Employee vs. Contractor: What Indiana Business Owners Need to Know

You hire a trainer for your fitness center. They run sessions a few days a week, and you pay them per class. Everything seems to run smoothly. 

Then tax time arrives, and you learn the IRS disagrees with how you paid them. 

Instead of treating them as a contractor, the IRS says they should have been on the payroll. Suddenly, what felt like a simple arrangement now carries the weight of back taxes, penalties, and the threat of an audit.

For many small business owners, misclassifying workers is a silent risk hiding in plain sight. It doesn’t get your attention until there’s a problem—usually in the form of back taxes, penalties, or an audit. And the rules aren’t always as clear as you’d like them to be.

That’s why it’s so important to understand the difference between employees and contractors. Below, we’ll walk you through the key differences, explain how misclassification can hurt your business, and help you avoid common mistakes that cost small business owners time, money, and peace of mind.

What’s the Difference Between an Employee and a Contractor?

At first glance, the difference might look like paperwork. Employees complete a W-4 form and receive a W-2. Contractors send invoices and receive a 1099.

But the real difference is about control.

• Employees work under your control. You decide when they work, how they do the job, what tools they use, and how much they earn.
• Contractors operate independently. They often set their own schedules, use their own equipment, and determine how to complete the work.

To help businesses determine the correct classification, the IRS applies a three-part test based on control and the nature of the relationship between the parties.

1. Behavioral Control

Ask yourself: Do you direct how the worker does the job? Do you provide training, instructions, or detailed procedures? If you’re managing the day-to-day work, this likely points to an employee relationship.

2. Financial Control

Do you set the rate of pay, cover expenses, or supply equipment and tools? Are you the only client they work for? These signs also suggest employee status rather than contractor.

3. Type of Relationship

Look at the overall relationship. Are benefits offered? Is the arrangement indefinite or long-term? Does the worker perform tasks that are central to your business? These are all hallmarks of an employee, not a contractor.

Real-life example: A full-time bookkeeper working in your office and following your procedures is clearly an employee. A freelance web developer who creates your website on a one-time basis using their own tools, timeline, and methods? That’s most likely a contractor.

Why Misclassifying Workers Is a Big Deal

Some business owners assume they can simply choose whichever classification they prefer, but the consequences of making the wrong choice are real and can be expensive quickly.

That assumption can lead to major problems.

Here’s What’s at Stake:

• Back taxes: The IRS can hold you responsible for paying the employer’s share of Social Security and Medicare taxes.
• Penalties: The IRS can impose fines for failure to withhold and pay proper taxes.
• Legal exposure: Misclassified workers may be entitled to unpaid overtime, benefits, or reimbursement for expenses.
• Workers’ comp issues: If a contractor gets injured on the job, and they were actually acting as an employee, your business might be liable.

In some cases, the IRS will examine time records, payment methods, job descriptions, and communications. If the IRS believes you misclassified a worker, it can reclassify the person and assess taxes and penalties for multiple years.

Employees vs. Contractors: Pros and Cons

When hiring someone, small business owners often ask: Which one should I choose—employee or contractor? That’s the wrong question. The law determines the correct classification, not your preference. However, understanding the pros and cons of each can help you make more informed staffing decisions within those guidelines.

Let’s look at the differences side-by-side:

When a Contractor Might Make Sense:

There are times when hiring a contractor is the right fit. If you need short-term help on a specific project, if the work doesn’t require your direction, or if the worker has their own tools, equipment, and schedule, a contractor can offer flexibility and savings.

Examples:

• A photographer for your website refresh
• A freelance copywriter for marketing materials
• A one-time IT consultant setting up your office network

When Hiring an Employee is the Better Choice:

If the person works regular hours, uses your tools, and performs tasks that are essential to your business, especially on an ongoing basis, they’re probably an employee. This includes team members in customer-facing roles, administrative support, or anyone whose performance and schedule you manage directly.

