Subcontractor or Employee?

Learning the rules about worker classification and managing the details correctly is a hassle, but the risks of doing it wrong are major. September 24, 2009

Young gun here - have never dealt with these issues. I am currently waiting on my insurance guy to give me a price on business insurance. He forgot about me last time I asked. Until then I need some other advice.

I work alone in my shop but want some help on an as-needed basis. I have a few people in mind that will work on these terms but I have no idea how to set this up. Do I need to provide workers comp to them, or do I hire them as a subcontractor... if that's possible? I will only need help maybe one week a month or two, not guaranteed either. I read on the IRS site that they have strict guidelines on subcontractors vs. employees. Greek to me. If they are a subcontractor, do they need to create their own sole proprietorship and get a tax number, etc?

So if they are deemed a subcontractor, I doubt they will want to provide their own insurance. I don't think they will feel obligated. At the same time, I don't feel I should have to pay insurance on someone when they may only work once in a while. They would only work when I get work, and that is never guaranteed.

If I hire them as an employee, then I would have to learn how to do payroll and all the tax implications and witholdings. Where I'm coming from is that I have to pay insurance on myself to go make money. Why shouldn't somebody else pay for an opportunity just like I do? Or is this just another learning experience of how business works?

Forum Responses
(Business and Management Forum)
From contributor T:
The short answer is, on an as-needed basis/casual labor, you can set it up as a subcontractor, 1099. IRS guidelines are very specific and will tell you just about anything you need to know. You will need to have your chosen one sign a 1099 form/contract that makes them responsible for their own taxes. Any total payments of more than $600.00 per calendar year requires you to 1099 them at the end of the year. It helps if they have other work. There are very specific rules requiring who is and is not a subcontractor. The IRS is very hip to the tricks. The basic being, you do not tell them to clock in every day at a specific time, etc., but this does not prevent you from having an agreed upon contract as to how and when a project will be produced. Insurance should be acquired by the contractor, but the cost is minimal, although you will want to have an umbrella policy also.

The easiest thing to do is find yourself a CPA/tax attorney and have them set the basics up for you. They get a high hourly rate, but a good one is very fast and efficient and will cover all the requirements for you. Once you know the rules you will be able to set it up yourself with any future subs.

Adhere to the guidelines or you could be responsible for all back taxes and penalties if you get caught cheating. It sounds as if a sub is what you need at this stage of the game. Play the cards right and you will be safe.

From contributor J:

"Or is this just another learning experience of how business works?"

As for insurance questions, ask your agents, not strangers on an internet forum. If you don't already know how or don't want to learn how to operate a business, then why are you in business? If you want to build cabinets, get a job building cabinets. Are you not reporting your SE income and paying taxes?

From contributor R:
"Where I'm coming from is that I have to pay insurance on myself to go make money. Why shouldn't somebody else pay for an opportunity just like I do?"

Because they aren't running a business! If you are going to have a business, take some business classes at a community college or online. The school of hard knocks is the most expensive you will attend.

From contributor S:
I have one sub that stays very busy with me. I got an audit from my insurance provider and because he didn't carry his own insurance, I was billed as if he were an employee. $1,200 that I didn't plan on dropping. I argued that he wasn't an employee, but in their eyes they still covered his actions under my direction.

The same goes for any sub - electrician, plumber, whatever. I got mad and switched to another company, same policy. The only difference is that they bill me for coverage of one part time employee regardless of what I say. I don't think an employee is what your situation requires, but I would ask an accountant.

From contributor G:
If you are real careful and know all the tricks and pitfalls you may be able to qualify them as subcontractors. My bet is that you have a 99% chance of committing an error that will result in them being employees, even with some help from an attorney and an accountant. (If the attorney and accountant were there every day guiding your hand, your chances are improved, but you cannot afford that and will likely make some error in following their instructions.) That is not meant to be insulting. If you are asking a web group how to do basic business things then you have not acquired enough experience and know how to do the subcontractor thing with any chance of not messing up. If you mess it up you have many state and federal tax problems and you expose yourself to virtually unlimited claims by anyone injured working for you.

