How Can You Tell a Common Law Employee From an Independent Contractor?

Knowing the difference between independent workers and employees is critical for compliance with tax and employment laws. Here's what you need to know.

Independent contractors can be an invaluable addition to your workforce. But how can you be sure the person you're contracting with is truly independent?

It's not simply a matter of mutual agreement. You can sign a contract with someone specifically creating an independent contractor relationship that won't hold up in court because the person is a common law employee.

Misclassifying a common law employee as an independent contractor is a major liability, exposing your business to potential lawsuits, penalties, back taxes, and audits. It can also damage employee productivity and morale. The longer the errors go on, the bigger the risk grows.

Before you contract with any worker, you need to know the difference between a common law employee and an independent contractor.

Overview: What is a common law employee?

The Internal Revenue Service (IRS) defines a common law employee as "anyone who performs services for you ... if you can control what will be done and how it will be done."

If you're thinking the last half of that definition could use a little fleshing out, you have a very good point. Anytime you hire someone to do work, you control some aspects of "what will be done and how it will be done." You don't just hire a kid to mow any lawn on the block, right?

So, how much control can you exert before a worker becomes an employee?

Common law employee vs. independent contractor: What's the difference?

The difference between independent contractor and common law employee rides on the control and independence evidenced in the relationship. You may be accustomed to taking a very hands-on approach to managing employees. Contractors require a different approach.

This is important because common law employees must be treated like any other employee. For example, you must collect payroll taxes and pay the employer's share, you must provide overtime when earned, and you may need to provide certain types of leave or benefits.

Independent contractors, on the other hand, are self-employed. They pay their own independent contractor taxes and generally are not entitled to leave or benefits. Simpler accounting and payroll tax savings are two benefits of including independent workers in your human resource (HR) strategies.

The IRS is keenly interested in making sure companies are paying independent contractors and employees correctly. The U.S. Department of Labor also enforces proper worker classification.

What is the common law employee test?

The IRS provides common law rules to help you correctly separate independent contractors from employees. The rules measure three criteria:

• Behavioral
• Financial
• Type of relationship

Employers must weigh these factors together to separate employees from contractors. There is no equation or bright line separating the two. You have to complete the full IRS independent contractor test, weigh the totality of the circumstances, and make a judgment call.

Many states have created their own common law employee tests.

California common laws, for example, use an "ABC" test that defines an independent contractor as a worker who is a) free from control and direction, b) performing work outside the company's usual course of business, and c) customarily engaged in that work as part of an independent business.

Anytime you're covered by state and federal labor laws, apply the more stringent rules to your business. Check out the laws of your home state and the state where the contractor is doing work for you besides the IRS requirements.

Let's get into the proverbial weeds on the IRS common law rules to see if we can get clarity.

How to properly classify and work with common law employees

Whether you're hiring a new contract employee or wondering whether your present working arrangements are by the book, you can evaluate your employment relationships through these five steps.

1. Document behavioral factors

The first factor in the IRS rules concerns the level of behavioral control over what work is done and how. To assess your level of control, consider how detailed your instructions are regarding each aspect of the work. Are you actively managing the worker, or are you just managing results?

BEHAVIOR

Consider all of these factors to assess behavioral control.

Go through the chart and check each box that's closest to your arrangement. You may find that you have a mix of both, and that's okay. You're just gauging one of many factors that will combine to determine final status.

For example: Maila works as a surgical assistant at a veterinary hospital. She works four evenings per week plus every other Saturday to fill the hours when the full-time assistant is out. She works at the hospital, but also travels to provide care to the hospital's clients.

She has a separate practice of her own part time, but she received a week of training in the hospital's procedures during onboarding. She brings her own surgical kit to work, but uses the hospital's equipment and supplies while on site.

The hospital controls major behavioral aspects of Maila's work, including schedule, location, client list, training, procedures, and supplies. This indicates that Maila is a part-time common law employee, not an independent contractor.

2. Document financial factors

Next, you need to consider how much financial control you have over the relationship. Here are the major factors the IRS considers.

