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: