As a small business owner, you've probably wondered whether that person you're hiring should be classified as an employee or a contractor. It's one of the most common questions we hear, and for good reason - getting it wrong can be expensive and stressful. We have heard some absolute horror stories from well-meaning business owners who got stung badly from contractor relationships that soured.
The consequences of misclassification aren't just paperwork headaches. You could face penalties, backdated holiday pay claims, KiwiSaver obligations, and even Employment Relations Authority disputes. The good news? Understanding the rules and upcoming changes doesn't have to be overwhelming.
Why does the distinction matter?
The classification of your workers affects everything from tax obligations to employment rights. Employees are entitled to minimum wage, holiday pay, sick leave, KiwiSaver contributions, and protection under employment law. Contractors, on the other hand, are responsible for their own tax affairs, don't receive employment benefits, and operate under commercial law rather than employment law.
For your business, this means different:
- Tax obligations: Employees require PAYE deductions, while contractors may need withholding tax (as covered in our schedular payments guide)
- Insurance requirements: Different ACC obligations and liability considerations
- Legal protections: Different dispute resolution processes and termination procedures
- Ongoing costs: No holiday pay, sick leave, or KiwiSaver contributions for genuine contractors
The current test: How it works today
Under current New Zealand law, determining whether someone is an employee or contractor involves looking at the "real nature of the relationship." Courts and employment authorities consider several factors:
The four-factor test
Intention of the parties: What did both parties intend when they entered the relationship? While written agreements matter, they're not conclusive if the reality differs.
Control: How much control does the business have over how, when, and where the work is done? Greater control typically indicates an employment relationship.
Integration: How integrated is the worker into the business? Are they part of the business structure or operating independently?
Economic reality: Who bears the financial risk? Does the worker have their own business, multiple clients, and responsibility for profit and loss?
Red flags that suggest employment
- Fixed hours or requirement to work set times
- Providing equipment, tools, or workspace
- Paying a regular wage or salary rather than invoiced amounts
- Requiring the worker to get permission for time off
- Controlling how the work is performed, not just the end result
- The worker doesn't have other clients or business activities
- Deducting tax like you would for an employee
Green lights for contractor relationships
- The worker invoices you for services
- They have their own business registration or GST number
- They provide their own tools and equipment
- They work for multiple clients
- They set their own hours (within project constraints)
- They bear financial risk for their work
- They can subcontract or delegate work
The upcoming change: Gateway test
The Government has agreed to amending the Employment Relations Act to provide a gateway test that businesses can use when responding to a claim that a person is an employee and not a contractor. If the working arrangement meets the 4 criteria set out in the test, the worker is considered to be a contractor. If any of the 4 criteria are not met, the claim would be considered under the existing 'real nature of the relationship' test.
The four gateway test criteria
The gateway test sets out four clear criteria, and if a working arrangement meets all of them, the worker is considered a contractor. These criteria are: A written agreement specifying the worker as an independent contractor. No restrictions preventing the worker from working for another business, and two additional criteria around control and business operations.
The complete gateway test requires:
- Written contractor agreement: A clear written agreement stating the worker is an independent contractor
- Freedom to work elsewhere: No restrictions preventing them from working for other businesses, including competitors
- Limited business control: The business doesn't require the worker to be personally available at specific times or locations (beyond what's necessary for the work)
- Worker provides tools/equipment: The worker provides the main tools, vehicles, or equipment needed for their work
You can check out the Employment Relations Amendment Bill for more information.
What this means for your business
If the working arrangement meets the 4 criteria set out in the test, the worker is considered to be a contractor. If any of the 4 criteria are not met, the claim would be considered under the existing 'real nature of the relationship' test.
If all four criteria are met: The worker is definitively a contractor, and this cannot be challenged.
If any criteria are not met: The current test assesses the parties' intentions, control, integration, and economic reality to determine the "real nature of the relationship" and will continue to apply.
Practical steps for small business owners
Before hiring anyone
- Clarify the relationship upfront: Determine whether you need someone integrated into your business (employee) or someone to deliver specific outcomes independently (contractor)
- Document everything: Whether employee or contractor, have clear written agreements that reflect the reality of the working relationship
- Review your current arrangements: If any of the 4 criteria are not met, the claim would be considered under the existing 'real nature of the relationship' test. Businesses should prepare to adjust their contracting practices where necessary. While the changes are still in development, businesses can use this period to ensure their practices align with current law.
For contractor relationships
- Ensure your written agreement clearly states they're an independent contractor
- Don't restrict them from working for competitors or other businesses
- Allow flexibility in when and where they work (within project requirements)
- Ensure they provide their own main tools and equipment
- Pay based on invoices, not regular salary/wage payments
- Don't provide employment benefits like annual leave or sick pay
For employee relationships
- Use employment agreements that comply with employment law
- Provide minimum employment entitlements
- Deduct PAYE, not withholding tax
- Consider KiwiSaver, ACC, and other employment obligations
- Follow employment law for any disciplinary or termination processes
Common mistakes to avoid
Hybrid arrangements: Don't create relationships that have both employee and contractor characteristics. Pick one and structure the arrangement consistently.
Control creep: Starting as a contractor relationship but gradually imposing more control and integration without changing the legal structure.
Written vs reality mismatch: Having a contractor agreement but treating the person like an employee in practice.
One-size-fits-all approach: Different types of work and workers may require different approaches. A graphic designer working on a one-off project is very different from someone providing ongoing administrative support.
Being led by the worker: We often hear from employers who have workers that asked to be a contractor as they feel it is more in their benefit. If this is the case, ensure that you don’t have other characteristics in the working arrangement that still mean this is really employment rather than contracting. If something goes wrong, it won’t be sufficient protection for you that they asked to be a contractor.
Getting professional advice
The employee vs contractor distinction involves both employment law and tax law. Consider getting professional advice when:
- You're unsure about a specific working arrangement
- You have workers who could potentially be classified either way
- You're planning to restructure existing relationships
- You want to ensure compliance with upcoming changes
Employment lawyers, HR consultants, and accountants can provide guidance tailored to your specific situation.
The bottom line
Getting the employee vs contractor distinction right isn't just about avoiding penalties - it's about creating clear, fair working relationships that work for everyone involved. The upcoming gateway test will provide more certainty, but it's important to understand both the current rules and the changes coming in 2025.
Take time to review your current arrangements, ensure your agreements match the reality of how you work together, and don't hesitate to get professional advice when you're unsure. Your workers and your business will benefit from getting it right from the start.
Remember: when in doubt, it's often safer to assume an employment relationship and provide appropriate protections and benefits. The costs of misclassification typically far exceed the costs of proper compliance.
This guide covers the essentials based on current law and proposed changes, but every business situation is unique. Always consult with employment law professionals and check the latest requirements with Employment New Zealand for your specific circumstances.
