Contractor vs. Employee: What Employers Need to Know, especially in Tennessee

When taking the big step to hire someone new, it’s critical to know whether they should be classified as an independent contractor or an employee. The difference isn’t just semantics — misclassification can trigger audits, fines, back taxes, and legal trouble. 

Let’s break down the differences, the pros and cons of each option, how the law applies at the federal and Tennessee state level, and what happens if you get it wrong — including the impact on workers’ compensation. 

What is the difference between an employee and an independent contractor? 

At the core, the difference between an employee and a contractor lies in control and independence. 

Employees work under your direction, using your tools, during your hours, and typically receive ongoing work. 

Independent contractors operate independently — they control how and when they work, often supply their own tools, may have multiple clients, and invoice you for services rendered. 

What are the pros and cons to hiring an employee versus an independent contractor? 

Hiring an Employee 

Pros: 

• Greater control over work schedule and performance 

• Stronger loyalty and stability 

• Easier to train and integrate into your business 

Cons: 

• Employers must pay payroll taxes (Social Security, Medicare, unemployment) 

• Employers must provide workers’ compensation insurance in TN and most other states 

• More HR responsibilities (W-2s, labor law compliance, benefits if offered) 

Hiring an Independent Contractor 

Pros: 

• No payroll taxes or benefits 

• Flexibility to hire short-term or project-based 

• Lower administrative burden 

Cons: 

• Less control over how work is performed 

• No exclusivity (they may work for competitors) 

• Higher audit risk if the IRS or TN determines they should’ve been employees 

What does the law say about the separation of employees and independent contractors? 

Federal Guidelines (IRS and DOL) 

The IRS uses a three-prong test to assess classification: 

1. Behavioral – Do you control or have the right to control what the worker does and how they do their job? 

2. Financial – Do you control the business aspects of the worker’s job (how they’re paid, reimbursement, tools)? 

3. Relationship – Are there written contracts? Will the relationship continue indefinitely? 

The U.S. Department of Labor (DOL) is increasingly focused on preventing misclassification under the Fair Labor Standards Act (FLSA). 

Tennessee Law 

Tennessee largely follows federal definitions but adds some of its own context. 

Tennessee Workers' Compensation law may use a 20-factor test (based on the IRS model) to determine whether a worker is an employee entitled to workers’ comp coverage. 

The TN Department of Labor and Workforce Development also enforces rules regarding unemployment insurance and classification. 

What do you need to know regarding workers’ compensation considerations? 

 In Tennessee, employees must be covered by workers’ compensation insurance if your business has five or more employees, or just one if you're in construction or coal mining. 

Independent contractors are not automatically covered by workers’ compensation—here’s where it gets tricky: 

Many insurance carriers will include contractors in your workers’ comp premium if the contractor doesn’t have their own workers’ comp coverage — especially in high-risk industries like construction or landscaping. This can surprise employers who thought they were saving money by using 1099 labor. If your insurance audit reveals that a contractor was uninsured or improperly classified, you could be billed retroactively and penalized. 

What are the risks of misclassifying employees and independent contractors: 

There can be costly disadvantages to misclassifying the labor supporting your business. In Tennessee, the Bureau of Workers' Compensation may issue penalties and back premiums. You may also have personal liability for medical costs and wage replacements if an injured worker is not properly classified. Unpaid insurance coverage can result in steep fines. All of these factors also add up to it possibly becoming difficult to obtaining affordable workers' compensation coverage in the future. 

Which businesses are most at risk of being penalized for improperly classifying labor? 

While any business can be audited or flagged for worker misclassification, some industries face higher scrutiny due to their structure or history of misclassification issues. 

High-Risk Industries for Contractor Misclassification: 

1. Construction and Trades 

• Subcontracting is common 

• Many 1099 workers are misclassified despite being treated like employees 

• TN requires workers’ comp for even one employee in construction 

2. Landscaping and Lawn Care 

• Seasonal work and day labor are often treated as contract roles 

• Workers may lack their own insurance or business licenses 

3. Trucking and Delivery Services 

• Owner-operators often blur the line between contractor and employee 

• Use of company-branded equipment or vehicles can signal employment 

4. Cleaning Services 

• Contractors often work regular schedules, wear company uniforms, and use company supplies 

• These are red flags under both IRS and DOL standards 

5. Healthcare (including Home Health Aides) 

• Control over scheduling and how care is delivered may signal employee status 

• Workers in this field are often unaware they are considered contractors 

6. Gig Economy or Tech Startups 

• Many rely on flexible work arrangements, but the legal system hasn’t caught up with this model 

• Recent court cases have forced companies to reclassify large groups of gig workers 

7. Real Estate and Property Management 

• Admin and maintenance staff are sometimes classified as contractors but function like employees 

• Leasing agents and assistants can trigger red flags if misclassified 

Here are the red flags auditors are looking for: 

Federal and Tennessee agencies use data analytics and cross-reporting between departments to identify patterns of misclassification — especially in the industries above. 

Your business may be at higher risk if: 

• You regularly issue Form 1099s to the same individuals over multiple years 

• Contractors work on-site, use your equipment, or follow a set schedule 

• Workers are uninsured and perform manual or hazardous labor 

• You operate in an industry with a history of enforcement actions 

How do employers get flagged for misclassification of labor? 

Even if misclassification was unintentional, the consequences are serious. Here's how employers often get flagged: 

• A contractor files for unemployment 

• A worker gets injured on the job and files for workers’ comp 

• A disgruntled contractor files a complaint with the IRS or Department of Labor 

• A random audit from IRS, DOL, or TN Department of Labor 

• A contractor fails to pay self-employment taxes, triggering an investigation 

How to classify labor correctly to avoid penalties: 

1. Document the relationship with clear, legally sound contracts and invoices from the contractor before making payment.

2. Do not treat contractors like employees — no setting hours, requiring exclusivity, or controlling their methods. 

3. Verify contractor insurance coverage — and get a certificate of insurance if they’re not covered under your policy. 

4. Consult a professional — an employment attorney, CPA, or HR consultant can help avoid mistakes. 

Classifying someone as a contractor might seem like a cost-saving move, but if they function as an employee, the legal and financial risks are significant.  

Tennessee, along with other states and federal agencies, is actively pursuing misclassification cases. 

When in doubt, err on the side of caution — or get expert help. Taking the time to get it right can save you thousands in penalties and protect your business from major liability. 

Need help reviewing your worker classifications or insurance exposure? Our firm assists  small businesses with compliance and bookkeeping to avoid costly surprises. Reach out to us.