She has sales, a firm ... but workers?

In this fertile valley township in central Vermont, Bonny Dutton's modest house and red barn occupy a plot beside a trout stream, with Bloodroot Mountain looming to the north.

Ms. Dutton, a single mother of one, says she knows what she has. Besides access to organic food and one of the state's best public schools, there's her commute: a short walk past the swing set to Fleece on Earth, the apparel firm she launched in 1993 and moved to her barn in 1999 after closing two shops.

What's not so clear is whether she has what the state of Vermont says she has: employees. She insists that her Vermont knitters - retirees who supply piecework from their own homes using her patterns - are independent entrepreneurs like herself.

The dispute, which has landed in court, highlights a much broader dilemma for a nation intent on nurturing entrepreneurs but also straining for tax revenue. Should lawmakers rewrite decades-old business regulations to accommodate the rise of independent business people who have no paid employees and now represent the fastest-growing type of business? Or should they crack down on such firms, potentially a lucrative source of tax revenue?

The decision has important ramifications, as some tiny firms consider shifting contract work offshore to avoid some of the rules they see as most vexing.

At the very least, many observers say, those rules should be simplified for independent entrepreneurs.

Often "they are managing every aspect of their business on their own," says Kristie Darien, executive director of the legislative office of the National Association for the Self-Employed (NASE). "They're the CEO, the CFO, the COO, the janitor, and the tax attorney. Because of the complexity of regulations, and the fact that they're not in plain English, they have difficulty figuring out what applies to them - not only on a federal level but also on state and local levels."

Ms. Darien - who points to home-office rules and zoning as two other areas of confusion - calls the independent-contractor classification issue a perfect example of a vague and highly subjective area of law. "If you call the IRS help line, you'll get different answers," she says. "It's a 20-point test, extremely complicated."

This month, NASE announced a new push for the passage of H.R. 230, the National Small Business Regulatory Assistance Act of 2005, which would direct the administrator of the Small Business Administration (SBA) to establish a program to provide "compliance assistance."

Other groups have similar aims.

"Regulations are not getting any simpler," says Beth Gaudio, an attorney with the Legal Foundation of the National Federation of Independent Businesses (NFIB). In March, Ms. Gaudio began a new program, traveling the United States to offer legal seminars through the NFIB's Area Action Councils.

"It's a '10 ways to stay out of court' kind of thing," she says, adding that small-business owners she has encountered have worked to comply with the laws.

Many small entrepreneurs are leery of dealing with such issues.

"They don't feel very comfortable going to the IRS or the EPA or OSHA, or whatever agency and asking 'Am I doing this right?' because it puts them in ... a position to be penalized," says Darien.

But some agencies have been reaching out.

"OSHA and EPA over the past 10 years have said, 'Wait, let's quit catching people doing something wrong. Let's start giving a little amnesty and showing them how to do it right,' " says Jim Blasingame, host of the syndicated radio/Internet talk show "The Small Business Advocate." The Internal Revenue Service and state agencies, he says, should follow suit.

In fact, the IRS did issue a draft of a compliance guide in the late 1990s, says James Morrison, who heads the exporters' affiliate of the National Small Business Association (NSBA). "I give the IRS a lot of credit for this: They sent it around to a lot of [small-business] associations before they issued it and said, 'How does this look to you?' " says Mr. Morrison. Charged with inconsistencies on the issue of independent contractors, he says, the agency rewrote it.

For the IRS, however, small business is a tempting target. Lately, for example, it has mulled over a withholding tax for independent contractors. The number of firms with no paid employees rose 3.3 million between 1992 and 2002, outpacing firms in all other size categories, according to the Small Business Administration.

Dutton thought she was an independent entrepreneur - until the state in 2003 demanded about $1,000 in unpaid unemployment insurance and penalties. The claim was made because one of her knitters, Ruthie Nichols, filed for unemployment after losing an unrelated job - and the state set out to determine what Ms. Nichols was owed, and by whom.

That drew attention to Nichols's regular work for Dutton, who calls the ongoing case a "witch hunt." She had another hearing last week and vows to take it all the way to the state Supreme Court.

"These people clearly aren't my employees," Dutton says of the knitters, who are issued 1099 forms so they can handle their own taxes. "Most of them have never even been to my studio."

The state - while declining to discuss Dutton's case - characterizes its approach to such cases as one of textbook enforcement. Worker misclassification, says a spokesman, commonly arises when a filing sends up a red flag, or after one of the state's 2,000 or so annual workplace audits unearths concerns.

"There's a perception issue," says David Tucker, director of unemployment insurance and wages at Vermont's labor department. "People sometimes think that if they just call [a work arrangement] a certain thing, then that's what it becomes."

But there are vast gray areas, Morrison says, in which officials try to determine the degree to which the individual doling out the money controls the worker. "There is a huge area of interpretation," he says, "and it's arguable that that's really not the most important factor to focus on at all.

"If you have somebody come out and pour a new driveway for you, is that person your employee? Well, that person probably thinks not, and you probably think not, but there have been cases in California that are very similar to that where the state tried to argue" that such an individual was an employee.

Mr. Tucker says that the laws aim to deter exploitation. "The policy question is whether or not individuals who for whatever reason work out of their home are in any way less entitled to unemployment-insurance coverage under the law, and the answer to that question has been no."

But he concedes there is room for confusion. In Vermont, says Tucker, a test takes into account factors including control, where the work is performed, and whether the worker could subsist independent of the work relationship. But the state also weighs "the reality of the relationship," he says. "You can have somebody that's not an employee for federal income-tax purposes [who is] an employee for unemployment purposes - but not an employee for workers comp. That happens all the time."

If that happens to Bonny Dutton, some of her goods could lose their "made in Vermont" cachet, and some local workers could lose their supplemental income.

At a recent craft fair, Dutton met a big-volume seller whose goods were made abroad. For that seller, unemployment and workers compensation are nonissues.

"She even said that, if I ever wanted to, she could be a liaison for me to have part of my line produced in Indonesia or elsewhere," Dutton adds. "Sometimes I am tempted to take the business in a whole different direction."