It is crucial to understand the differences between employees and contractors because as an employer, you will be held responsible for getting it right.

Coping with the typical ebbs and flows of running a small business sometimes requires an extra pair of hands.

This has seen independent contractor appointments become a frequent alternative to traditional Pay as You Go (PAYG) employment, particularly when specialist skills cannot be readily obtained by recruiting full- or part-time employees.

However, it is important to not rush in and hire someone without taking account of the many factors that under the Independent Contractors Act 2006 and Fair Work Act 2009 differentiate an employee from a contractor. Any such arrangements are likely to be scrutinised by industry watchdog the Fair Work Ombudsman.

CPA Australia points out that there are dangers in engaging an individual as a contractor without properly understanding relevant legislation. You may find the person is considered an employee at law, which involves a range of legal obligations – and liabilities – if you get it wrong.

According to the Ombudsman, the Fair Work Act contains provisions to protect the rights and entitlements of independent contractors.

Although its website explains the factors that may differentiate an employee from an independent contractor, there is no single indicator.

"Each determination is based on the individual merits of the work arrangement in place," the information sheet states. "Courts always look at the totality of the relationship between the parties when determining the status of a person's employment."

Common indicators that may help to ascertain a person's employment status include the degree of control they have over work performed; whether hours are standard or set by the employer (as opposed to negotiation), expectations from work performed (i.e. ongoing or for a specific task); superannuation entitlements; provision of tools and equipment (by the employer or provider); method of payment (regular or on completion of a contract or project); and if paid leave is accrued.

It's not uncommon for businesses that fail to fully appreciate the key distinctions between the two working arrangements to find themselves in hot water – and the risk is particularly high for small accounting practices that need to deal with intense periods such as end of year tax reporting.

Smaller firms and solo operators often outsource work without properly recording the terms of engagement in writing. Should a dispute arise about whether a provider was a contractor or employee – or there is disagreement between the parties about the terms of the contract – it could ultimately lead to litigation.

Therefore, it is imperative all terms of engagement are recorded in a written contract before the start of an arrangement, and that both parties sign it. Even if you have already engaged the person, it's not too late to enter into a written contract and acknowledge that it applies retrospectively.

Professional services firm KPMG released a report last year that cited a famous Federal Court of Australia remark; namely that contracting parties "cannot create something which has every feature of a rooster, but call it a duck and insist that everybody else recognise it as a duck."

The report, Engaging contractors: time to get your ducks in a row , explains that engaging independent contractors can have unforeseen employment law and tax consequences if the relationship has features similar to a PAYG arrangement.

In cases where liability is proven, company directors will be held accountable, the report warns.

Even so, KPMG senior manager Paul Hum acknowledges that working out whether an individual is an employee or contractor is not necessarily straight-forward.

"Unless there's a sudden significant change in the arrangement between engaging parties, it's extremely difficult to draw a line in the sand at a particular point in time," Hum says.

"Our advice to businesses typically centres on developing robust procedures and policies to identify and prevent risky arrangements upfront. If an individual is not identified upfront as being a risk, the risk should be reassessed each time the arrangement is extended or changed."

The ramifications of inappropriately categorising an employee are similarly complex, he adds.

"Employers have to comply with a whole range of different obligations which don't apply to contractor arrangements. Excluding penalties and interest, this could be anywhere between 15 and 30 per cent of amounts already paid."

In the event a contractor is deemed to have actually been an employee, such obligations include fringe benefits tax (FBT) and the superannuation guarantee charge (SGC) to the Australian Taxation Office(ATO), payroll tax to revenue offices, workers compensation to insurers or relevant authorities, back pay (if award conditions were not met), and leave entitlements, Hum explains.

Also, be warned that the Fair Work Ombudsman interprets sham contracting arrangements as any attempt by an employer to deliberately disguise an employment relationship as an independent contracting arrangement – usually to avoid responsibility for employee entitlements.

Under the sham contracting provisions of the Fair Work Act, an employer cannot:

Fair Work Inspectors can seek penalties for contraventions of sham contracting arrangements or coercing a party to enter into a reform opt-in agreement. The courts may also impose a maximum penalty of $51,000 per contravention.

If you have any uncertainty as to whether your contractors are actually employees, contact us at Clarke McEwan.