Can Shop Workers Legally be Subcontractors?

      An extended discussion of IRS rules defining employees and independent contractors, and how those rules relate to workers in a cabinet shop. February 23, 2010

Question
If you are a one man shop, would it be more beneficial to hire an employee, or bring a guy in on a 1099? I am thinking of having a guy come in and work as a sub doing shop work.

Forum Responses
(Business and Management Forum)
From contributor C:
Just make sure he gives an invoice for services rendered. Make sure he also is in on some of the decision making processes, has a time line, who's cutting what, and he needs to use his own screw gun, tape measure, etc. Read E-Myth. And move on.



From contributor W:
This is a touchy subject at best. There are several areas of concern to all involved. Does he have workman's comp? Basic health insurance is not going to pay for an emergency room visit to stitch up a cut during working hours. The first question asked by the clinic is how and where and what were you doing? Do you control his hours of work or schedule his tasks with your customers?

This might seem at first glance a winning situation, but do think it all through. The many reasons and items that can trip you up or cost you that dollar of income are the very things that make hiring someone the best structure for a lasting, productive, mutually profitable employment experience.



From contributor B:
You are just asking for trouble here. In order for this person to qualify as a 1099 contractor, you would have to abdicate any and all authority over him, or else lie to the IRS. The first time something happens to him, you run the risk of losing your shop and everything you own because you were trying to screw over the government. Think twice before trying this, my friend. You are on very, very thin ice.


From contributor L:
You would be frightened by the output of one good part timer or full timer that produces. I have used a sub on the floor sparingly, and we got a lot of crap done in a hurry, but the comp crap always has had my hair standing up on the back of my neck.


From contributor O:
There is a well-developed body of IRS rules and guidelines which you flaunt at great risk. "Come in" and "doing shop work" are the operative words.

In general, if you control what, when and how someone performs work for you, that person is an employee and not an independent contractor. Add in the apparent fact that they would be using your tools, and any independent contractor argument is a dead loser.
It's certainly less expensive in the short term to call someone an independent contractor, but that can blow up big time if the independent contractor is held to have been an employee.

The multitude of rules are laid out on irs.gov. You can dig as deeply into it as you want, right down to the guidelines they give to their own auditors on how to make an EE/IC determination.

My experience with this issue was 20 years ago when I had a few people who really were totally independent contractors, selling my computer equipment to their own leads. Not housed by me. Not directed by me. Straight commission only. I didn't tell them what, when, or how, they were totally on their own. Slowly they came into my orbit, working so closely that they officed in my space, sought my approval for this, that and the other thing, and generally acted like employees even though they were still paid nothing but straight commission.

Having some familiarity with the EE/IC tradeoff and its pitfalls, I reached the point where I was simply no longer comfortable treating them as independent contractors and unilaterally changed their status to employees and started withholding, etc.

A couple of years later, when the IRS did a line-by-line audit of my corporation, then doing about $5 million a year, the auditor asked about the independent contractor-to-employee change. I explained why I did it. His comment was that it was exactly the right thing to do and most people wouldn't have done it, which was why he had imposed so many penalties for improper treatment of employees who were called independent contractors. He never even asked for any of the details of exactly why I had made the change when I did, he just accepted it as proper.

The cost, if you are caught, will be 5.85% of everything you have paid the "independent contractor," plus interest, plus penalties for failure to file all of those quarterly form 941 wage reports, plus FUTA/interest/penalties, etc.

My advice is to honestly classify people according to the rules and avoid potential problems down the road. You should consult a CPA or tax lawyer if you have any doubt about how to treat someone. A mistake can be expensive.



From contributor H:
This is a no-brainer. And you can't try to make it what it's not. If he's in your shop, doing work for you, and uses any of your tools, he's an employee - period.


From contributor E:
One of my past employers tried this and it went on for close to two years. When the IRS got done with him he could not walk straight, and that is an understatement. One, they know what you were up to and why. Two, the fines were through the roof and they do not want to hear anything you have to say. Last but not least, the state canceled his workman's comp and such. Last time I saw him he told me, "Welcome to Walmart."


