Employees are often misclassified as independent contractors. Misclassification can sometimes be an innocent mistake by all parties involved, or a conscious decision made by an employer to avoid certain responsibilities and costs as legislated by the Personal Income Tax Act or other regulatory bodies. In either case, the penalty for making the wrong distinction can result in serious tax exposures to organizations.
In accordance with Section 108 of the Personal Income Tax Act, 'Employment' includes any appointment or office, whether public or otherwise, for which remuneration is payable for tax purposes. A person in paid employment should be distinguished from another who is self-employed, as an independent contractor.
This article highlights the difference between an employee and an independent contractor, the factors to be considered as a guide for companies in classifying an individual as an employee and independent contractor and how the difference impacts tax obligations.
Distinction between Employee and Independent Contractor
An employee is a person who works for the employer on a regular basis, in return for a remuneration called 'salary'. The terms and conditions of the employment are described under a contract known as a 'contract of employment'. An employee gives up elements of control and independence and is eligible for certain benefits and works within the constraint of a workplace.
An independent contractor on the other hand, is a self-employed person, that is, a consultant, lawyer, accountant, engineer or any other person who provides services to other organizations for a fee. Common law principles further define independent contractor status by a method of payment. If a person is on an employer's payroll and receives a steady pay, clearly the person is an employee and not an independent contractor.
An independent contractor is free from any control or influence of the company as he can apply his discretion concerning the manner and method of completing the task and whatever the outcome of the task, the independent contractor is responsible for it.
How to determine whether a person is an employee or an independent contractor
- Contract of Service- Employment
Under the Nigerian laws, the relationship between an employer and an employee could be likened to that of a master and servant relationship, hence a contract of service is created at the inception of this relationship. This is so because the employer is directly in control of the work-related activities of the employee. Such as the time of work, the tools and equipment used for the work, when and where the work should be done and the way the work must be done.
- Contract for Service- Service/Independent Contractor
This is an agreement between an independent contractor and a client to carry out a specific project or assignment for a fee. In this case, the independent contractor who is considered an expert in the service he is contracted for is in direct control of how work is done and provides the requisite work tools for the job.
Major differences between an Employee and an Independent Contractor
It can sometimes be difficult to correctly identify the differences between an employee and an independent contractor. Hence, having a classification process that puts policies to serve as a guide in determining the tax treatment of the income received for services rendered is required, such as:
- Direct control of their work & provision of work
tools and equipment
Independent contractors control their work, the manner and time their work is done, and the tools and equipment used to do their work. Unlike employees, independent contractors are not subject to control by their clients and their work is done with little or no supervision.
Also, they usually provide their own work tools and equipment, while employees use the work tools and equipment provided by their employers. Also, unlike independent contractors, employees may be required to work from offices provided by employers.
- Usually operate their own businesses and openly market
Independent contractors usually operate as sole proprietors, partners and companies; while employees operate only as individuals It is not uncommon for independent contractors to have a business name and work for multiple clients.
They also openly market their services because they are in direct control of their business. Conversely, many employees are not allowed to work for other employers as they are limited by a Non-compete Agreement or other provisions that may limit or prevent them from engaging in other paid employment.
- Experts in their Industries
While employees receive some sort of training for their jobs, independent contracts bring their specialized expertise to their work. Consequently, independent contractors may not require any special training to do their work.
- Responsible for their own taxes and generally control
While employers withhold and remit taxes on behalf of their employees, independent contractors on the other hand file their personal income tax returns annually and directly remit their taxes to the government.
Unlike the employees who receive a specified salary at a particular period, independent contractors are generally compensated for services provided directly be service beneficiaries. They may have a standard billing rate for their service which is usually paid after an invoice has been issued to the client.
- Employees usually work for an indefinite period of
Unlike independent contractors, employees usually work for an indefinite period of time. While independent contractors are usually engaged for a specific project for a shorter period of time.
- Independent Contractors may Subcontract or Delegate
Generally, independent contractors may contract sub-contractors to do their work since they have control of how their work is done. Employees, on the other hand, are required to do their work themselves except in cases where a supervisor or head of the department may be allowed to delegate work to members of their team who are also employees of the employer.
While the independent contractor is sometimes subject to Withholding Tax (WHT) on his income, the employee is taxed under the Pay As You Earn (PAYE) system.
This practical distinction is muddled somewhat by section 3(3) (d) of the PITA which defines employment as including "any service rendered by any person in return for any gains or profits." The definition does cover independent contractors, but in practice, they are never taxed as an employee. They claim deductible expenses, capital allowances and loss relief, where applicable, before declaring a chargeable profit. In contrast, employees are only entitled to some tax-free personal allowances and reimbursement.
The analysis above indicates that the word 'employment'; as used in the context of Nigeria tax law has less expansive meaning than the ordinary meaning of the word. For example, a person may 'employ' himself\ in the profession of law, but he is not necessarily an employee of his clients for tax purposes. Accountants who act as auditors for several companies practice a profession and cannot be treated as employees of the companies. But an accountant who is appointed to be a company's internal auditor holds an office under it. He is an employee of the company. Thus, an employment exists where a person holds an office or receives wages or salaries from an employer for duties performed. As stated earlier, this is often described as a "contract of service."
In a case where an employee works for more than one employer, it may not be expedient to charge each of his wages as a separate employment income. Rather, his engagement may be services of contracts performed as part of a profession or vocation. The income from all sources could then be aggregated and taxed as the profits or gains of a business or profession.
Therefore, under the PITA, persons who hold office or appointments for remuneration or render services in return for any gains or profits are persons in employment. However, gains or profits from professions are distinguished from employment... "The dividing line between a profession and an employment could be narrow one and may not be easy to determine".
It is critical that business owners correctly determine whether the individuals providing services are employees or independent contractors.
Classifying a worker as an employee or an independent contractor has a significant effect on the tax treatment of the payments made for the services rendered. Thus, organizations need to pay close attention to workers' classification issues to ensure compliance with the Nigerian tax provisions.
Employers should also think carefully about entering independent contractor relationships that is for long-term or indefinitely. They should consult a competent Tax Professional to periodically conduct audits of all positions and review the requirements for an employee versus an independent contractor to avoid unanticipated consequences and penalties.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.