As kids, we were told ghost stories about haunted houses where they lived in the walls, coming to life, dragging chains and moaning and scaring the daylights out of us. At the time, our hearts beat faster, raising our pulse and accounting for a few chewed fingernails. But what about today, do you believe in ghosts? The Internal Revenue Service does.
The U.S. Department of Labor (DOL) and the IRS have a responsibility to find out if your subcontractors are just that, not really just ghost employees, on your payroll but not shown. If the test is given, the test for being subs, you would owe the employer part of all the employment taxes (fica, futa, suta, and even 401K contributions in some cases).
Here’s a big surprise: If you claim someone is a sub and the IRS audits the situation, you don’t get the benefit of the doubt. You meant well but didn’t follow the rules and the penalty is big, maybe devastating.
How does it happen? There are lots of ways. Here are a couple of examples: 1.) your brick mason charges a third less than the competition, does a good job but has to be paid as soon as the job is done so he can pay his men and you pay him; 2.) your framing sub wants to please you and asks what time he can start work. You tell him 8 o’clock and remind him he is to use only approved materials. Both “subs” are being really accommodating but might be putting you in harm’s way because both, in their own way, violate the subcontractor, prime or general contractor relationship. That’s not good.
Using subcontractors for construction is a popular way to build and is going to be around for a long time to come. To use subs correctly, one must meet the criteria set down by the IRS about the relationship you and your subs have. Those criteria take the form of three “controls” and how you meet them; they are as follows:
1) Behavioral Control — do you exercise control over how they behave, can you dictate what time they go to work, what they wear, what rules they have to follow?
2) Financial Control — do you furnish working capital for the enterprise calling themselves a subcontractor, how often do you pay them? If either of the answers to the questions is the same thing you do for your employees, guess what?
3) Relational Control — do you have an “employee type relationship” or do you convey instructions via a request for bid and award work matching a particular scope of work with a required finish date?
The real rub is that if you are guilty of any of the types of control listed above, your subs may be considered employees because there isn’t an arm’s length type of transaction between you and your “subs.” If your employees go to the hardware store and buy some nuts and bolts and build a widget, it’s yours. If you put out bids for building your widget and give the contract to William’s Widgit Builders, then it’s a subcontract; but if you tell William he has to start at 8 a.m. and he has to wear a shirt of the company’s colors; oh and by the way, you have to use Brand X tools, your subcontractor’s status may be questioned by the Internal Revenue Service and that’s not a good thing.
We use subcontractors because there is a natural efficiency in doing so. There is a layer of profit paid to the subcontractor as there should be, but one that carries with it the savings of paying payroll taxes, employment taxes and local and state income taxes. We pay a price for this privilege and we should insist on getting value received for investment.
Take a good look at the relationship you have with your sub or trade contractors to see if there are any ”ghosts” being paid as subs that don’t meet the test; if it’s just elbow-length instead of arm’s length, maybe it’s something you should fix.
The penalty for calling someone a sub to save paying employment taxes is really frowned upon and will cost you a ton, While You’re Here . . .