Employees vs contractors: what businesses need to know

Choosing the right people is crucial, for managing costs, compliance and flexibility in your business. 

Lots of businesses turn to independent contractors to fill skills gaps, handle short-term projects, or even make up most of their workforce. Alternatively, your business may have steadier demand and need the stability and structure of a team of employees. 

So, a key consideration for business owners is whether to hire an employee or engage a contractor. We will explore the key tax and legal obligations you need to consider when making this decision. 

What is the difference between employees and contractors? 

When you are taking on personnel, understanding the difference between employees and contractors is crucial. This classification impacts your business’ tax obligations, as well as the legal rights you must provide.  If you wrongly assume an individual is a self-employed contractor when they should be treated as an employee, you could risk historical tax charges, penalties, and reputational damage. 

HMRC’s employment status manual gives a list of factors that go into their decision on employment status here. They include: 

• who has control over working times and locations;  
• whether the individual must personally provide their service,  
• who provides the required equipment,  
• how the person is paid,  
• whether there is ‘mutuality of obligation’,  
• What rights you have provided to the individual , and 
• whether they are treated as part and parcel of the business. 

What do I need to consider when hiring an employee? 

If you decide to hire an employee, you will be responsible for deducting income tax and employees National Insurance Contributions (NICs) from employees under the Pay As You Earn (PAYE) system. You are also obliged to pay employers’ NICs. Legally, employees also have certain employment protections and rights, such as different types of statutory pay and the right to make a claim for unfair dismissal.  

Hiring an employee can therefore be expensive and is a permanent option when it comes to expanding your workforce (unless you offer a fixed term contract – which is employment with a set end date) 

What do I need to consider when engaging a contractor? 

Contractors may be self-employed individuals, or more typically they set up their own personal service companies (PSCs) from which to offer their services. 

When engaging a contractor through a PSC, you need to consider if the off-payroll working rules (often referred to as IR35) apply. Broadly speaking if you have a medium or large size business or are a public sector organisation, you must determine if the contractor is within or outside IR35. If you’re a small business, the responsibility lies with the contractor.  

Is my company considered a small business for the off-payroll working rules? 

Small businesses are regarded as meeting two of the three criteria:  

• less than £10.2m turnover; 
• a balance sheet of less than £5.1m, or  
• under 50 employees.  

For small businesses it will be the contractor’s responsibility to consider their employment status. This means that if you take on a contractor as a small business, you are not responsible for deducting and paying the individual’s income tax and employee’s NIC to HMRC. You are also exempt from paying employers’ NIC. 

However, if your business exceeds the criteria to qualify as a small business, and you engage contractors via PSCs, then you as the engager would have responsibility for compliance with the off-payroll working rules.

What about a contractor who doesn’t work through a PSC? 

If you take on a self-employed individual (i.e. with no PSC) as a contractor, there is a risk they could be classed as an employee if their employment status for tax purposes is not carefully established. If HMRC determined they were an employee you would need to deduct income tax and employee’s NICs through PAYE and pay employer’s NICs. 

Self-employed individuals do not have employment rights, but if determined to be an employee, you would have to provide these rights. These would include paid annual leave and statutory sick pay for example. This could therefore end up a lot more expensive than you planned for, so many smaller businesses insist on only engaging through PSCs when taking on contractors. 

What is the CEST tool? 

The Check Employment Status for Tax (CEST) tool has been developed by HMRC to help you assess an individual’s employment status for tax purposes. 

CEST asks questions about the way the contractor will work and provides HMRC’s answer on their tax employment status, which HMRC will stand by as long as all the inputs are factually correct.  

If using CEST, keep a record of all your inputs and the answer it provides in case of future queries from HMRC. 

Where can I get further support? 

At TaxAssist Accountants, we can guide you and your business through taking on personnel and make sure your business stays fully compliant. 

If you are a contractor working though a PSC, we can arrange a contract review to help reduce the risk of HMRC challenges under IR35. 

If you need any help or assistance with your employment tax affairs, call us on 0131 654 1771, or use our online enquiry form here. 

 

 

Last updated: 8th October 2025