How to Use the Common Law and Reasonable Basis Tests to Classify Employees and Independent Contractors

If you’re a payroll provider, then classifying and onboarding your customers’ workers correctly is essential to keeping them payroll tax compliant. But in some cases, determining employee status—whether a worker is a true employee or an independent contractor—can be difficult.

In general, an employee is defined as a person who performs a service, with the employer controlling the methods and the results of the work done. This can be either a full-time or part-time position. Employers must withhold income taxes and employment taxes like Social Security and Medicare from each employee’s paycheck. They also must match Social Security and Medicare taxes from their employer wages. 

A person with independent contractor status, also known as a 1099 employee, is defined as a person who performs a service for an employer, but controls how and when their work is done. In terms of payroll tax implications, independent contractors are responsible for 100% of their tax liability, and employers often do not owe any taxes with regard to self-employed workers, but that’s not always the case. For example, if the contractor does not provide a Taxpayer Identification Number (TIN), backup withholding may be required by the employer.

So while there are distinctions in worker classification, there are nuances that can make it difficult to understand how to classify workers correctly. Employers may misclassify employees as independent contractors by earnest mistake, or in some cases they may attempt to bypass paying withholding taxes or avoid providing benefits. This type of worker misclassification can lead to substantial losses in revenue for the federal government. Because of this, both the Internal Revenue Service (IRS) and Department of Labor (DOL) are ramping up their efforts to identify cases of misclassification. 

To help you and your customers avoid an IRS audit or a violation of the Fair Labor Standards Act (FLSA), explore these contractor or employee tests to determine a worker’s classification.

The common law test

You can most often determine a worker’s classification under the common law test, known as the FSLA Economic Reality test as of March 2024, which helps determine the employer-employee relationship. The IRS uses this test to classify its own workers. Under the common law test, determining the degree of control over what work will be done and how it will be done is key. 

The criteria that the common law test uses can be split into three categories: financial, behavioral, and the type of relationship between the worker and employer.

Financial criteria

An employer’s degree of control over the economic aspects of a worker's job helps illuminate a worker’s status and whether the worker is an employee or an independent contractor:

• If the worker has financial control over their income sources, they may be an independent contractor. Independent contractors have control over their income sources and are free to pursue other business opportunities, often under the umbrella of their own business. In contrast, while employees may moonlight, their primary daily employment is through one employer.
• If the worker is paid lump sums through accounting, they may be an independent contractor. Employees receive wages through payroll.
• If the worker is paid per project rather than on a regular time interval, they may be an independent contractor. While the method of payment for employees is transacted on a predetermined schedule, whether they are hourly or salaried, independent contractors are often paid a flat fee per job. 
• If the worker is not required to be reimbursed for their business expenses, they may be an independent contractor. While employees are privy to reimbursement for expenses related to the business, independent contractors are responsible for their own expenses like supplies, transportation, and other business-related costs.
• If the worker can earn or lose a profit on the services they provide, as they incur cost for equipment, unreimbursed expenses, and more, they may be an independent contractor. Employees do not take on that financial risk.

Behavioral criteria

Along with financial criteria, you should also examine behavioral control as part of a contractor or employee test. It covers who has power to direct how, when, and where workers perform their tasks. Indicators include:

• The level of control an employer has over how work is completed. If a worker is told when, where, and how to perform their job, that worker is an employee. If the worker has complete control of their hours and other details of how they perform their role, they are typically an independent contractor.
• The training provided by the employer. If a worker receives any type of training to aid in performing his or her job, that worker is an employee. 

Relationship criteria

The working and legal relationships vary immensely between employers and employees versus independent contractors. Some ways to understand these relationships are:

• Whether a written contract exists. Independent contractors utilize these to define their scope of work. Employees, on the other hand, usually sign at-will employment contracts.
• Whether benefits like health insurance and paid time off (PTO) are provided. Only employees receive these, while effectively self-employed independent contractors are responsible for their own insurance and do not earn PTO.
• Whether the professional relationship is long-term. If a person is hired on an ongoing basis (think back to the at-will employment contract), that worker is an employee. If the person is hired to complete a project or short-term assignment, they are likely an independent contractor.
• Whether the services provided are a core aspect of the business’s regular operations. If they are, the worker offering those services is typically an employee. If the work performed is a special project, the worker may be an independent contractor. 

You could come across instances in which an employee is performing work that could also be performed by an independent contractor. That’s why it’s important to look at these criteria as a whole, rather than piece-by-piece. It’s also important to note that tax classification has nothing to do with the way a worker is referred to by the employer. An individual could have a title of “agent” or “consultant” but still be classified as an employee by law.

The reasonable basis test

Even if a worker meets the criteria of an employee under the common law test, they may still be considered an independent contractor. That means the worker is exempt from federal withholding if the employer has a “reasonable basis” to do so. Here’s what qualifies as a reasonable basis to not withhold federal withholding from a worker’s paycheck:

• A past IRS audit of the employer that did not result in a penalty attributable to the employer’s treatment of a worker as an independent contractor.
• A long withstanding, consistent practice in a significant segment of the employers’ industry of treating workers in similar situations as independent contractors.
• Advice from the employer’s business lawyer or accountant familiar with the business or similar reasonable advice.

Never assume you have a reasonable basis to be exempt from federal withholding without consulting a tax compliance expert. If you’re unsure, seek out additional information with the IRS, DOL, or payroll compliance partner.

Becoming familiar with the common law and reasonable basis test criteria can help determine if a new hire is an employee or independent contractor. The more familiar you are, the better you can steer clear of misclassifying workers and the financial and legal repercussions of doing so.