From contributor J:
There's another option you may want to look into - using an employment service. I don't have firsthand experience, but it's been talked about here in the past. I believe you can hire anyone you want; you just have them work through an agency. It will cost more but they take care of all the paperwork and insurance aspects.


From contributor S:
If the person you hire as a sub only does work for you, he is an employee. You can not use him as a sub unless he can prove he does work elsewhere. As for using an employment service, we tried that at one time and you have no control over who you get. Whoever signs in that day is who they will send. We got some pretty pathetic people, who you need to depend on to be professional.


From contributor D:
You mention this as a strategy to help your growth. I agree with the other posters - steer very wide of this area. I'll add that as you grow, you want to have sound, reliable (and legal) methods to do so. To become dependent upon artificially cheap labor, or evading taxes, or similar will put you at a false profit of sorts, and then when the labor vanishes, or the feds make some demands, you are out of business or worse.

I'm not saying that deception is your intention. I assume it is not, but giving any shop labor a 1099 is a sure way to tax trouble, no matter what your intentions. One other component for good growth is a CPA that you can talk to about these things. Less expensive than you may think, and invaluable for the things they can do for you.



From contributor J:
I was under the impression that you could actually send your own guy to the employment agency and not have to pick from their people. Maybe different agencies have different policies?


From contributor N:
What if the person you are hiring really is a licensed independent contractor, who does work for you as well as others, takes care of his own insurance, bonds, etc?


From contributor B:
What the heck is a licensed independent contractor? As many folks here have attempted to point out, there is a legal definition of a true independent contractor according to the Internal Revenue Service. I have never heard of a license for such a thing, and suspect you are conflating two different concepts here.


From contributor H:
A licensed independent contractor would not need to come to your shop, use your tools, etc. There is also a percentage ratio somewhere. He can't only work 10% elsewhere and 90% for you. That still makes him your employee.


From contributor G:
1. Your chances of setting him up correctly as an independent contractor are zero. Judging from your initial posting you do not have even the beginning of an idea how to set up any sort of independent contractor so that it doesn't come back and bite you in the butt. (You are not stupid; the issue is just so complex that unless you are willing to go to law school, you will just fall into a trap.)

2. When it fails, the costs will put you out of business. You will be responsible for all taxes that were not paid. Without workman's comp, you have unlimited liability for injuries. If he goes out to buy materials, or even buy you both lunch, and injures someone...

3. I won't even suggest that you go see an attorney in your area to help you, my usual suggestion on legal questions, because there is no way to do this.



From contributor G:
The way to do this, if you want no further responsibilities for him as an employee, other than to pay so much an hour, is to hire the assistant through a temp agency (or equivalent). They pay him, do the deductions, cover his workman's comp, and rent him to you for so many bucks an hour. It may well be cheaper that you're handling all the employee issues, bookkeeping, insurance, taxes and so on. Use a real agency, not some fly by night outfit (or some clever fake corporation/agency dodge), because if they don't do all those deduction, accounting, insurance things, then it will all fall back on your head (or you will spend the most amazing amount of money defending yourself).

For safety, have your attorney or your insurance agency check the rent-a-guy's insurance to make sure that they have you covered for third party claims while he is on your property (i.e. if he hurts anyone). Then, if you do not intentionally harm him and also don't fire him for age, gender, race, etc., you should be reasonably safe.

At some point you will need a team consisting of an accountant, attorney and insurance agent who all are experienced in small businesses, but that is a different set of issues. (Collectively they will see that you are doing business in a legal way, in the best entity form for you, you have the right licenses, permits, etc, use a good contract, keep the right books and they will see that your back is covered with insurance.)



From contributor T:
Because something is an IRS rule doesn't make it fair, rational, or good for small businesses like ours. Long ago I hired a helper who was a carpenter/remodeler but very game to learn cabinetmaking. He wanted to maintain his ability to take on independent work as a carpenter, had a liability insurance policy for that work, had his family health insurance through a church related co-op, and wanted to take as many weeks vacation as suited his fancy. He chose what hours he would work, and invoiced me for all payments. These were conditions he brought to the table and lobbied for, not me. Most of these things fit the criteria of being an independent contractor. Of course when he worked for me it was either in my shop or on an installation, and he worked for me anywhere from 60-80% full time for a couple years. These criteria make him an employee according to IRS regulations.

