Employee or Subcontractor?

Every contractor understands the advantage of getting work done with subs rather than employees. Employees come with headaches like payroll taxes (F.I.C.A., F.U.T.A., S.U.I), employee insurance, fringe benefits and overtime. Collectively, those add about one-third to labor cost. With subcontractors, you simply write a check payable to the sub. No withholding tax. No fringe benefits. No overtime.

So why would any contractor have employees?

The simple answer is that many don’t. That’s known as paper contracting. For details, see my blog post.

But there’s another reason, usually referred to as employee classification. States and the I.R.S. have rules about who qualifies as a sub (an independent contractor) and who has to be paid as an employee.

What makes a sub?

Simply labeling someone a subcontractor doesn’t work. In fact, no single test settles the matter. States and the I.R.S. apply their own rules. But all would agree that most employees:

• Work under employer control and can be laid off.
• Comply with work hours and the sequence of work set by the employer.
• Can’t substitute someone else to do the work.
• Are paid by the hour, week or month rather than by the job.
• Use the employer’s tools and get reimbursed for expenses.

Subcontractors are in business for themselves. They:

• Promote their services and have a business address.
• Usually work under contract for several prime contractors.
• Work for a contract price and cover their own job expenses.
• Have to redo unsatisfactory work at their own expense.
• Stand to make a profit or suffer a loss on the job.

What’s the risk of misclassification?
Make a mistake about who’s a sub and who isn’t and you could get hit from two directions. The employee could file I.R.S. Form 8919 to collect unpaid Social Security and Medicare Tax on wages. Then your state and the I.R.S. could claim a tax lien for failure to withhold. The I.R.S. can be a pit bull when collecting delinquent payroll tax – including seizure of personal assets.

If you’re concerned that subs on your jobs could be classified as employees, here’s a case in point.

Bernie Kurio had worked for several years as a Houston drywall contractor before he got caught up in an I.R.S. sweep. An audit of Bernie’s books resulted in an assessment of $89,063 for failure to withhold payroll taxes. Bernie’s protest of the assessment was denied by the I.R.S. regional commissioner. But that wasn’t where it ended.

Bernie appealed to U.S. District court. Surprise! He won. The tax lien was discharged. The court’s decision makes good reading for every contractor concerned about employee classification. Here are the facts that won the case.

When Bernie landed a drywall job, he called several hanger team leaders. The team with the best price per square foot got the work. Hangers, tapers, floaters, sanders and truckers used their own tools and equipment. Bernie controlled only the result, not the hours or who did the work. Drywall crews understood they were independent contractors and – here’s the key point – most reported earnings on their Schedule C.

Bernie’s case, Kurio v. United States, dates from 1970 and has been followed ever since. Stay within the facts of the Kurio decision and you should have no trouble with either state or federal authorities.

Use written subcontracts to end any debate about employee classification:

• Payment will be by the job.
• You control only the finished product.
• Subs are responsible for their own taxes.

Construction Contract Writer makes that easy. The trial version is free.

Paper Contracting

When you hear the term paper contractor, it’s usually in the context of someone being “only” or “just” a paper contractor. I believe this prejudice against general contractors working as consultants is breaking down. And for good reason.

What was known as paper contracting in the last century has morphed into construction management (CM) contracting in the 21st century. CM contracting is replacing traditional construction contract practice on many types of projects -- from the largest public and private jobs to small home improvement projects. Traditional construction practice (prime contractor and subcontractor) has disadvantages that every traditional prime contractor knows all too well: risk of loss, oppressive state regulation, warranty problems, construction claims and callbacks. Modern construction managers avoid most of these hazards by limiting their responsibility to what they do best -- construction management. CM contracts leave the construction headaches to others -- liens, trade disputes, slow payment, code compliance, inspections and government regulation.

What is a construction manager (a paper contractor)? That’s easy. A construction manager earns a fee as a consultant:
Reviewing the plans and specs.
Preparing bid packages and evaluating bids.
Checking insurance coverage.
Approving the proposed contracts.
Communicating with contractors and suppliers.
Monitoring day-to-day construction.
Keeping the owner informed of progress.
Approving payment requests.
Assisting with change orders.
Protecting the owner from construction claims.
Directing project closeout.

What's NOT included in a construction manager’s portfolio? That’s easy too. The construction manager earns a fee for consulting services -- period. The construction manager neither buys nor installs materials, has no contracts with the trades and pays no bills. The owner signs contracts with trade contractors, pays all the bills and holds installing contractors responsible for their work.

Most of a construction manager’s task will come as second nature to an experienced general contractor. What won’t come easy is the construction management contract itself. CM contracts are very different from traditional prime contracts -- and have to be drawn precisely to avoid problems with property owners, trade contractors, suppliers and state regulators.

The recent case of Thurber Lumber Co. v Marcario underscores my point. Joe Marcario agreed to manage construction of a new home for Don Nenninger in Suffolk County, NY. Marcario ordered materials from Thurber Lumber and recommended trade contractors for the job. Marcario forwarded bills from subs and suppliers to Nenninger and Nenninger paid those bills directly. That worked fine until Nenninger ran into trouble with financing and stopped making payments. Thurber Lumber sued both the contractor (Marcario) and the owner (Nenninger) for $59,391.51. 

The court didn't accept Marcario's claim that he was working as a paper contractor (consultant), not a general contractor. Marcario could have made his CM status clear by giving Thurber a summary of his CM (consulting) contract before placing the first order. A CM contract would have left no doubt that Nenninger alone was liable for materials delivered to the Nenninger job. But Marcario didn’t have a written CM contract. And that was Marcario's $59,391.51 mistake. 

The court found Marcario liable for materials Thurber Lumber delivered to the Nenninger job -- just as if Marcario had been the general contractor, not a consultant.

Moral to the Story
Don’t try CM contracting without a good CM contract. Construction Contract Writer drafts CM contracts legal in any state and for any type of work. The trial version is free. And if you need a good "hands on" guide to CM contracting, have a look at the book Paper Contracting. A PDF download is available for less than $30.