When Your Contractor is Not a Contractor – You Might Lose More Than Just Your Business
When I have a client that isn’t sure or is concerned about their work arrangement, I will often send them off to the ATO’s Decision Tool. It’s not an exact science. As I covered in my last blog post, there are a few indicators that need to be considered when looking at whether you have an employee or contractor, and none of them can be considered in isolation. When you read the info on the table that's on ATO website or anywhere else, you can get yourself caught up in interpreting it the way you want it to be interpreted, like everything. You read it and go, "Yeah, but" and so you conclude that gives you the answer you want to have. When you use the ATO’s decision tool It's straightforward. It's a yes or a no; it's black or white. In fact, I was on a call with someone just a couple of weeks ago and they were talking about their contractors. I said, they're not contractors. They're employees. They told me they had advice from their old Accountant that they were contractors. I said, I'm going to open the tool and we're going to walk through these together right now, live. It was that clear. We just punched the data in, and I said, I'm going to send you the screenshot. They are employees. You need to fix this. The point I am trying to make here is that the ATO’s decision tool will take you 5 minutes to get a better idea of what’s going on. That 5 minutes might give you the answer you don’t want but it may reduce the consequences of continuing for another 5 years.
How did I get here – A wolf in sheep clothing?
Before I talk about the risks in making a mistake, it is important to understand how so many businesses get themselves in this situation. They end up with employees when they thought they had contractors. There are several reasons why businesses consider contractors or think that contractors are a better option than employees, in the beginning. This is often where businesses get caught, in my experience. There are lots of benefits of having contractors. Contractors can be valuable in your business and in growing your business when they're used correctly, in the true sense of the contractor. Certainly, from my perspective, I get asked about the value of using contractors or get questions about engaging contractors. When businesses are going through a stage of growth, whether it's a start-up or they get to a certain stage, and they've got those growing pains. They know they need more hands-on deck. They need to offload more from peoples' plates. Perhaps, the prospect of hiring another employee, or hiring a first employee even, feels a bit overwhelming, a little bit scary with all the commitments that come with having an employee.
Many people just hate the idea of having a staff member and with that comes compliance. There is the Workers’ Comp, there is the obligation to have a proper single touch payroll, and all those obligations that are now becoming mandatory and have been for a little while now. It's only going to become more and more. A lot of people don't want that headache. They also don't want the obligation of paying someone $120,000 a year whether the work's there or not. That's a big leap for some people to go and engage someone to join their team. The ability to turn off and on that capacity is smart. Why would you pay someone to be sitting around dormant, if you don't have the work on?
Contractors are an important part of a business growth model. I think they can be useful, but where employees get caught is they're trying to dress a wolf up in sheep's clothing and say someone's a contractor when they're not.
What’s the big deal?
I am not saying don't use contractors. I am saying be very deliberate and intentional about how you use contractors and where you use contractors. It works for that capacity, but that wouldn't work for every task in my business or every task in everyone's business. At some point, to grow, you need employees. Trying to avoid it is not the answer. You're only just exposing yourself to risk.
Why contractors are such a hot topic with our legislative government bodies, like the ATO? The government doesn’t like contractors, which might come as a shock to people. They do make up a big part of the economy, generally. Why is there some much friction and analysis around these contractor arrangements and shared contracting? What's the big deal? Well, the government likes certainty, as we all do. It's far easier to collect tax from an employee because the employer has in their activity statement every month or quarter. Whereas, if someone's paying the gross amount across to a contractor, then they're not reliant upon that entity to be doing the right thing, whether it's a sole trade or a company or whatnot. Again, there is a catch. Does that person just not declare it? There're checks and measures now with the contractor reporting and all the rest of that. It's certainly not perfect. There is also the ability to split income. Someone who earns $90,000 a year pays a hell of a lot more tax than two people on $45,000 per). In round numbers, it's about half. You're paying half as much tax if you can spread the income. That's a stereotypical example where a husband and wife share the income, even though it might only be the wife or the husband that has done the work. Then, that's a loss of the overall collection of revenue for the government. That's assuming it gets declared in the first place. Obviously, there's a higher chance of non-compliance compared with an employee on wages. It's far easier for the government to just collect their money on the employer’s activity statement.
