Employees or contractors: which are better for start-ups?

At a glance

As a growing business, you may be looking to expand your team, which means weighing up the pros and cons of hiring contractors vs employees.

Freelance and contract workers can help plug skills gaps quickly and flexibly. On the other hand, employees are likely to be more loyal and for regular tasks, may be more cost-efficient than hiring contractors on premium day rates.

There are tax and legal implications for both, so it’s sensible to take advice before hiring anyone and ensure your contracts are up to date.

There are many pros and cons to hiring contractors or employees, depending on your role and sector. Early-stage businesses often prefer to hire contractors, as it gives them more flexibility and is easier to administer. Freelance and contract workers are a lower-risk approach to filling skills gaps, with fewer commitments and liabilities; plus, you can flex or limit the time they work for you.

You don’t have to pay contractors sick pay, benefits or pensions, and they cover their own support costs, such as for IT, transport and other equipment. This can make them a more cost-effective option for a temporary project or role.

Another benefit is the ability to hire a contractor with specific expertise, which you might not be able to afford full time. It’s a great way to fill expensive skills gaps, which is often critical to growing a successful business.

Contractors don’t have the same rights as employees, though you must still provide a safe working environment and not discriminate against them. If you’re unhappy with a contractor’s work, it’s also easier to end their contract.

What are the drawbacks of hiring contractors?

Contractors often charge a higher hourly rate than employees because they cover their own costs, and they may have highly sought-after skills.

Steven Harcourt, Director at Prime Accountants Group, says: “Contractors will likely have other relationships and could have less loyalty to your firm than an employee. Once the task is completed, they can move elsewhere, so your business may lose some continuity.”

You also have less control over how and when they work, and they may have a way of working that doesn’t fit your business systems or culture. In contrast, you can train employees to do exactly what you need, instil them in your culture and discipline them if necessary.

Helen Thomas, HR Director at the HR Dept, says you must be clear with contractors about whether you agree to them working with your competitors and if so, how. Ensure they don’t share any of your intellectual property and consider asking them to sign a confidentiality agreement.

“When they stop working for you, you have limited control over any information gained during the project,” she says. “Consider whether building that knowledge in an employed team might be more useful long term.”

What are the drawbacks of hiring employees?

As employees have more rights, that creates more employer’s liability, and you’ll need employer’s liability insurance.

Helen says there’s more administration associated with employees, including checking legal right to work, creating the employment contract and registering as an employer with HMRC. The first time you do this there’s more to consider, but once you’re set up, each subsequent employee needs less input, she adds.

You’ll also need to meet all UK laws on tax and HR, including in areas such as minimum wage and holiday pay. Though employees’ hourly rates are generally lower, you’ll have to offer them a pension, sick pay and possibly training and other benefits. You’ll have to pay employees’ and employers’ National Insurance. Plus, you need to set up PAYE systems to pay them. All these things generate extra costs, which, Helen says, can add up to an extra 15% to 30% of salary.

Which sectors and roles suit employees and contractors?
Philip Richardson, Partner and Head of Employment Law at Stephensons, says: “In some sectors, you need people to do the work regularly and consistently, and whom you can train and [help] build experience on specific tasks – so employees work best. This often occurs in manufacturing roles, but there many other examples.

“If a role requires lots of trust, again you probably want an employee unless you know a contractor well.”

Other roles, such as building an IT infrastructure, may be more sporadic or project-based and need rare, specialised skills – these can lend themselves more to contractors.

Tax and legal differences between employees and contractors

When using a contractor, the company is not responsible for paying taxes in the same way they are for an employee. There may also be tax advantages to an individual being a contractor. IR35 is a tax rule designed to crack down on ‘disguised employees’ – workers hired as contractors but treated like employees to exploit this and pay less tax. You can check your workers’ employment status for tax with an online government tool

There’s a simplified test for certain companies, including those with less than £10.2 million turnover. But Helen says it’s essential to consider the work relationship carefully, as employment tribunals will consider the actual working relationship, not the paperwork that you’ve agreed with the supplier or consultant. Under employment law, a contractor can challenge the working relationship – and if they feel they’re ‘employed’, can progress this through a tribunal.

“The rules are much tighter than they used to be, so be very careful that self-employed workers fit the definition and you can evidence that,” she says. “Many employers encounter this problem because they don’t understand the difference.”

Employed versus self-employed status depends on issues such as whether the worker:

•    is obliged to do the task;
•    has control and freedom over when and where they work, and who for; 
•    are free to delegate to a subcontractor. 

If you lose a tribunal claim, you could be liable to pay the worker holiday, sick or redundancy pay going back years. So if you have any doubt about this status, take advice before hiring, and review contracts regularly to reflect any changes. 

When should I start using employees?

The point at which it becomes beneficial to hire employees rather than contractors is specific to each business. But you can always mix the two, and experiment with contractors until you’re sure you need an employee in that role.

Joanne Thorne, Technical Compliance Manager at SJD Accountancy, says: “Many businesses do both successfully. For example, full-time staff run daily operations and consultant specialists, such as a financial director, business adviser or a non-executive director, cover other areas.”

Steven says that at some point, it usually becomes preferable to start growing a committed workforce of employees to advance your business. Workers may also benefit from the feeling of security in an employed position.

“To identify this point, look at your business-model forecasts and ensure you’re projecting a steady profit,” he says. “Play with scenarios to see if an employee could help you scale further. If you’re feeling too stretched for such decisions, that’s a sign that employing a manager or administrator could help.”

But don’t worry about the cost of taking on employees – it’s more about business growth and freeing up your valuable time. So, when the time’s right, be brave and take the plunge with employees who can take your business forward.

How we can help

Contact us today to talk through your business objectives and ambitions – we can help you look at your finances and carry out forecasts to help you work out the affordability of making changes to your workforce.

The levels and bases of taxation, and reliefs from taxation, can change at any time and are generally dependent on individual circumstances.

Where the opinions of third parties are offered, these may not necessarily reflect those of St. James’sPlace.

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SJP Approved 16/03/2023

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