FINANCES

Consider these factors to evaluate financial control.

Once again, look at each financial factor in turn and add those findings to your analysis.

For example: Leon is a drywall contractor who works regularly with a residential general contractor (GC). He has his own service truck and tools, which he brings to every work site. He pays his own expenses and receives a flat payment for each job based on square footage.

Drywall is supplied to the site by the GC, but Leon uses his own materials such as compound and tape. Leon schedules his jobs a month in advance with the GC. Leon also works for another GC in the area, but most of his work comes from the one GC. Leon hires assistants as needed to complete his jobs on time.

Based on financial factors, Leon meets independent contractor requirements. He has invested in his own equipment, pays his own expenses, supplies many of his materials, and pays his own assistants. As a result, he has a lot of control over how much profit he makes from each job.

3. Consider the nature of the relationship

The third prong in IRS common law rules addresses the terms of your working arrangements. These are the factors the IRS considers when evaluating control according to the contractual relationship.

TYPE OF RELATIONSHIP

The nature of the relationship is the third prong of common law rules.

For example: Chris, a web designer, works for an online auction company 25 hours per week to revamp the company's website. The parties sign an independent contractor agreement provided by the designer.

The work has to be done on site because the owner wants Chris to work with marketing staff so they can learn the content management system. The company allows Chris to buy into healthcare benefits so long as he puts in at least 25 hours per week. The company indicates the position has the potential to go long term.

Based on the relationship terms, the designer is likely an employee despite the independent contractor agreement. The website is integral to the company's core function, an online store. The company provides benefits and envisions a long-term relationship.

As you can see, the employment contract is just one of many factors determining an employee's status. That's why it's so important to understand the full common law rules and apply them to each relationship you're considering to ensure that you're properly classifying everyone you hire.

4. Phone a friend

With luck, you'll have a clear winner by the time you get through all three legs of the common rules.

If you're still not sure about the relationship after going through the full common law rules, you can also ask the IRS to weigh in by filling out IRS Form SS-8, Determination of Employee Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

It will probably take months before you get a decision, and you may need to make back tax adjustments based on the agency's findings.

Since there is no bright line to rely on, this is a good time to consult an attorney to review your analysis and draw up or review the contract.

5. Review employment tax obligations

If you determine a worker is a common law employee, you will need to treat the person like any other employee for purposes of payroll, employment taxes, overtime, and mandatory leave and benefits. This includes Medicare and federal and state unemployment taxes.

If the person is an independent contractor, you can sign your contract with confidence and enjoy the simplified paperwork and tax savings they afford.

HR software such as Zoho People makes it easy to ensure accurate payroll and tax forms for employees and independent contractors.

FAQs

• What test does the IRS use for determining a common law employee?

  The IRS uses a three-prong test that evaluates the company's control over the worker's behavior, finances, and relationship with the company. This requires evaluating numerous factors and considering all of them together to make a final determination.

• Does a common law employee get a 1099?

  No. Wages for common law employees are reported on IRS Form W-2. Earnings for independent contractors are reported on Form 1099.

• What is the difference between a common law employee and statutory employee?

  Statutory employees are independent contractors who are treated as employees by statute for certain employment tax purposes.

  Under IRS regulations, these include certain types of delivery drivers, life insurance agents, home assemblers, and traveling salespeople. State laws may establish further classes of statutory employees.

• What is the difference between a common law employee and a regular employee?

  A common law employee is someone who is hired for a limited purpose or scope of work, but who is sufficiently dependent to qualify for regular employee status under federal or state common law rules. Common law employees are treated just like any other employee under the law.

• Can an owner be a common law employee?

  If an owner can serve as an employee, there’s nothing preventing the owner from being a common law employee.

Reap the benefits

When the relationships are properly sorted out, working with independent contractors can be great. They can save you taxes, hassle, and paperwork, and you can part ways easily if your needs change. By ensuring workers are properly classified, you can ensure those benefits are here to stay.