Tax traps for contractors

Working as a contractor may seem a great way to be self-employed and find a better work-life balance, or just a good way to find work when full-time jobs are scarce.

But there are many traps for the uninitiated and particularly on the tax front.

Tax experts offer six steps to avoiding trouble with the Inland Revenue Department.

1. Are you a contractor or an employee?
Ernst & Young partner Jo Doolan said with the economic downturn more companies have switched to hiring contractors rather than employing full-time staff, to cut down on costs such as sick leave and holiday pay.

But on closer examination these contractors have been deemed to be employees - without the advantages of being contractors or the legal rights of employees.

Accountant and tax advisor Denise Maffey said if you're unsure what your employment status is ask yourself "who has control?".

"Employers will typically put someone on contract because there is no requirement to play nice under the Holidays Act," she said.

"When you are on a contract you are engaged for a specific period. You do your own research and provide your own equipment.

"If the boss starts to tell you when to start, what to wear, what gear to use, you're an employee."

2.Withholding Tax is not PAYE
Most contractors have withholding tax of 20 per cent taken out of their earnings, which is okay if you earn under about $55,000 a year, said Maffey.

"But if you're on more than about $30 an hour that is not going to be enough and you're going to end up with a tax debt," she said.

"That problem is compounded by many contractors, particularly those working as labourers or agricultural workers, being unaware they need to file end-of-year tax returns.

"If those workers don't know they have to file returns, then they won't know they have not paid all their tax requirements. They end up being pursued by the IRD for failure to furnish."

By far the most common trap for contractors was a lack of discipline in setting aside enough income to cover tax payments, says Lou Draper, marketing manager for BW Chartered Accountants.

"It's tempting to think that what comes into your bank account is all yours," she said.

"Most contractors get their first few invoices in and are really focussed, setting some aside for tax and other expenses.

"Then time goes by and they borrow out of the work account always intending to repay it but never managing it. Then at tax time it all goes badly."

The answer was to get good advice or make use of cloud accounting packages like Xero to track income and outgoings.

3.Your first year is not tax-free
While it may seem as though you pay no tax in your first year as a contractor, that was not actually true, said Draper.

"You do pay tax for that first year, you just don't pay it at the end of that year," she said.

Instead contractors paid Provisional Tax in their second year, as well as Withholding Tax and end-of-year PAYE.

"You hear a lot about small businesses going under after two years," she said.

"Nine times out of 10 that's because they haven't allowed for the double lot of tax you pay in that second year. They can't afford to keep operating and find that extra amount of money to pay Provisional Tax."

It was the same with GST, she said.

"People see that 15 per cent they've invoiced for and forget that it has to be handed on. It's not theirs." Doolan suggested contractors combine Provisional Tax payments with GST in their first year to avoid being "pinged" with a double lot of tax in their second year.

4. Educate yourself
Before setting up, all prospective contractors should make an attempt to educate themselves on tax compliance and get good advice, Draper said.

Maffey said there was a general lack of "civic understanding" around tax among a lot of contractors, which caused problems down the line.

Apart from the issue of owing the taxman money, failure to furnish tax returns also impacted on contractors' ability to claim Working for Families entitlements and how much they were assessed for child support payments.

5. Should you become a company instead?
Contractors should not be lured into setting up a company based on the fact that they would taxed at 28 per cent rather than 33 per cent, Doolan said.

If you are the sole person operating that company then you'd still be taxed at the higher rate.

There were non-tax reasons for becoming a company, however, such as limiting liability and making it easier to grow your business and attract clients.

6. Ask for help
If you get into financial or tax trouble ask for help early, Draper said.

"Talk to a financial advisor or accountant and the IRD can be really helpful if you talk to them early and are upfront about having made a mistake," she said.

Doolan said an accountant wasn't always necessary but it was important for contractors to consider the value of their own time.

"In your first year you are trying to generate business and make a good impression," she said.

"Is spending time on your GST returns the best use of it?"

An IRD spokesman said anyone having difficulty meeting a payment date or who had made an error in their returns should talk to the IRD as soon as possible so the issue could be corrected.

Burying your head in the sand would only make things worse.