Independent contractor or employee?

This article aims to explain the difference in the tax status of an independent contractor and an employee; what the pro’s and cons are should you consider working as an independent contractor, and the tax consequences should you be incorrectly classified as an independent contractor for tax purposes as opposed to an employee.

Often employees agree to be independent contractors to avoid the withholding of employees’ tax (PAYE) and to claim deductions for expenses against their income.

However, to determine the tax status and the obligation to withhold PAYE the South African Revenue Service (SARS) will consider the actual relationship between a client and those that work for it or provide services to it.

If the person is incorrectly classified as an independent contractor, there could be a substantial tax bill due plus penalties and interest.

What is the difference?

The main difference between an independent contractor and an employee is in the contract itself.

An employee contract is one which stipulates that the employee agrees to render a service to the employer for an undetermined period, in return for which the employer undertakes to pay a fixed amount of remuneration for those services rendered. The employee is subject to the control and supervision of the employer. The employer also determines what hours the employee shall work, how and when the various tasks shall be performed and provides all the resources to enable those tasks or services to be performed.

An independent contractor contracts to undertake and complete a specific task at a certain date. Upon completion of the service or task, the contractor will be paid. 

Below are some of the other differences to be aware of:

• An independent contractor is responsible for paying income tax on their earnings and register for income tax and provisional tax with SARS, while PAYE is deducted from the salary of an employee through the company’s payroll and paid to SARS.
• An independent contractor does not contribute towards the Unemployment Insurance Fund (UIF) and therefore cannot claim from the fund.
• An independent contractor can claim business-related expenses to reduce their taxable income.
• An independent contractor needs to consider registering for value added tax (VAT) when the value of their taxable supplies exceed R1 million in any consecutive 12-month period or choose to register voluntary when their taxable supplies exceed R50,000.
• An independent contractor should register at SARS for PAYE as an employer if it employs people to assist with providing the work or services to his or her clients.

When are you considered to be an independent contractor for tax purposes

A person that is self-employed is carrying on an independent trade from his client.

SARS uses two tools to determine whether the person is carrying on an independent trade. The first tool is the statutory test, and the second tool is the common-law “dominant impression test”.

There are two statutory tests, and the first statutory test consists of two parts.

Firstly, to qualify as in independent contractor, the services or duties should not be performed mainly (more than 50%) at the premises of the client. This refers to the premises of either the person paying for the services or the person receiving the services.

Secondly, the person should not be subject to the control or supervision of any other person regarding the manner of performing duties or hours of work.

The control-or-supervision part of this test refers to “any” person. This is wide, and could include the payer of the amount, the recipient of the service or any other person who has a contractual right to control or supervise the person in respect of those specific services.

If the person meets any part of the first statutory test any amounts paid to that person will be subject to PAYE, however, the second statutory test must also be performed before a decision is made to withhold PAYE.

The second statutory test deems the person to be carrying on a trade independently if they employ three or more full-time employees who are not connected persons in relation to him or her and are engaged in their business throughout the year of assessment.

This test is conclusive and overrides the first statutory test.

Where the statutory tests are not met it unfortunately does not mean than the person is automatically an independent contractor. The common law “dominant impression test” must then still be applied to finally determine whether the person is an independent contractor or an employee.  This test requires that all aspects of the contract and the relationship must be evaluated, and then a decision is made based on the dominant impression formed in that evaluation. 

Not an easy task, but SARS does provide guidance in the form of an Interpretation Note with a “common law dominant impression grid” that sets out 20 of the more common indicators.  These indicators take a detailed look at the relationship to determine if it is an employer and employee relationship or a client and independent contractor relationship.

There are three categories of these indicators, namely:

• Near conclusive, which relate most directly to the acquisition of productive capacity.
• Persuasive, which relate to the control of the work environment.
• And resonant of either an employer-employee relationship or an independent contractor or client relationship, whichever is relevant.

Pro’s and cons should you consider working as an independent contractor

Should one consider embarking on the journey of an independent contractor, the following pro’s and cons needs to be given thought to.

Pro’s

• Flexibility and autonomy are advantages as one will be able to choose when and where you work which can benefit your personal lifestyle and able to make your own choices and decisions without external pressure or control based on one’s own values and principles.
• Negotiate a rate per hour which can compare to or exceed a salary payout under a permanent employment contract. As mentioned above, business related expenditure can be claimed to reduce one’s taxable income.
• Gain valuable experience and the opportunity for continuous improvement and learning as your work will expose you to multiple diverse projects with various businesses and industries.

Cons

• An independent contractor does not enjoy employee benefits such as UIF, employer medical aid contributions and employer retirement benefits and therefore need to plan for retirement.
• As one’s income might be unpredictable depending on the amount of contracts you have, you will have to manage cashflow which requires careful tax planning
• An independent contractor needs to purchase their own tools of trade.
• Independent contractors carry their own professional liability insurance for protection against claims arising from negligence, errors or omissions in their work.  If their work is deemed unsatisfactory, there is a risk that a client may file a claim or lawsuit for damages.
• Independent contractors are only entitled to payment of he/she produces the work and is not awarded for efforts as in the case of an employee.
• An independent contractor must consider all tax implications in respect of income tax, provisional tax, VAT and PAYE.

Tax consequences should a person be incorrectly identified as an independent contractor

Should it be established that a person was incorrectly identified as an independent contractor and the company that the services were rendered to failed to withhold PAYE, said company may be liable for the unpaid payroll taxes and may face penalties, interest or even criminal prosecution.

The consequences for the person incorrectly classified as independent contractor are as follows:

• If an employer has not been absolved of its personal liability to withhold the PAYE, the Income Tax Act grants the employer a statutory right to recover the amount of PAYE not withheld from the independent contractor.
• The employee will not be entitled to an employees’ tax certificate until such amount which is due to the employer is paid and the employee may not claim any tax credit in respect of the PAYE that was paid by the employer in his personal tax assessment in such instance.  The employee will however still be obligated to report the income, which would lead to double economic taxation. 
• SARS may view the incorrect classification as misconduct by the taxpayers in question when the tax returns were submitted, which means that prescription does not apply.
• In addition, SARS might impose understatement penalties at the maximum of 200% of the shortfall.

 Consclusion

Careful consideration needs to be taken when one proclaims themselves as an independent contractor as there are many pitfalls.  It is important to understand the key differences between an employee and an independent contractor to ensure compliance with the Income Tax Act.  Correctly classifying workers as either employees or independent contractors affects matters such as taxation and employee benefits. Misclassification can lead to financial liabilities as pointed out above.

Should you be in doubt, consult with our experienced team at Forvis Mazars.

Contact our Private Client Tax team if you need assistance with any of your personal tax affairs.

Authors

Naomie Fourie, Assistant Manager & Elzahne Henn, Director