A common law employee is someone hired by an employer, with the employer having the right to control the employee's work. The test of whether someone who does work for your business is your common law employee is whether you have control over what the employee will do and how it will be done.
What a Common Law Employee Looks Like
The relationship between an employer and employee differs in each business situation. In general, though, here are some of the factors that might determine a common law employee relationship:
- The employee is assigned to work specific days and hours, as needed by the employer.
- The employee's decisions are subject to employer approval. The amount of employer oversight on decisions depends on the employee's length of service and experience.
- Customers are the property of the employer, not the employee.
- The employee must provide periodic reports to the employer.
- The employee is paid a specified amount as a salary or hourly worker.
- The employer pays medical insurance and other benefits to the employee.
The Federal Common Law Employee Test
The IRS has set rules for determining the status of a worker as either a common law employee or an independent contractor. The basis for these rules is the principle of control. The IRS says that its determination is based on looking at information that provides evidence of control and independence. Basically, this means that the IRS looks at each business on a case-by-case basis, applying the rules to the rules to the situation. The three general rules that determine the amount of control vs. independence are:
Behavioral. Does the company control or have the right to control what the worker does and how the worker does his or her job?
Financial. Are the business aspects of the worker’s job controlled by the payer? (these include things like how a worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
Type of Relationship. Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
If you review the list in the first section, you can see that all of these questions are
Why Is the Common Law Employee Test Important?
The distinction between an employee and an independent contractor is an important one for the IRS because it affects taxes (of course), specifically (a) withholding of federal income tax (FIT) and (b) withholding of FICA taxes (for Social Security and Medicare). Simply stated:
- Employees have FIT and FICA taxes withheld from their pay and employers must also make payments for these taxes.
- Independent contractors are self-employed. They don't have taxes withheld from payments they receive. They pay these taxes themselves; the companies they work for don't.
The IRS and states consider a worker to be an employee unless it can be proved that the worker is an independent contractor. That's why the common law employee test is so important.
Common Law Employees and State Laws
In recent years, states have been establishing ABC tests for determining common law employee vs. independent contractor status. These tests affect state taxes, like income tax and state unemployment taxes, not federal taxes. At present, 26 states, including California, have some variation of these tests. There are three parts. The worker is an independent contractor if these tests are met:
- The worker must clearly be free from being required to take direction for work performance, as shown by both the terms of the employment contract and the actual working relationship.
- The work must be outside the employer's usual business activities. If the business is a trucking company, a trucker would be inside the usual business activities, but a plumber would be outside the usual business of the trucking company.
- Workers must be "customarily engaged" in an independent business or a business similar to the work performed for the hiring company.
Some states, like California, use all three of these tests, while other states use only two. Check with your state if you have questions about the status of workers.
How Your Business Can Avoid Issues With the Common Law Employee Test
Federal and state agencies can and will audit or inspect businesses looking for violations of common law employee relationships. Sometimes these inspections are the result of complaints. Here are some ways your business can avoid problems in this area:
- Clarify the relationship with independent contractors, using written agreements that clearly state the nature of duties and responsibilities and the nature of the relationship.
- Make sure you aren't demanding too much of independent contractors. They should be free to work with other employers, manage their own time, control their expenses, and bring their own tools and materials.
- If you aren't sure if a worker or an independent contractor, you can ask the IRS to review the status of workers. They have a voluntary program that reviews your situation and gets a determination letter. You can use IRS Form SS-8 to request a review.
Being thoughtful about how you deal with workers can help you get through any common law employee issues. Of course, it's always good to check with an employment attorney before hiring workers.