The nasty consequences of getting it wrong
Putting it simply – If your contractor is not a contractor then the ATO wants you to withhold PAYG and pay their super. You will also need workers' compensation insurance for that employee. This is where it gets into the nitty-gritty and the risk if you haven't accounted for any of that. Just to quantify that, if you had a contractor that you paid $100,000 a year, then you're exposed to super and workers' comp. You've had them for three years and then the audit comes along. Well, 9.5%-10% of $300,000 is a significant kick that most small businesses would have ... it would ruin many businesses and take the fun out of running your business. Yes, that’s right, if your contractor hasn’t been a contractor for 3 years the penalties can be applied retrospectively. That’s a big stick and if we think back to how long it takes to use the ATO’s decision tools, it’s 5 mins well spent.
Not so Super for you
If your contractor is not a contractor, suddenly, you're up to 10% on potentially whatever you've paid them over an extended period. Now that would ruin most businesses but the scariest part about unpaid super payable, even if you are a Proprietary Limited company, is that the ATO can come after you personally for that the outstanding amounts. I'll use the example- two or three contractors, $100,000 a year each. We thought they were contractors, but they were deemed employees for super. Let's see, $300,000 a year in contractors, and let's say you've been doing that for three years. You've paid $900,000 to these people. Then, suddenly, someone says you've got to pay super for them. There's $900,000 times 10%, so we're already up to $90,000 plus interest, plus penalties. Let's call that $120,000, at least. Then, if you had been paying super along the way, you would've got a tax deduction for that $90,000. If you are paying superannuation even a day late, let alone three or four years late, it is not deductible. That $120,000 that you're having to pay is a non-deductible cost to your business.
Now, many businesses would say, fine, I'm just not going to pay it. I'll fold my company up, because I don't have $120,000 and I'll go and start again, and they can't touch me. Here's the bad news for the entrepreneurs out there. Superannuation……………that's a personal liability for the director. You may not have even known you had a super obligation. As soon as you've realised it, three years after the fact, you want to pay it but can't so the company folds. You can't just open a new company and start again. That's when you're having some rather challenging discussions with your spouse -who you own the house with. You've got to sell the house to pay that. The ATO will come after you personally through a director's penalty notice. There is no escaping it. Most people want to do the right thing, but they were just unaware that perhaps they were not doing it quite the right way, as opposed to someone that's being dodgy. You try to follow by the rules as best you can and then you get hit out of the blue like this, and there's no escaping it.
If your contractor is deemed an employee, workers' compensation can be levied retrospectively like super. Regardless of whether there has been an accident. Depending on what industry you are in this can be significant and if the outstanding super liability hasn’t crippled your business, workers comp might. In accounting with low workers' comp rates, you only get a paper cut every now and then. If you're working with asbestos or mould or any type of trade, it could be 10% or 15% that you're adding onto your $900,000, plus your super. It might be another 10% on top of your super amount.
When we're dealing with government departments, it's not like the legal system where you're innocent until proven guilty. The onus of proof is on the business entrepreneur, to be able to explain why their contractor are contractors and not employees. You just don't want anyone getting their nose into your figures, because they won't be there for your own good health and benefit. They will be there trying to extract as much revenue as possible. The problem is, when someone starts poking around and doing an audit, it opens a can of worms. They're not limiting the audit to just what they were there to look at. They might expose the business to risk through what else they find. Don’t mess about with defining your work arrangements as it could potentially kill off your business if you get it wrong. It is important to understand that when it comes to Superannuation, your company structure does not protect you and your personal assets will be at risk. If you are concerned about your current Contractor’s reach out to your Accountant for advice.