Your business is growing, and you have gotten to a point where you need additional help. You decide to hire someone to alleviate some of your workload. You found the right person and you hired him. This person could be an employee, or he could be a contractor. How do you know? And why does it matter if the worker is an employee or a contractor?
As a business owner, you need to know the status of the worker because your obligations are going to be different. These include payroll processing obligation, tax filing obligation, and pay arrangement. You will need to understand the criteria to differentiate because the CRA has put the onus on you to determine whether the worker is an employee or a contractor.
Payroll processing obligation
Your business is required to comply with payroll withholding and remittance obligations for employees only. These include:
- Deduct payroll taxes for both employee and employer
- Remit payroll deductions to the CRA
Payroll taxes for employees include CPP, EI and income taxes. As an employer, you are required to make CPP contributions and EI premiums based on the amounts withheld from the employee. If you mistakenly classify a worker as contractor and the CRA later determines it to be an employer-employee relationship, you will be liability for all unremitted payroll taxes plus the following penalty:
- Failure to deduct payroll taxes
- Failure to remit payroll taxes
Each type of penalty may be 10% of the payroll taxes that should have been calculated, withheld and remitted. The CRA may increase the penalty to 20% for second occurrence in the same calendar year.
On top of that, CRA also charges interest on any outstanding balances compounded daily.
Payroll withholding and remittance do not apply to contractor. When you pay a contractor, you simply pay based on the agreed upon amount.
Tax filing obligation
For employees, you are required to file a T4 return with the CRA and issue a T4 slip to each employee by the end of February of the following calendar year. The T4 return reports the cumulative earnings for all employees, EI insurance earnings, EI premium, CPP pensionable earnings, CPP contribution, and income taxes deducted. Depending on the company’s compensation structure, you may need to disclose additional benefits provided such as using a company vehicle, cash allowances, and expense reimbursement related to personal use.
If the worker is a contractor, you simply file a T4A to report the total pre-tax amount paid during the year.
Should there be a misclassification on the status of the worker resulting in late filing of the appropriate tax forms, the penalty for late filing could reach $7,500.
In either scenario, your bookkeeping records must reconcile with the amounts reported on the T4 or T4A to prevent a payroll audit from being triggered.
Generally, an employee has consistent pay periods and is paid on a regular basis whereas a contractor could be paid sporadically based on the completion of a job. As a result, the pay arrangements are different.
As an employer, you are responsible to determine how much the employee gets paid, deduct the applicable payroll taxes, and pay the net amount to the employee. You can write a cheque each time you pay the employee, but it is more efficient to set up direct deposit for recurring payments.
In contrast, the contractor needs to request payment from the company by issuing an invoice, and you will pay the contractor once the invoice is approved.
By law, you are required to issue a pay stub for each pay period to an employee however, it is not applicable to a contractor. To facilitate this process, it is recommended that you set up a personal account for each employee where they can access their pay stubs online. It is more efficient for you, and it is more convenient for the employee.
Criteria to differentiate
As you can see, your obligations are quite different based on the status of the worker. A proper classification between employee vs contractor is critical to avoid unnecessary payroll penalties and interest. These penalties are compounded if you have mistakenly treated more than one worker as a contractor. Unfortunately, the CRA has put the onus on you to determine the status of your worker. As such, it becomes pivotal to understand the criteria to differentiate between the two.
The question here is: who is determining how and what work needs to be done? Do you provide detailed instructions to your worker or does he perform most of the tasks independently? How much supervision does the worker need in order to complete the job? Can the worker provide their service to other companies?
If the employer effectively has control over how the job should be carried out, even if the contractor agreement states otherwise, this may be considered an employer-employee relationship.
Tools and equipment
If tools and equipment are involved, the question becomes: who is responsible for providing the tools and equipment, including repair and maintenance? Who retains the rights to the tools? Who is providing the workspace?
The context of the job plays an important role. A truck driver with his own truck would likely be considered a contractor due to the ownership of the primary tool for the work involved. A mechanic on the other hand, may own some of their tools but would be in an employee-employer relationship due to the circumstances of the job.
Can the person you hire turn around and subcontract out their work? If they can, it is an indication that you have a contractor relationship.
Whether the worker has financial risk involved is also a major factor in determining the type of relationship he has with you. Employees usually don’t assume any financial risks with their employment. For example, employees do not pay for overhead and rent whereas contractors generally incur business related expenses.
Other questions to consider include: is the worker only hired on a project basis or does the worker get the same pay on a fixed schedule? Is the worker financially liable if he does not fulfill his obligation?
Opportunity for profit
The last factor to consider is whether the worker has a chance for profit or loss. Does the worker have the ability to earn additional profit or is there a risk of incurring a loss? Contractors or self-employed individuals can pursue additional jobs and contracts, which can result in significant difference in profitability. They also have operating expenses which need to be managed in order to increase overall profits.