Independent contractor vs employee: Key differences explained

Published Tuesday 6 January 2026

Table of contents

• What's the difference between a contractor and employee?
• How to classify workers correctly
• Legal obligations and employment rights
• Tax implications for your business
• Think carefully about what your business really needs
• Get your worker classification right from the start
• FAQs on independent contractors vs employees

Key takeaways

• Apply the eight-question classification framework to determine whether workers should be employees or contractors, focusing on factors like control, business integration, and financial investment to avoid costly misclassification penalties.
• Recognize that employees provide stability and lower hourly costs but require ongoing legal obligations like PAYE, National Insurance, and statutory benefits, while contractors offer flexibility and specialized skills at higher rates with minimal administrative burden.
• Understand that your tax responsibilities differ significantly between worker types: you must handle payroll deductions for employees but contractors manage their own taxes, except when IR35 rules apply to disguised employees.
• Seek professional advice from accountants or employment lawyers when worker classification is unclear, as HMRC actively reviews these arrangements and misclassification can result in backdated taxes, penalties, and legal disputes.

What's the difference between a contractor and employee?

An employee is a worker you directly control and manage. You decide what they deliver and how they do their job. Employees work under your direction with set hours, workplace rules, and ongoing supervision.

An independent contractor is a self-employed worker you hire for specific projects or tasks. They control how the work gets done while you control the end result. Contractors operate their own business and often work for multiple clients.

Key differences at a glance:

• Control: You manage employees directly; contractors manage themselves
• Relationship: Employees have ongoing employment; contractors have project-based agreements
• Obligations: Different tax, legal, and benefit requirements apply to each

Worker classification varies by location and affects both rights and responsibilities. Consult your accountant or employment lawyer for guidance specific to your situation.

How to classify workers correctly

Worker classification determines your legal obligations, costs, and business flexibility. Getting it wrong can result in penalties, back taxes, and legal disputes.

Use these eight questions to help you classify your workers correctly:

1. Is the person's work an integral part of your company's business?

If their role is essential to your business, they're more likely to be classified as an employee.

2. Does the individual have a significant impact on the company's profits?

If so, it's likely they'll be classified as an employee.

3. How does a worker's investment in the company compare to yours?

An independent contractor usually invests in their own tools, equipment, and training. If a worker has little or no financial investment and relies on you for most resources, they're more likely to be classified as an employee.

4. Does the work require a special skill set?

If your worker provides a specialised or unique service, they may be an independent contractor. However, if the service or skills they provide are easy to replace, it's more likely they'll be classed as an employee.

5. What degree of control does the worker have?

A worker is more likely to count as an independent contractor if they can decide:

• their own hours
• where they work
• when they work
• a specific end date

6. Does the person provide regular and written progress reports to the company?

An independent contractor usually provides regular updates on their work and sends an invoice every week or month.

7. Does the person make their own self-employment deductions?

Independent contractors need to pay their own self-employment taxes.

8. Does the person have more than one client?

An independent contractor usually has more than one client, as opposed to working with one company full-time.

Some independent contractors are considered employees for tax purposes, under IR35 rules. It's up to the employer to determine a contractor's status, so make sure you read up on IR35 legislation when employing a contractor.

If you're unsure about your answers to these questions, check with your lawyer, accountant, or tax office to clarify your position.

Legal obligations and employment rights

You need to understand your legal duties because they differ greatly between employees and contractors. Employees are protected by employment law, which gives them rights to things like the National Minimum Wage, statutory sick pay, paid holidays, and pension auto-enrolment.

Independent contractors, on the other hand, don't have these statutory employment rights. Their rights and obligations come from the contract for services you both agree on. They're responsible for their own business and aren't entitled to the benefits you provide to employees.

Tax implications for your business

The way you handle tax and National Insurance (NI) is a key difference. For an employee, you must run payroll, deduct Income Tax and NI through the PAYE system, and pay employer's National Insurance contributions on top of their salary.

For an independent contractor, you typically pay their invoice without any tax deductions. They are responsible for paying their own Income Tax and NI. However, you must be aware of IR35 rules. If a contractor is deemed to be a 'disguised employee' under these rules, you could become responsible for their tax and NI.

