What's the Difference Between an Employee and a Contractor?

This article will explain the difference between employees and contractors and how to tell which type of worker you have hired.

A lot of start-up owners want to hire contractors, and for good reason. Contractors tend to be more flexible in their work schedules. They are cheaper as you don’t have to pay for their payroll taxes: Canada Pension Plan (CPP) and Employment Insurance (EI). They also might not feel so bad if they have to let a contractor go if cash flow goes south. As appealing as those reasons are, none of them are sufficient to call someone who works for you a “contractor” versus an “employee”. The difference may seem subtle, but the consequences of getting it wrong can be severe.

As accountants, we tend to play it safe. There’s a good amount of hard-wiring involved with that, but we have also seen the results of risky behaviour. Getting on the wrong side of the CRA, especially payroll taxes, can sink your business. I am not beyond taking a risk, but it should be calculated. Erring on the side of safety when classifying the people who work for you is prudent, as I will show you below.

What could possibli go wrong?

We often hear from start-ups that they hired contractors to keep flexibility, have part-time workers or save on costs. These may be good business practice, but they are not valid reasons for calling someone a contractor versus an employee. Getting it wrong can hurt (or sink) your business. CRA takes it seriously. By not determining whether someone working for you is an employee or a contractor, you open yourself up to having to retroactively pay all deductions and payroll taxes PLUS penalties and interest. The penalties are nothing to sneeze at either. Read on to understand the actual difference between an employee and a contractor.

The Pros and Cons of Contractors

First, why would you want to hire a contractor over an employee?

  1. They are generally more flexible with part-time or short term work.

  2. You won’t have to pay the employer portion of CPP and EI premiums for them. These cost your business upwards of 7% on top of the wages you pay an employee.

  3. You won’t have to collect and remit their tax deductions, which can be an administrative burden and cost.

However, you should also consider that some of the downsides of hiring contractors:

  1. They are generally less engaged and committed to your company than employees. In Game of Thrones, you often hear about sell-swords and how their allegiance is to themselves. I think of contractors the same way: they need to take care of themselves first as you are not providing them with the security of employment.

  2. You will likely pay them more per hour to cover their down-time, so are you better off?

  3. Culture plays a huge role in building a successful business. If you are hiring a true contractor, it’s unlikely you will be able to instill your culture into them.

  4. The gig economy is starting to get a bad rap. Transferring all the risk onto workers is taking its toll. There are many former freelancers that understand it’s lonely out there on their own and want to do their best work without worrying about invoicing and sales tax.

Ok, so I haven’t convinced you that you should hire this worker as an employee. If you haven’t hired them yet, great: you can structure your relationship with the below rules in mind to achieve the result you like.

Employee Versus Contractor: The “Rules”

When evaluating whether you have hired an employee or a contractor, you must remember the first rule: there are no rules. Unfortunately, there are no hard and fast rules, but these guidelines are enforced:

1. Control: Who controls when and how the work is done? If the worker has control, it points toward a contractor relationship.
2. Ownership of Tools: Who owns the tools to get the job done? If the worker owns the tools, it’s another point for Griffyndor! … er, I mean toward your worker being a contractor.
3. Ability to Subcontract or hire assistants: Can the person you have hired subcontract the work out to someone else? Answering “yes” points towards a contractor, “no” looks more like an employee.
4. Financial Risk/Opportunity for profit: Employees generally do not take on financial risk, contractors may incur a loss or produce a profit on the work they do.
5. Responsibility for Investment and Management: Has the contractor actively invested in and/or managed their own business? Some indicators here include: having a business license, licensing their own software, hiring their own people, advertising their services, etc. For example, a true contractor will likely have invested in advertising their services to the broader public.

This CRA Guide has lots of examples for each factor.

Plan Ahead to Get the Result

With a little planning before you hire your help, you can ensure you have the correct arrangement. Here are a few things you can do to ensure you have a contractor relationship:

  1. Make sure the contractor understands if he should be registered for GST/HST (more on this topic here.)

  2. Make sure you are not the only business they are working with.

  3. Make sure the contractor is advertising their service and/or have a website.

  4. Make sure contractor is covering their expenses like phone and equipment (computer, tools, etc.)

  5. Make sure the contractor is preparing invoices and that these aren’t in line with regular payroll cycles.

  6. Have a contractor agreement/contract in place.

  7. Finally, if you still not sure, request a ruling from the CRA by filling out this form.

Remember: the CRA wants you to have employees. Contractors make it very hard to collect taxes as contractors can wait until the tax deadline to claim and remit their taxes, if they claim that income at all. In order to stay on the safe side, follow the guidelines above to avoid payroll risk.

More questions? Please reach out.

This article was written with the help of CRA’s online guide and Chapter Three of Byrd and Chen’s amazing: Canadian Tax Principles - Professional Edition. Highly recommended reading ;)