Anaya Nolan
The distinction between a common-law employee and an independent contractor is important for tax purposes. A common-law employee is typically someone hired by an employer, with the employer having the right to control the employee's work. This includes what work is done and how it is done. Common-law employees are usually paid a W-2, while independent contractors are given Form 1099. However, the relationship between an employer and employee can differ in each business situation, and there are various tests to determine whether a worker is a common-law employee or an independent contractor.
| Characteristics | Values |
|---|---|
| Common-law employee | Someone hired by an employer, with the employer having the right to control the employee's work |
| Independent contractor | Self-employed; they pay their own taxes and are not entitled to standards and rights laid out in employment and labor laws |
| Common-law test | A set of guidelines used by the IRS to classify workers as either employees or independent contractors |
| Worker classification | Affects tax and reporting requirements to federal and state governments |
| Employee benefits | Health insurance, sick leave, vacation pay or retirement contributions |
| ABC test | A test used to classify a worker as an independent contractor |
| 20-factor test | A test used to evaluate who controls how a person’s work is performed |
| Three factors of the common law test | Behavioral control, financial control, and the relationship of the parties |
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What You'll Learn
Common-law employees vs. independent contractors
The distinction between a common-law employee and an independent contractor is important for tax withholding purposes. A common-law employee is someone hired by an employer, with the employer having the right to control the employee's work. This includes what work is done and how it is done. The employer-employee relationship is governed by the substance of the relationship, not the label, and it does not matter whether the individual is employed full-time or part-time.
The IRS uses the Common Law Test to determine whether a worker is an employee or an independent contractor. This test measures how much behavioural and financial control an employer has over an individual and the type of relationship both parties share. A worker who meets the guidelines of the Common-Law Test is considered to be an "employee".
Employees are generally hired indefinitely, whereas independent contractors are usually hired for a specific time period or project. Employees have income tax, Social Security, and Medicare withheld from their paychecks, whereas independent contractors do not. Independent contractors are also not entitled to standards and rights laid out in employment and labour laws.
To determine whether an individual is an employee or an independent contractor, the relationship of the worker and the business must be examined. All information that provides evidence of the degree of control and the degree of independence must be considered. For example, if there is an evaluation system in place that measures work performance, this would specify that the worker is an employee. However, if the evaluation simply judges the end result, they could either be an employee or an independent contractor.
It is important for business owners to correctly determine whether individuals providing services are employees or independent contractors, as misclassifying workers may result in IRS-imposed financial penalties.
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Common-law test factors
The IRS uses the Common Law Test to determine whether a worker should be classified as a common-law employee or an independent contractor. Here are the factors that determine the worker's status:
Behavioural
This factor examines whether the employer has control or the right to control what the worker does and how they do their job. This includes the freedom to decide which assignments to take, whether to ask for additional work from other clients, and whether to advertise their services. The employer-employee relationship is further indicated if the worker's decisions are subject to employer approval and the worker does not exercise managerial skills that affect their profit or loss.
Contracts and Benefits
The existence of written contracts, employee-type benefits (such as pension plans, insurance, and vacation pay), and whether the work performed is a key aspect of the business are all considered. Independent contractors typically have more freedom in negotiating their contracts and are not entitled to the same benefits as employees.
Business Activities
The worker is likely an independent contractor if their work is outside the employer's usual business activities. For example, a plumber working for a trucking company would be outside the usual business activities of the trucking company.
Economic Realities
This factor considers whether the worker is economically dependent on the employer for work or if they are in business for themselves. This includes the ability to earn profits or suffer losses through their independent efforts and decision-making. Independent contractors often have more freedom in negotiating their pay, deciding whether to accept or decline work, and purchasing equipment or materials.
It is important to note that the determination of a worker's status is based on multiple factors, and each business must be evaluated on a case-by-case basis. Misclassifying workers can result in IRS-imposed financial penalties, so it is crucial to properly classify workers as either employees or independent contractors.
