Self employed contractor tax
- Catherine Gannon
- Updated: Sun, 29th Jan 2017
Self employed contractors. i.e. employing staff on a self employed basis, can create tax problems. Employers avoid statutory employment benefits but risk paying taxes the contractor should pay.
Unfortunately, clients often face:
- Unplanned income tax and national insurance liabilities for payments made to contractors;
- Employment law liabilities;
- No intellectual property protection;
- Frustration, as these issues are avoidable.
Engaging workers on a self-employed basis is attractive. Employers have no obligation to provide statutory employment benefits. Contractors have limited protection under employment protection legislation. Employers can more easily hire and fire contractors, and save employer’s NI contributions.
However, employers risk significant tax liabilities when engaging contractors. Often it is unclear if the contractors are genuinely self-employed for tax or employment law purposes. In addition, if there is no contract, employers cannot stop contractors walking off with intellectual property such as:
- Customers lists;
- Employee contacts;
- Source code.
Self-employed contractors tax risks
HMRC often challenges a worker’s employment status for tax purposes. Usually HMRC initiates a PAYE audit or random enquiry. HMRC’s powers are increasing.
HMRC does not wish to abolish IR35. HMRC wants contractors to be taxed as if they were employees and for PAYE to operate. HMRC sees the “end user”, in effect the employer, as a more expedient tax collector than a contractor.
Thus the “end user”, i.e. the employer, must operate IR35 on behalf of individual contractors who operate via personal service companies. These end users carry the administrative burden of IR35 compliance. HMRC, seeking to collect income tax and national insurance under PAYE, will investigate end-users.
Employing staff on a self employed basis
Here an employer or end-users defence is stronger if both parties signed a contractual agreement. Otherwise if a worker did not pay tax on a self-employed basis, the worker might look to the employer for payment. The worker might then claim that they:
- Were actually employed;
- Started as self-employed, but becomes employed when established within the business.
Employers, or end-users, may require a worker to initially work on a self-employed basis. For whatever reason, the end-user terminates their contract. Then, the disgruntled worker might seek redress.
Sometimes workers argue they were employed, so they can bring claims e.g. unfair dismissal at an employment tribunal. In addition, they claim the employer should have paid tax on their behalf.
IR35 penalties for employers
If an employment tribunal decides a worker was employed, HMRC will learn about, and agree with, the employment tribunal’s judgement. The end-user’s tax liabilities could dwarf any employment tribunal award.
HMRC might not give credit for income tax and National Insurance paid by the worker under self-assessment, if HMRC believes the business engaged self-employed people to take advantage of this dispensation.
Thus the business could have to pay all amounts that should have been deducted under PAYE, even if the worker has also paid income tax under self assessment.
Even if the business can set off income tax/NI paid by the worker against their tax liability, the business still faces penalties for failing to operate PAYE or make NI contributions.
HMRC calculates penalties for lodging inaccurate PAYE/NI returns as a percentage of the total amounts that should have been paid for up to six years. HMRC does not take account of income tax or national insurance paid by the worker under self assessment during this six year period.
The percentages payable as penalties range from up to 30% where the failure to make payment was down to carelessness, up to 70% where the failure has been deliberate but not concealed and up to 100% where the failure has been deliberate and concealed.
Employing a contractor: tax example
In this example, a business paid someone they thought was a contractor £100,000 gross of tax. The business thought the worker would declare the income to HMRC. However, if the tax was unpaid, the employer could face the following tax bill:
|Cost of wages||£100,000|
|Tax due on wages @40%||£40,000|
|Grossed-up from tax due||40,000 x 100/(100-40) £66,666|
|Total value plus tax payable||£166,666|
|National insurance – employers and employees class 1||£30,977|
|Total due to HMRC||£66,666 + £30,977= £97,643|
|This does not take account of interest and penalties payable for the late payment of tax under PAYE|
If the business deliberately chose to engage individuals on a self-employed basis, then penalties will increase. The business is also liable for interest and late payment penalties.
The tax liabilities for one one highly paid contractor, engaged for many years, could be tens of thousands of pounds. If HMRC decides one contractor is actually an employee, HMRC will then scrutinise all arrangements with contractors. The tax liabilities could destroy the business.
Summary: engaging self-employed contractors
Some employers decide that directly engaging self-employed contractors does not justify the risk. Employers can better safeguard their position if there is a signed contract. This contract sets out:
- The workers’ status,
- Restrictions on competitive behaviour, that protects:
- Intellectual property,
- Confidential information.
For employers and end-users we draft and review contracts for self employed staff.