What is a common-law employee?

According to the IRS, a common-law employee is someone who performs work for an organization that has control over what work is done and how it’s done—it’s essentially a “traditional” employer-employee relationship. The designation applies to both full- and part-time employees. Determining whether someone is a common-law employee comes down to how much control the employer has over the details of how a given individual performs their work. 

How the IRS determines if workers are common-law employees

Performing a common-law employee test to determine the nature of the relationship is important for IRS classification purposes. Designating a worker as an employee as opposed to an independent contractor makes the employer responsible for withholding that person’s federal income taxes and the Federal Insurance Contributions Act (FICA) taxes, which help pay for Medicare and Social Security. However, employers don't have to do the same withholdings for independent contractors, who are responsible for managing their own taxes and insurance contributions. 

Businesses must adhere to IRS rules for employee classification to avoid hefty sanctions and penalties. Designating employees as independent contractors as a means to avoid health insurance obligations or reduce the paperwork burden is illegal. To ensure employees are properly classified, companies can apply a simple common-law employee test to evaluate the relationship. The test has three components:

• Behavioral: How much control does the company have over the employees' work and how they do it?
• Financial: How involved is the employer in the business aspects of the worker’s job? How much do they control pay (when and how much), expense reimbursements, and the tools and equipment to do the work?
• Relationship: How crucial is the worker’s contribution to the operations of the company? Does the worker have a contract or qualify for benefits? 

Some states have also implemented additional tests to differentiate between employer-employee relationships and independent contractors. According to state common-law employee definitions, an individual is an employee if they have to take direction from an employer, their work is within the scope of the company’s normal business activities, and the employee doesn’t have an independent business that performs the same or similar work. 

Depending on the state law, individuals may need to meet some of or all these qualifications to be classified as an employee.  

The factors contributing to a common-law employee designation include: 

• The employer determines the days and hours an individual works
• The employer has to approve all the individual’s decisions, and the level of oversight depends on the worker’s experience and length of service
• The employee has to provide regular updates to the employer
• Customers or clients belong to the employer, not the worker
• The employer pays a set salary or hourly wage 
• The employer provides medical insurance and other benefits 

Common-law employees vs. independent contractors

Here are some examples to help you differentiate between independent contractors and common-law employees.

Identifying an employee

Bill is a graphic designer. He works for a marketing company and earns an annual salary. His employer withholds taxes from his biweekly paychecks and covers a portion of his company-sponsored health insurance premium. His manager assigns projects for him to work on, which he does using a computer and software provided by his employer. He works a set schedule and requests time off several times a year. 

Based on the amount of control Bill’s employer has over his work, the fact that he works the hours established by his manager using tools and equipment owned by the company, and receives benefits, he is an employee.

Identifying an independent contractor

Bill’s friend Nancy works for the same marketing company as a freelance writer. She completes assignments regularly at a set pay rate that she negotiated when she signed a contract to provide services to the company. She works from home on a personal laptop, keeps her own hours, and has the option to decline work if she chooses. She receives payment after she completes her assignments and takes care of paying her own taxes and health insurance. 

Nancy is an independent contractor. Although the company provides parameters for her work in the form of assignments, Nancy has total control over when and how she works. She provides a service that no one else in the company has the talent or capacity to perform, and she runs her own business, as evidenced by supplying her own equipment, covering her own business expenses, and managing her own taxes.