Employee or contractor? Classify correctly to avoid legal risk

This is one of the costliest mistakes a new business owner can make

“I’ll call them a contractor so I don’t have to pay super and leave” — this is a common line of thinking, and also a mistake that can lead to backdated tax debts, penalties, and drawn-out legal disputes.

In Australia, the fact that someone has an ABN and considers themselves a contractor does not automatically make them a contractor in law. Classification depends on the real nature of the working relationship — not the name you give the contract.

What the ATO looks at to classify

The ATO uses several factors to determine whether someone is an employee or a contractor — no single factor decides everything:

Control over the work: An employee works under your direction on how, when and where the work is done. A contractor usually decides how they complete the work.

Ability to subcontract: A genuine contractor can usually hire someone else to do the work in their place. An employee cannot simply send someone else instead.

Tools and equipment: A contractor usually uses their own tools and equipment. An employee usually uses yours.

Commercial risk: A contractor bears the risk if the work is faulty (they pay to fix it themselves). An employee is paid regardless of the quality of the work.

Result or hours: A contractor is usually paid for a specific result. An employee is usually paid by the hour or week.

Degree of integration with the business: A contractor usually works for many clients. An employee is usually tied to one employer.

There is no simple formula — the ATO assesses the whole picture. Check the ATO’s classification tool at ato.gov.au/business/employee-or-contractor.

The consequences of getting it wrong

If the ATO or Fair Work determines that someone you treated as a contractor is actually an employee, you have to pay backdated:

• Super: All unpaid super from the beginning until now, plus the Superannuation Guarantee Charge (SGC) — far more complex and costly than ordinary super
• PAYG withholding: The tax that should have been withheld
• Penalties and interest: The ATO charges interest and penalties on the backdated debt
• Leave entitlements: Annual leave and personal leave under Fair Work

The total damage can be very large — especially if it has gone on for several years and several people have been misclassified.

On the contractor side — “sham contracting”

The Fair Work Act prohibits sham contracting — deliberately classifying an employee as a contractor to avoid employment obligations. This is not just a civil breach — in serious cases it can lead to substantial fines for both the business and the business owner personally.

Not every case of misclassification is deliberate sham contracting — but “I didn’t know the law” is not a mitigating reason in most cases.

A genuine contractor — the practical conditions

A genuine contractor usually: has their own ABN, works for many clients, uses their own equipment, bears commercial risk, and is not integrated into the day-to-day running of your business the way an employee is.

Even a genuine contractor may still have to be paid super in some cases — specifically where more than half the value of the work is their personal labour. Check at ato.gov.au.

The practical steps

Before you sign a contract with anyone as a contractor:

1. Use the ATO’s classification tool to check
2. If the result is unclear, get advice from an accountant or solicitor
3. Make sure the contract reflects the true nature of the relationship

Classifying correctly from the start is far cheaper than fixing it after the ATO comes knocking.