He was a fast learner, 100% reliable, professional on the jobsite, very safe and cautious in the shop, in every way a gem of a worker and a true gentleman. I paid him premium rates knowing he was paying self-employment taxes, and bonuses on many jobs because he was worth it. If he got hurt while working for me, he could have held me liable, but would not have, since we shook hands on that when he started. Now, if we got in a car crash on the way back from an install and he was killed, his family might not have honored that agreement, and understandably so.

So I was surely open to liability in that worst-case scenario. And I would be very unlikely to do it again, as the country has become far more litigious in recent years, and he was a one-in-a-million guy, and my business was a new venture without the complication of other employees. But once upon a time two hard-working adults with mutually beneficial interests could work together and be fair about it, even if it skirted an IRS rule or two. In today's world, I concur with most other posts that it's not worth the risk.

Find someone you want to hire, then approach a temp service together and strike an agreement. You'll pay the agency for a fixed length of time and they'll handle the taxes and worker's comp. Then you can hire him outright, as long as you're ready to supply your own worker's comp and take care of the tax witholding stuff.



From contributor P:
There was a shop in my area a while back that used all subs. He would bring in a set of plans, and get prices from the shop subs for making boxes, making doors/drawers, running molding, assembly, finishing, hinge up and install. I thought it was an interesting concept and he did it for years until he cut off his fingers (3 on his right hand, dado blades), but each person would give him a price and he would put the bid together. Then the subs would come in and do what they bid. For me with 8 employees, I like having more control on who does what and where.


From contributor G:
If one of the "subs" had lost those three fingers, even a third rate plaintiff's attorney would have spent about ten minutes blowing through that scheme. The rest of the trial would feature an economist who would give a longwinded explanation of the market price of half a hand (although he would be polite enough to call it reduced lifetime earnings for a woodworker with loss of x percent of the use of his right hand). The owner would be in a trial, paying a defense lawyer's fees, because without workman's comp you can be sued, and here is the great part - there is no limit on the amount that can be awarded the plaintiff! (This would certainly be the result even if the guy had gotten really cute and had drawn lines on the floor and rented the space to the sub and made the sub buy-rent-lease the molder, saw, finishing equipment, etc.)

I am sure that there are hundreds of true stories out there about someone who didn't pay taxes, didn't buy insurance, didn't get permits or licenses, and so on. It is like driving your car without insurance. The story goes great right up to the minute that something happens, then everything goes bad... very bad. The verdict can easily be greater than the value of the business, as well as all the owner's personal assets. (Yes, in this sort of fraud it is reasonably likely that the corporate veil can be pierced and the owner's personal assets are on the line even if he is incorporated.)



From contributor G:
"Because something is an IRS rule doesn't make it fair, rational, or good for small businesses like ours."

That is certainly 100% true, however in this particular case, what is unfair, irrational and bad for small businesses in requiring that employers deduct taxes and SS for employees, pay workers comp for employees, and buy insurance to protect the public from injuries from employees?

By the by, the workman's comp part is a pure gift from the state. Do you know how much more the premiums would be to cover you against claims from injured employees if those premiums also had to cover litigation costs and uncapped (unlimited) liability for injuries?



From contributor Q:
You must apply the acid test to the sub relationship to be sure you are in compliance with state and federal laws. Before you do anything, learn about the twelve or fifteen acid test questions. Check with the IRS, your insurance carrier, your workers comp carrier, your accountant, and your employee/employer advocate. After gaining their knowledge, you would then proceed to accept or reject that relationship.

As a general building contractor, I have a number of subcontractors. Before employing as a sub, each must provide me with insurance certificates, work comp certificates, and a current state license. There are a number of other acid test issues that must also be addressed.

Each year, when enduring audits for each of the insurance carriers, we are challenged on each subcontractor, unless we have many forms of documentation.



From contributor M:
I agree with all the reasons that have been given to avoid this potential disaster. Also, often in our attempts to cut costs, we end up creating more. This is one of those cost cutting ideas that is better left way back on the shelf behind a sign that reads "rejected" (ideas).

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