When Does a Contractor Become an Employee?

Many small businesses rely on contractors to supply specific skills or to cover particularly busy spells. But if you increasingly rely on a contractor for long periods to the point where they become much like an employee, you could open yourself up to legal disputes and even fines.

What is a contractor?

A contractor is anyone who sells their services to another party. They will carry out work for clients under contract agreements and invoice for their services. They will be self-employed, working through their own limited company or as a sole trader, and so are not entitled to the benefits employed staff receive, such as sick pay and holiday pay.

Contractors offer benefits to many companies, being a flexible workforce, often highly skilled, that doesn’t take up much time regarding HR requirements. They will also be responsible for their own taxes.

Signs that your contractor might now be an employee 

Perhaps you initially took on a contractor to complete a specific project which has overrun, or you were so impressed by them you’ve continued to use them elsewhere in the business. This is not an issue as there is no time limit for how long you can use a contractor; the problem arises when the working relationship becomes less clear.

So, if, for example, you start to define the hours they work, they’re using company equipment rather than their own, you’ve requested that they work solely for you, or they’ve ended up on your payroll, you’re clearly straying into employee territory.

Why does this matter?

While you may think that if both you and the contractor are happy with the situation and the work is getting done, there’s no need to worry about such definitions, but this isn’t the case. If your contractor starts to work under terms that closely resemble that of an employee, they also acquire the same employment rights. While many contractors may be happy with the status quo, they could try to claim back pay they missed out on, such as holiday or sick pay, in which case you could also end up being liable for backdated National Insurance taxes and PAYE.

What is IR35

In an attempt to prevent employers and contractors from gaining a tax advantage from what it saw as sham contracting, whereby people were classed as contractors but were effectively employees, HMRC devised a set of laws known as IR35.

IR35 is tax legislation that aims to stop individuals from avoiding tax by supplying their services to clients through an intermediary, like a limited company. It also means people should not be encouraged to work as contractors to avoid companies having to provide them with the statutory benefits that employees get. 

As of April 2020, every medium and large business has been responsible for setting the tax status of its contractors. If this tax status is deemed incorrect, that business will be responsible for any fees and penalties, making it very important to get it right. HMRC can examine a contractor’s tax status at any time, focusing on the contractor’s relationship with the business rather than any written contract, to determine whether they are inside or outside of IR35. 

How to keep your contractors as contractors

With the threat of hefty fines for companies and contractors potentially having to pay back large amounts in unpaid tax, it’s important to ensure that your contractors’ status is clearly defined. There are a few steps you can take here:

1. Don’t take control

As you’re paying a contractor, you may feel it’s OK to decide on things such as how, where and when they do their work. Be careful, though. HMRC uses several key tests to determine whether a contractor is what they term a ‘disguised employee’ and so will fall inside IR35, and control is one of its key principles. So, for example, the contractor should be in control of where, what, when and how they work. They should also only carry out the task they have been hired to do, so don’t constantly move your freelancers from job to job. Similarly, if a contractor starts asking for permission to take holiday, you’re entering dodgy territory, nor should you pay them when they’re on leave. Such actions could put them firmly inside IR35.  

2. Give them a contract

While HMRC won’t accept a contract as evidence that a contractor isn’t an employee, it’s still sensible to have one in place. This also allows your contractors to have it reviewed by an IR35 specialist if there are any areas of concern. It’s also advised that you avoid using your contractor’s name in the contract, as this could mean they are providing services personally. The wording should clarify that they are providing ‘contract of services’ as a business-to-business service provider.  

3. Avoid ‘Mutuality of Obligation’

This is another test that HMRC will use to determine employment and IR35 status. Mutuality of Obligation (MOO) means that an employer is obliged to provide work, and a worker is obliged to accept the work. Instead, you should ensure that your contractor is free to refuse work from you and take alternative work from other companies. You may want to keep evidence if work is refused, as this will demonstrate an evident lack of MOO.  

4. Keep your distance

It’s important to make sure that your contractor is slightly removed from any normal business activities. So, for example, you shouldn’t involve them in the appraisal process, nor should you allow them to use any staff-specific facilities, such as canteens or car parks. If they visit your premises, treat them as a visitor rather than an employee.  

5. Keep the situation under review

When you start working with a contractor, you may tick all the boxes to confirm they are outside of IR35, but things can change. If you start using them on more projects, they become more friendly with the team and so start using staff facilities; if they turn down other work to help you meet your obligations, or you loan them equipment to help them get the job done more efficiently, you could creep into IR35 territory. Regular reviews of all your contractor relationships are therefore to be advised.