About the only way you could manage it is to hire your help by the day or hour through a temp service, which covers their employees' workman comp and taxes. You hire the temp agency so the people they send over are their employees, not yours. (Don't get cute about this and set up a phony temp agency - if the temp agency doesn't do the insuring and taxes, the fault can fall back on you.)

Go to night school, learn everything you need to know, buy the workman's comp. Either do the employee books or hire an accounting service.

From contributor J:
"The same goes for any sub - electrician, plumber, whatever." No, it doesn't. You are confused about this, but your insurer isn't. In the context of this discussion, a subcontractor and an independent contractor are not the same.

"I was billed as if he were an employee." That's because he was.

From contributor E:
Use a temp service while you are learning. Costs more per hour. You only write one check. They pay workers comp and taxes. Service takes care of everything. I have two part timers for installs. I run both through a service. It makes life so much easier. If you go the subcontractor route, be careful. Make sure you document how they work independently from you.

From the original questioner:
"If you don't already know how or don't want to learn how to operate a business, then why are you in business?"

What gave that impression? Actually, I love to learn. I've learned lots of things from many of you. This is just another bump in the road for me that I will climb over. Thank you all for your advice. I will seek help through an accountant and hopefully the insurance man will get back to me this time. I've already got a few guys in mind so temp agencies are out, but would be a great alternative in case these guys don't work out.

Yes, the sub route sounds like it would work out great. At least that's the way I would like it. The extent of the legality in all this sounds best to leave to a pro. If the pro cautions me or tells me it's too complicated for my situation, I'll likely just hire as an employee. I bet an accountant would teach me how to do payroll and tax forms.

From contributor L:
You can use a temp agency to employ people, but you don't have to use people the temp agency sends out - you can send your people down to the temp agency. They sign up with the temp agency. You tell the agency how much to pay them, etc. In a couple of hours they're back in your shop working under your direction all covered with W/C insurance, taxes, etc.

Technically your people work for the temp agency. You pay the agency, the agency pays your people. You're covered. They're covered. All is right with the world.

None of this comes cheap. This method of hiring may seem expensive at first, until you compare how your family would be impacted if someone in your employ was injured in your shop. In the end you have to figure this labor cost, whatever it is, into your bid. Keep at it. You're doing well to ask these questions. You'd never know it by some of the comments, but everyone starts out as a young gun.

From contributor G:
I am unable to see how, reading all the advice given, you managed to conclude:
"Yes, the sub route sounds like it would work out great."

From contributor A:
If you don't use an agency, if they work in your shop with your tools, they are an employee in this state (CA). Pay the insurance and sleep at night. Remember, even the "occasional labor" can file claims long after they leave your supervision.

From the original questioner:
I believe what I meant to say was that if everything was set up properly through the accountant/attorneys, etc, then it sounds like it would work how I wanted it to originally. But like you and others say, it can be dangerous and there are certainly pitfalls that I or anybody would likely get caught up in. Thanks for the caution.

Contributor L, thank you for explaining that. I didn't know it could work like that. I will keep that option open and do some more research with the right people.

From contributor G:
Even with a good attorney and accountant the independent contractor gambit is too risky for you. I have practiced law in the State of Indiana and in the federal courts, before I turned to woodworking. I still have clients I advise on business matters. What you want to do is very tricky and the stakes are not high, they are unlimited.

