Contractor vs Employee Contract: Key Differences

Legal Status: Employee vs Self-Employed

UK law distinguishes between employees, workers, and self-employed contractors. Each has different rights, tax treatment, and obligations. The distinction is not always clear-cut, and misclassification can result in significant tax liabilities and employment tribunal claims.

• Employees have full employment rights including unfair dismissal protection, redundancy pay, and statutory leave
• Workers have some rights including minimum wage, holiday pay, and rest breaks but not unfair dismissal protection
• Self-employed contractors have no employment rights but greater flexibility and potential tax efficiency
• The tests for employment status are different for employment law and tax law purposes

Tax and Cost Implications

The total cost of engaging someone differs significantly depending on their status. Employers must pay employer's National Insurance (13.8%) on employee earnings, plus pension contributions, holiday pay, and other statutory entitlements. Contractors invoice for their services and handle their own tax.

• Employer NI at 13.8% adds significantly to the cost of employment compared to contractor fees
• Employers must auto-enrol employees into a pension scheme with minimum 3% employer contribution
• Contractors typically charge higher day rates to cover their own tax, insurance, holiday, and pension
• If IR35 applies, the tax advantage of using a contractor largely disappears

Contract Structure Differences

Employee and contractor contracts are fundamentally different documents reflecting fundamentally different relationships. Using the wrong type of contract — or creating a hybrid — can lead to misclassification issues and unwanted liabilities.

• Employee contracts include notice periods, holiday entitlement, and sick pay; contractor agreements do not
• Contractor agreements should include substitution rights, no mutuality of obligation, and project-based scope
• Employee contracts typically restrict outside work; contractor agreements explicitly allow it
• Contractor agreements should require the contractor to carry their own insurance and handle their own tax

Key Takeaways

• The legal test for employment status considers the reality of the working relationship, not just the label on the contract.
• Engaging a contractor is not always cheaper once IR35, higher day rates, and management overhead are considered.
• Using an employment contract for a genuine contractor — or vice versa — creates legal and tax risks for both parties.