Contractor or employee? A guide for small businesses

Whenever a small business takes on extra help — whether for a seasonal rush, a one-off project or ongoing growth — one of the first decisions is whether that person should be engaged as an employee or a contractor. Getting it right matters. The legal test has changed, and the penalties for getting it wrong have increased.

Employee

An example of an employee would be a retail assistant who works nine to five every weekday. These workers are given a specific set of tasks by their manager, work under that manager’s direction and have their tools provided for them.

When it comes to tax, an employee’s income tax is deducted by their employer through PAYG withholding, either managed independently or by a tax accountant. Superannuation is paid into a nominated account by the employer.

Contractor

An example of a contractor is a welder hired to repair a metal sign. They take on a contract that pays a set fee, generally upon satisfactory completion of the work. A portion of that fee may then be paid out to subcontractors they’ve engaged themselves. They’re given a timeframe to complete the work but aren’t required to work set hours, and they supply their own tools.

Contractors generally pay their own income tax and organise their own superannuation, but there’s an important exception that trips up many small businesses. If a contractor is engaged principally for their labour, the Australian Taxation Office treats them as an employee for superannuation purposes, regardless of whether they hold an ABN or have “contractor” written into their agreement. In that case, the business still has to pay their super.

How the employee-or-contractor test has changed

Until recently, Australian courts largely determined a worker’s status by looking primarily at the written contract between the parties. Since August 2024, that’s changed for many businesses. Under a new “whole of relationship” test introduced into the Fair Work Act, courts must now look at the real substance, practical reality and true nature of the relationship. That means looking not just at what the contract says, but at how the work actually happens day to day.

This test applies to incorporated businesses (companies with “Pty Ltd” in their name). If your business operates as a sole trader or partnership, a different test may apply. It’s worth checking your specific position with your accountant.

This Fair Work test isn’t the only one that matters, either. For tax withholding purposes, the ATO still generally gives primary weight to a genuine, comprehensive written contract. A worker’s status can be assessed differently depending on which law is being applied. This is exactly why getting advice before engaging someone matters.

Why correct classification matters

Incorrectly treating an employee as a contractor (sham contracting) carries real consequences, and the defence available to businesses has tightened. Employers must now show they genuinely and reasonably believed the arrangement was legitimate contracting, rather than simply that they weren’t careless about it.

Based on the current Commonwealth penalty unit rate, the maximum penalties are $21,840 per contravention for an individual and $109,200 for a business with fewer than 15 employees. Larger businesses face up to $546,000, or three times the underpayment amount, whichever is greater.

On top of this, a misclassified business can also face PAYG withholding penalties and a superannuation guarantee charge — calculated at more than the super that should have originally been paid. There’s no single factor that determines whether a worker is a contractor or an employee. It’s the combination of factors, assessed against the correct test for the situation, that counts. 

If you’re unsure of your obligations when engaging a new worker or need a business development consultant, contact Wilson Porter today for expert accounting advice.