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Employee to contractor: why the transition isn’t always a home run for SMEs

Man at desk with a laptop working as a contractor from home

NSW has seen a significant increase in new company registrations between June to September in 2021 (37,853) than the same periods in 2020 (33,366) and 2019 (29,741). While this might indicate a boom in small businesses, and certainly a number of these new companies represent the re-evaluation of the futures and lifestyles of many Australians looking for a change from their day job, I’ve witnessed first hand what may be behind some of these numbers.

Recently, we’ve seen an increasing number of individuals leaving employment and setting up a business, typically as a company, only to conduct the same duties they were engaged to provide to their employer while they were an employee, but now in the form of a contractor. While this transition is not a new phenomenon, it is one that has become much more commonplace amid the pandemic and particularly lockdowns.

But why the sudden uptick?

From speaking to clients on both sides of the fence, employers and employees, we have identified two main reasons driving this transition into a principal-contractor relationship: either the employer encouraged the employee to engage as a contractor, or the employee sought to avail of the additional tax benefits of trading as a business.

For those who become contractors, there are definitely benefits. From a lifestyle perspective, there is the freedom and flexibility to operate a business in the way that you desire, and from a taxation perspective, there are additional deductions available to them that aren’t available to a typical employee, such as writing off assets and home office occupancy deductions. Furthermore, there may be options to minimise tax through other entities.

From the business side, asking an employee to engage as a contractor is usually undertaken when a business is looking to save money by avoiding the costs and compliance burdens (such as leave, superannuation, and administering PAYG) of employment relationships.

However, in each scenario, there are a number of misconceptions that could lead to costly mistakes for the small business or for the contractor, or both.

For one, this new arrangement may actually amount to “sham contracting”, an illegal practice that can attract heavy penalties from Fair Work Australia, penalties which could cripple a small business particularly when margins have been small amid a pandemic. In short, an employer cannot force an employee to do the same work as a contractor, nor can an employee be dismissed for not complying with such a request.

Furthermore, from a taxation perspective, there are a lot of misunderstandings when it comes to the taxation of the profits of companies (or other entity types, such as partnerships and trusts) providing services from the effort of one individual to one principal. The ATO introduced Personal Service Income (PSI) Rules to prevent splitting income in order to pay less tax and to restrict deductions in this situation. Splitting or alienating income will attract the attention of the ATO. Generally, in single principal-contractor relationships, the ATO requires income to be attributed to the individual who generated the income and this is a distinction often misunderstood by small businesses.

So, what should you do as a small-business owner? It would be wise to seek external counsel when the concept of suggesting a transition into a principal-contractor relationship with an employee. For all of the benefits a company could experience, if done incorrectly or for the wrong reasons it could draw the ire from a Tax Office which has its microscope trained on business practices stemming from COVID-19.

Originally Published by Inside Small Business – 22 November 2021