Suppose you talk to your attorney and accountant and get a grasp on it. Now your friend, the independent contractor, has his truck stolen and loses all his tools. You're a good guy, so you give him what he needs until he can get his own... Bam! If in California, you just lost an independent contractor, and got an employee. In Indiana the test involves balancing up to perhaps 25 different factors or more. (You don't balance them, nor your attorney - the judge and jury decides the outcome.) The problem is the outcome. If your friend is hurt and the court/jury decide that he was an employee, then you may be sued for an unlimited amount of money. If the jury rules the accident (or your failure to insure) was intentional or willful harm, then even bankruptcy may not make that judgment amount go away. However, if you carry workman's comp, the injured employee (everywhere I know about) is limited to collecting from the workman's comp insurance and you are off the hook. Again in the words of contributor S, "Pay the insurance and sleep at night."

You have the same sort of problem with state and local taxes. Big trouble if they rule your friend is an employee and not an independent contractor. Working your way through a system of setting up your employees (for that is obviously what they are) as "independent contractors" is a bit like walking through a mine field. Lots of ways to go wrong, the risks are hard to see, and the consequences are nasty. It is a game for the experienced, if at all.

If you really don't want to go the route of worker's comp and withholding, etc., then contributor L has it nailed. Call a temp agency and have them hire your friends and rent them to you by the hour/week/month. He explained the rest.

It is really hard to run a business where what you want to do is woodworking, without a big chunk of your time getting eaten up with the paperwork. Most small business owners sooner or later end up not being able to do what the business does, but just managing the administration and paperwork.

From the original questioner:
Thanks for taking the time giving that example. I would definitely like to keep things simpler and did not realize what this could lead to. Now that I've basically got two options for my situation, I can carefully weigh the advantages and disadvantages of each one. I actually wouldn't mind at all learning how to set up payroll through an accountant. Even if I never used it, I would have knowledge of it at the least. It is quite a pet peeve of mine when I want to do something but have no idea how. This happens often it seems. I'm sure many can relate. I will also have a talk with the temp agencies and find out the costs and details to add into my results.

From contributor Y:
I do a lot of SCORE counseling and this question comes up quite frequently - i.e. whether or not to hire subs on a 1099. Here is the upside - you'll save about 10% of salary costs based on not paying FICA, Medicare, and Unemployment Insurance (depending on where you live).

Here is the downside - you may get into trouble. First, you must satisfy the IRS and State conditions for classifying a sub as an independent contractor and getting at cross purposes with government taxing entities is like wrestling with a bear - big, stupid, strong, and determined to kill you - not to mention requiring endless fishing for old records. Second, in many states if your sub doesn't have workman's comp insurance and is injured, the bill reverts to you. Moreover, the nicest sub in the world can become a mean one if the bill is big and the money isn't there. Third, if the sub is employed a lot, i.e. you get a lot of business, the sub may feel wronged when business slows and they get to thinking about unemployment benefits.

Workman's comp protects you. Unemployment protects you. And scrupulously paying your taxes, both for you and your employee, on time, separates the men from the boys.

There are some businesses where 1099s are natural - I have a SCORE client who hires models for auto shows and the like, so for her, hiring is a matter of staffing a single run. But I think that most woodworking companies probably ought to operate using employees. The paperwork is not particularly formidable and in a few months you'll get used to it. Calculating taxes takes very little time after the initial learning curve. Using the tax tables for spot labor is easy. And as far as workman's comp premiums are concerned - that's just a fact of being in business - cheap when the time comes to pay the bill.

What I too often see is people using 1099s when they know perfectly well that they aren't really in the right mode. The savings are minimal, the risks are formidable, and the anxiety isn't worth it.

From the original questioner:

Very good info - thank you. The difference of 10% or so is nothing. The part about the sub not keeping insurance on himself, yeah, I can see that happening. You never know.

From contributor Q:
If you want to join the many other cabinet shops and installers that hire subcontractors and 1099 them, then never complain when you are bidding jobs less than cost like the next guy operating this way, never be surprised when this person gets injured and sues you, your company and the homeowner or GC, never complain when he files for unemployment benefits and lets them know that he worked for you.

You have a choice - conduct business professionally and build yourself a reputable company while minimizing your risk and the risk of the customer, or join the many that are driving this industry in the ground.