Think carefully about what your business really needs

Your business needs determine whether employees or contractors work best for you. Consider your workload consistency, required skill sets, and long-term growth plans when making this decision.

Benefits of hiring employees

Employees provide stability, loyalty, and consistent availability for your business operations. Here's why they might be the right choice:

• Deep business knowledge: They learn your processes and work independently without constant training
• Lower hourly costs: Base wages are typically less than contractor rates due to job security and benefits
• Guaranteed availability: They're committed to your schedule when workload increases
• Business continuity: You can take time off knowing your operations continue running

What to consider when hiring permanent employees

Hiring employees creates ongoing legal and financial responsibilities that continue regardless of business fluctuations. Your employer obligations include:

• Training and development: Provide necessary skills training and professional licensing
• Guaranteed payment: Pay wages consistently, even during slow business periods
• Cash flow planning: Maintain reserves to cover payroll obligations
• Payroll compliance: Handle tax withholding, National Insurance, and pension contributions
• Administrative burden: Manage ongoing paperwork, reporting, and legal requirements

With employees, you have specific legal payroll compliance requirements. You need to withhold your employees' taxes and handle other deductions. All of this takes time, effort and money.

Benefits of hiring independent contractors

Independent contractors offer flexibility, specialised skills, and reduced administrative burden for project-based work.

Key contractor advantages:

• Speed and expertise: Access skilled professionals quickly for specific projects
• Self-sufficient: They handle their own training, licensing, and professional development
• Cost efficiency: Higher hourly rates but potential overall savings through efficiency
• No ongoing costs: No benefits, holiday pay, or salary commitments required
• Easy termination: End contracts without employment law complications

Drawbacks of hiring contractors

While hiring independent contractors has its advantages, contractors come with trade-offs that may impact your business operations:

• Higher costs: Premium rates for specialised skills and flexibility
• Limited loyalty: Less commitment to your business long-term success
• Reduced control: Less influence over work methods and daily schedules
• Location flexibility: Often work remotely, reducing direct oversight
• Skill gaps: May need different contractors for varying project requirements
• Availability risks: No guaranteed capacity during busy periods

Get your worker classification right from the start

Getting worker classification right helps you avoid penalties, back taxes, and legal disputes. HM Revenue & Customs (HMRC) actively reviews worker status, particularly around IR35 compliance.

Take action immediately if you suspect misclassification:

• Review current arrangements: Assess all worker relationships using the classification framework
• Seek professional advice: Consult employment lawyers or accountants for complex situations
• Correct classifications: Reclassify workers before HMRC discovers the issue
• Document decisions: Keep records showing how you determined worker status

Getting worker classification right protects your business and ensures smooth financial operations. Manage your contractor and employee payments efficiently with Xero's accounting software, which helps track different worker types and maintains compliant financial records. Try Xero for free.

FAQs on independent contractors vs employees

Deciding between a contractor and an employee can bring up a few questions. Here are answers to some common ones.

Does a contractor have the same rights as an employee?

No, their rights are different. Employees have statutory rights like paid holiday, sick pay, and minimum notice periods. A contractor's rights are determined by the terms of their contract for services.

What happens if I misclassify a worker?

Misclassifying a worker can lead to investigations by HM Revenue & Customs (HMRC), resulting in financial penalties. You may be liable for backdated PAYE tax and National Insurance contributions, plus interest.

How does IR35 affect contractor classification?

IR35 rules are designed to identify 'disguised employees,' or contractors who work in a similar way to permanent employees. If a contractor falls 'inside IR35', you may be responsible for deducting tax and NI as if they were an employee.

Can I change a contractor to an employee later?

Yes, you can offer a contractor a permanent employment contract. If they accept, their status changes, and you must begin to provide all statutory employment rights and handle their payroll through PAYE.

Do contractors cost less than employees overall?

Not necessarily. While you avoid costs like employer's NI and paid leave, a contractor's day or hourly rate is usually higher to compensate for this. You should compare the total cost for the work required, not just the headline rate.