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Employee benefits
A 1099 worker is an independent contractor, and while they are commonly referred to as an employee, they are actually self-employed. Typically, organisations do not offer their 1099 employees any benefits, but this is changing due to a tight labour market and the need for highly specialised talent.
There are many benefits that can be offered to 1099 workers, including:
- Health insurance, dental and vision coverage.
- Retirement savings plans, such as a Simplified Employee Pension (SEP) IRA plan, or a Simple IRA.
- Life insurance, disability insurance, pet insurance, and retailer discounts.
- Paid travel expenses.
- Training and certifications.
There are also benefits for employers who hire 1099 workers, including:
- Greater flexibility and independence.
- No requirement to pay health insurance premiums or unemployment insurance.
- No requirement to withhold payroll taxes.
- No expectation to provide benefits or time off.
However, it is important to note that any benefits provided to 1099 workers must be declared as taxable income. Additionally, employers must be careful to correctly classify their workers to avoid IRS-imposed financial penalties.
The distinction between a common-law employee and an independent contractor is important for tax withholding purposes. A common-law employee is typically defined as someone hired by an employer, with the employer having the right to control the employee's work, including what work is done and how it is done. This distinction is made on a case-by-case basis by the IRS, considering all information that provides evidence of the degree of control and independence in the relationship.
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Tax implications
The distinction between a common-law employee and an independent contractor is important for tax withholding purposes. Worker classification affects tax and reporting requirements to federal and state governments.
Common-Law Employee
According to the IRS, a worker is considered a common-law employee when their employer has the right to control the work they do and how that work is done. Common-law employees are workers that an employer can fully dictate what they do. The standard Common Law Test indicates a worker is likely an employee if the employer has control over what work is to be done and how to get it done.
When it comes to taxes, employers must withhold and pay for Medicare and Social Security taxes as well as unemployment insurance on wages that are paid to a common-law employee. There is also the employer's share of Social Security and Medicare taxes that must be paid when a worker is classified as an employee.
Independent Contractor
An independent contractor is a self-employed worker. They are typically given Form 1099 and are responsible for making their own tax payments. They are not entitled to the same standards and rights laid out in employment and labor laws, and they do not get taxes withheld from their payments.
To be classified as an independent contractor, a worker must be free from the requirement to take direction for work performance and the work must be outside the employer's usual business activities. Additionally, independent contractors typically have their own workspace and pay for their tools and equipment, and they are allowed to work for multiple businesses or clients.
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State-specific tests
Worker classification is a complex area, and while the Fair Labor Standards Act (FLSA) sets guidelines for classifying a worker as an independent contractor, each state agency may have its own rules for classifying workers.
The standard Common Law Test, used by the IRS, New York, and 17 other states, determines worker status by examining behavioural control, financial control, and the relationship between the parties. The test considers the degree of control and independence between an employer and a worker. The IRS has a set of rules that specifically looks at the following categories:
- Behavioural: Does the company control or have the right to control what the worker does and how the worker does the job?
- Financial: Does the employer control the business aspects of the worker's job, such as hiring, firing, scheduling, prices, pay rates, and supervision?
- Type of relationship: Are there written contracts that outline how both parties work together? Are employee benefits like health insurance, paid time off, and sick days offered?
The ABC Test is another method used to determine worker status. The U.S. Department of Labor and 33 states, including California, use this test. The ABC Test considers the following factors:
- Work location: Is the work performed away from the hiring organisation's facilities?
- Worker's occupation: Is the worker customarily engaged as an independent contractor in this trade or occupation?
- Control: Is the worker free from the direction or control of the hiring organisation by contract or agreement?
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Frequently asked questions
A common-law employee is someone hired by an employer, with the employer having the right to control the employee's work and how it will be done.
Common-law employees and independent contractors have different classifications for tax withholding purposes. Common-law employees have FIT and FICA taxes withheld from their pay, whereas independent contractors are self-employed and pay these taxes themselves.
The IRS uses a three-pronged test, also known as the common-law test, to determine a worker's status. The three factors are behavioural control, financial control, and the relationship of the parties.
