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Common Law Employee Test

What is the Common Law Employee Test?

The Common Law Test is a guide to determine whether or not a worker should be classified as an employee or an independent contractor.

The standard Common Law test defines a worker as an employee if the employer has control over what work to be done and how to get it done. When employers can only direct or control the result of the work done — and not what will be done and how it will be done then a worker is typically defined as an independent contractor.

The IRS has a set of rules for the Common Law Test and it looks at the following categories:

  • 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? (This may include things like how the 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?

Classifying Employees

Your small business must properly classify workers as either employees or independent contractors. Typically, an employee is someone you plan to hire full time and receives a W-2, while an independent contractor is brought in for project-based work and given Form 1099 MISC.

Worker classification affects tax and reporting requirements to federal and state governments. It's an area where you'll want to pay attention to because misclassifying workers may result in IRS-imposed financial penalties. Once you determine the proper classification (employee or independent contractor), an employee is then categorized as either exempt or nonexempt. Whether an employee is classified as exempt or nonexempt is determined by the Fair Labor Standards Act (FLSA) and is based on job responsibilities and salary level.

Exempt employees are typically paid a salary and there are no minimum wage requirements or overtime pay requirements. The FLSA defines an exempt employee as one not covered under FLSA rules. Nonexempt employees are protected by the FLSA, which provides guidelines for minimum wage, record keeping, child labor laws and equal pay.

Withholding Payroll Taxes

Worker classification determines if you need to withhold income, Social Security and Medicare taxes from a worker's wages when processing payroll.

With an employee classification, the employer must withhold two key payroll taxes: Social Security and Medicare. Additionally, there is the employer's share of Social Security and Medicare taxes that must be paid when a worker is classified as an employee. There are federal and state unemployment insurance contributions that also need to be made by the employer. Employers pay the unemployment tax on their own behalf as it is not withheld from employees' pay.

Employers have minimal reporting responsibilities with independent contractors and are generally not responsible for tax withholding.