Independent Contractors
Independent contractors are individuals or entities that provide services to a company in which the company has control over or is guided by a contractual agreement. An independent contractor can often be a sole proprietorship where the company hires individuals rather than dividing up their services into a large employee staff. While independent contractors may work on-site or remotely, they typically have more flexibility and autonomy than employees do . Individuals and entities may act as an independent contractor, and they are expected to pay their own taxes for the income received from their clients. Independent contractors are often provided with a 1099 tax form at the end of each year.
Independent contractors may be paid by job or by project rather than by the hour and they often work in a variety of industries. Some common examples include: computer programming, janitorial services, construction, tutoring and entertainment.
What is a Subcontractor?
A subcontractor is a party retained to perform part or all of an obligation under a primary or underlying contract. Subcontractors always work in the context of a separate, primary agreement and are hired by a party to act on behalf of the original contractor. Subcontractors are typically thought of as parties that work with general contractors in the construction context. By retaining a subcontractor, the general contractor—a subcontractor of the owner—turns over a portion of its contractual responsibility to its subcontractor or sub-subcontractor. Common examples of subcontractors and sub-subcontractors in the construction trades include carpenters, roofers, electricians, concrete suppliers, plumbers and drywall contractors.
Subcontractors can also be found outside the construction industry. Software companies, for example, may use subcontractors to provide programming work or to provide the software according to specifications provided by the larger company. A consultant or an advertising firm may hire a subcontractor to perform a certain service, such as market analysis or media buying.
Whatever their industry, a subcontractor generally is a separate entity from the party who engaged it, but its obligations are and remain ultimately owed to the original contractor with whom the subcontractor had no direct contact.
The Role and Responsibility: Comparing the Two
Often the most significant distinctions between independent contractors and subcontractors can be found in the details of their agreements and the manner in which they function in a specific project. Much like a subcontractor may be subject to the terms of a prime contract, an independent contractor’s rights and obligations may be subject to a master services agreement. Oftentimes, the terms of the contract play a substantial part in defining the roles of each party in a construction project.
Usually, an independent contractor holds the contractual relationship with the end user of the completed project. For example, the owner of a home may contract with a general contractor to have a home built. The general contractor may then utilize different subcontractors to perform certain aspects of the job. The relationship between the owner and the contractor is governed by the general contract, in which the specific rights and obligations of the parties are defined.
Conversely, the relationship between the general contractor and a subcontractor is generally governed by a prime contract, or sub-contract. The sub-contract will typically outline the scope of work the subcontractor is required to deliver. For example, in a situation where the general contractor builds the shell of a home, and then sells the home "as is," all additional work performed to finish out the home will depend on the sub-contract between the general contractor and the applicable subcontractor.
The main difference between the two roles is that a subcontractor is not ultimately liable for payment or breach of contract with respect to the prime contract; whereas an independent contractor has an obligation to the contract with the other party.
Legal and Tax Considerations
The IRS takes the classification of workers seriously. In fact, a business is expected to treat subcontractors and independent contractors the same in relation to tax reporting, which is to say: 1099 it should form be used to report compensation paid for services. 1099 forms are used to report independent contractor income, payments to vendors, and payments to subcontractors. While an independent contractor may be performing work on your own or your company’s behalf, payment for that work is still considered a reportable expense for tax purposes. Additionally, the worker who performs services for a business does not have to be a citizen or resident of the U.S. The IRS states in Publication 15A that "To be a worker, both you and the worker must intend that the worker will be your employee. You must have the ability to direct and control how, when, and where the worker performs the job."
Just as the purposes of hiring subcontractors and independent contractors are similar, so too are the legal considerations and ramifications of not following proper guidelines. If a business misclassifies a worker, even unknowingly, it may still owe back payroll taxes or other withholding taxes. For example, if a business treats a worker as a contractor and fails to withhold taxes, then the liability for those taxes still falls to the business. Whether the business could pursue the worker for the unpaid taxes is another question. In any case, the business will have to bear the burden of the tax liabilities.
Making a Contract: What to Look Out For
When you’re hiring for your business, contracts are one of the areas to pay attention to as you determine if the person or entity you want to hire as an independent contractor is truly in a state that meets that standard versus whether they are merely a subcontractor.
Below are a few things to keep in mind when it comes to contractual agreements for independent contractors and subcontractors:
Terms of Engagement
We all need to know where we stand, so there will be terms specified for the position that will state how long the person is expected to be with you (although this can be a little bit more squishy for an independent contractor – definitely want to have more defined terms for subcontractors). For an independent contractor, you might have a "not to exceed" timeframe for the work to be done, whereas for a subcontractor, you might have an expiration date by which the work should be completed .