IRS and DOL Red Flags to Watch For

The IRS and Department of Labor have seen all the tricks, and they’re quick to notice patterns that suggest misclassification. 

Here are some red flags that may trigger closer scrutiny:

• Paying someone hourly, but treating them as a contractor
• Classifying someone as a contractor, even though they only work for you
• Telling them when and how to work, but not treating them as an employee
• Giving them company tools, equipment, uniforms, or materials
• Sending both a W-2 and a 1099 to the same person in the same year

Auditors often trigger an investigation when a business reclassifies a worker mid-year—for example, shifting someone from employee to contractor status or vice versa. That’s a red flag, especially if no significant change occurred in their job duties or relationship with the company.

Common Misconceptions That Can Lead to Trouble

Misclassifying someone is often the result of a misunderstanding, not malicious intent. But good intentions won’t protect you if the IRS decides you got it wrong.

Here are a few myths that trip up business owners:

• “They asked to be a contractor.” The law doesn’t change based on what the worker wants. The facts of the job determine the classification.
• “They work part-time, so they must be a contractor.” Part-time workers are still considered employees when the employer manages their hours.
• “I gave them a 1099, so we’re fine.” Filing a 1099 does not necessarily make the classification correct. It only signals to the IRS that you think it’s a contractor relationship, and if that’s wrong, they’ll want to know why.
• “They have an LLC, so they’re automatically a contractor.” Business structure isn’t a get-out-of-jail-free card. If you control the person’s work, you must treat them as an employee.

What to Do If You’re Not Sure

If you're unsure how to classify someone—or you suspect you may have gotten it wrong—it’s best to take action now, before the IRS does it for you.

Here’s how to move forward:

1. Review the IRS Guidelines

The IRS offers a helpful checklist and detailed explanations to guide your decision. The IRS bases its classification on the three-part test: behavioral control, financial control, and the nature of the relationship.

2. Seek Professional Help

An accounting or payroll expert can walk through your specific situation, ask the right questions, and offer advice based on real business scenarios.

3. Consider Filing IRS Form SS-8

The Form SS-8 allows you to request a formal worker classification determination from the IRS. Keep in mind: once they decide, it’s binding. Use this only if you want certainty and are prepared to accept their ruling.

4. Keep Your Records

Document everything. Contracts, job descriptions, pay records, and communication logs. These help support your decision if questioned later.

5. Avoid Dual Reporting

If you need to reclassify someone, do it cleanly. Avoid sending both a W-2 and a 1099 for the same worker in one tax year. That’s one of the clearest signals to the IRS that something’s not right.

Business Owners Can Avoid These Mistakes

Many small businesses operate in industries where classification gets tricky. For example:

• Fitness centers that pay instructors by the session
• Restaurants that bring in part-time or seasonal help
• Dental offices that hire contract dentists or hygienists
• Sales teams, especially those with remote or commission-only roles

In these scenarios, business owners often fall into the trap of choosing what’s convenient instead of what’s compliant. They may agree to treat someone as a contractor simply because the worker asks for it. But doing so can backfire.

When in doubt, it’s almost always safer to classify someone as an employee. Yes, it might cost more in the short term, but it provides long-term protection and peace of mind.

Confident Hiring Starts With Clear Classification

Hiring help should make your life easier, not expose you to penalties, paperwork, or unexpected issues with the IRS. But when you’re not clear on the rules, even a small misstep can lead to big consequences.

The classification decision should never be a guess or a shortcut. Make an informed, well-documented decision by defining how the worker performs the job, who controls the work, and how the role aligns with your business.

That’s where we can assist you.

We help business owners get this right. From payroll support to accurate worker classification and compliance reviews, our team helps small business owners stay in control, avoid IRS trouble, and hire with confidence. Whether you’re onboarding your first contractor or managing a growing staff, we can help you make smart, clear decisions that keep your business protected.

Book a call with us today to see how we can help your small business.