and stay together.  When your team is employees who plan to stay with the business long-term, you have the potential to build a much stronger and more effective crew.

Contractors may well have other projects to do or take side gigs like running a BeerMoney blog, and may not feel so much like one of the team.  That said, I’ve known contractors who were as much part of the crew as employees.  It depends on the individuals as well as their status.

You need to take into account all the above before deciding on whether to hire an employee or contractor.

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