Payment Terms and Provisions
Independent contractors should have terms around how they will bill your business and how you intend to pay them and on what schedule. You can have terms as specific as net-30, or even net-60 if you need a little longer to process payments. Subcontractors are generally paid at the end of the project or upon completion of certain phases of the project.
Project Deliverables
What is your independent contractor supposed to deliver and when? Are they going to be providing reports, databases, products, etc. on a regular basis? What happens if the project changes and they are asked to alter their original deliverables? With subcontractors (those who are contracted to complete the work necessary to fulfill a larger project), the deliverables will typically be governed by the contract(s) in place between the general contractor and their client(s).
The Decision: Independent Contractor or Subcontractor?
When it comes to choosing between an independent contractor and a subcontractor, factors such as the needs of the project, budget, and level of oversight all come into play. An independent contractor may be the best choice for your project if it is highly specialized. If your project requires a trade that isn’t offered by most contractors or if it’s particularly technical in nature, then a skilled independent contractor may be a better fit. Although a one-man operation may initially seem like more of a risk than a larger company, you may be saving in the long run by not investing in a large team with higher overhead costs.
Although an independent contractor might be more affordable for a small, one-off job, a subcontractor will likely be a better choice for larger or more complex projects. For example, a subcontractor who specializes in kitchen remodeling may invite several tradespeople, such as plumbers, painters, and electricians to work alongside his crew at different stages of the job. If you’re planning a kitchen remodel, it’s certainly more convenient to source these different tradespeople from the same company than trying to manage a team of several independent contractors, or attempting to do it all yourself.
Keep in mind your own level of experience as well. If you’re an expert in home improvement, then you probably don’t need or want as much oversight as a less experienced homeowner might. On the other hand, there are also certain aspects of your project which would benefit from firm oversight, whether you hire a subcontractor or an independent contractor.
Finally, consider your budget. You’ll likely pay less per hour for an independent contractor than you would for a subcontractor, but remember that your workers are only part of the expenses. If you’re planning a large renovation which will require many different tradespeople, you could benefit from selecting a subcontractor who can supply the entire crew.
Common Misconceptions
Despite the simple definitions, a number of misconceptions about their use persist in the industry. So let’s take a moment to consider the reality of the use of these terms by small contractors.
Myth 1: Independent contractors are subcontractors and vice versa
The easiest explanation for this one is that they are both individuals. Beyond that, independent contractors provide services directly to the client while subcontractors provide services to a contractor, usually as part of a larger project. They are both responsible for their own taxes, insurance, retirement plans and other employee benefits.
Myth 2: Independent contractors are less expensive than subcontractors
The cost to the client is whatever the contractor charges. All of the same issues that are faced when hiring employees are also faced when hiring subcontractors or independent contractors. An independent contractor has their own equipment, they may have their own insurance, they may not have their own retirement plan, etc. No matter who you are hiring it is important to do full due diligence on that individual to confirm they are qualified and that you are charging a competitive rate.
Myth 3: Independent contractors can turn down jobs from clients if they don’t want to work with them
This seems like it should not be a misconception, but some may treat independent contractors like their employees. Unless otherwise stated in the contract, an independent contractor can refuse any job she doesn’t want to do (assuming the reason is non-discriminatory, otherwise there could be some liability). However, if the subcontractor does the same thing, it can be considered a breach of contract and could potentially lead to litigation if the client decides to pursue enforcement of the contract.
Not all subcontractors are independent contractors but all independent contractors are subcontractors. The important thing to remember when using either is that you must follow the law.
Practical Example
Company A requires a software upgrade for its existing systems. It contacts Company B, a software solutions company, to develop the upgrade.
Company B does not have a programmer available to work on the project at this time. However, it does know of Company C who has the skills to make the upgrade. Company C made these same upgrades for Company B in the past, and Company B knows and trusts Company C to make the necessary changes.
Company B contracts with Company C to perform the necessary work on an hourly rate basis. At no time does Company C make any representations to Company B or Company A that it is anything but a one-woman operation.
Once the upgrade is complete, it is tested by Company C. Company B did not participate in the testing of the code, and had no role in how the code was written .
Company B submitted the bill to Company A. Company B used its own invoice, but submitted the bill as though Company C was one of its employees.
Company C is an independent contractor of Company B. Company B is not also a contractor of Company C. Company C is a savvy business person who knows it cannot be classified as an employee of Company B; otherwise the IRS will make her pay all applicable taxes. Because Company C is really acting as an employee of Company B, it could have chosen to only bill Company B, and could have passed the expenses along to Company A.
Company A is not bound to Company C’s contract with Company B. Company C performed work for Company B, and Company A contracted with Company B, not Company C. If Company A had a problem with the software, it is under no obligation to go to Company C to resolve it.