Subcontracting & Your Small Business

It's not uncommon for an individual or company to hire a third party to work on a job or project that's being done for the other person's customer or client. For example, say your small business has a contract to build a home for a property owner. To complete the project, you hire another person to perform some of the work and supply some materials.

In many cases, a subcontractor relationship has been created. And, if you find yourself in this position--or maybe the reverse, where your small business is being hired to do some work--it's a good idea to know some things about how subcontracting and your small business work together.

Subcontracting Basics

Usually, a subcontractor is not an employee, but rather, he is an independent contractor, and the distinction can be important for you. Generally, you can't control exactly how and when an independent contractor performs his or her tasks. But, on the other hand, you don't have to give him or her the same benefits you give to your employees, like pension benefits and health insurance, you don't have to withhold payroll taxes, and you usually can't be held liable if he or she is negligent and injures someone.

The Relationships

It's always a good idea to have a written contract that controls the relationship between a prime contractor and subcontractor. The contract should include things like:

• Details on what specific tasks that the subcontractor is being hired to do and when you expect that he or she will complete the task.
• When and how the subcontractor will be paid. It's not uncommon for prime contractors to hold off paying a subcontractor until the prime contractor's customer has paid him or her. But, it's more common to pay subcontractors as he or she delivers goods and services as promised and gives the prime contractor periodic invoices or billing statements.
• An express statement that he or she is a subcontractor.

Generally, if for some reason you fail to pay the subcontractor for his services, he can file a lawsuit against you for breaching or violating the contract. Likewise, if the subcontractor fails to perform the services or deliver supplies and material as agreed, you can file a breach of contract lawsuit against him. Typically, in either case, the damages that the injured person can recover are based on the contract price. That is:

• If the subcontractor breaches, you can recover the difference between the cost of services the subcontractor would have been paid and the price you had to pay someone else to complete the subcontractor's job
• If you, the prime contractor, breach the contract, the subcontractor can usually recover the price he would have received if the contract wasn't breached
• If you paid the subcontractor in advance and he failed to perform the contract, a court will typically order the subcontractor to repay you, which is sometimes called "restitution"

Sometimes, the contract between you and the subcontractor contains a "liquidated damages" provision, which specifies how much one party will owe the other if there's a breach. Usually, these damages are used as a strategy to ensure that the other party performs his job. So, in our house-building example, your contract could state that the subcontractor has to have the roof completed by a certain date. If the roof isn't completed by that date, a liquidated damages provision might state that he or she must pay you $100 for each day completion is late.

What about the property owner? Generally, the property owner can't enforce the contract between you and the subcontractor. So, if the subcontractor isn't working on the roof to the owner's satisfaction, he can't file a breach of contract lawsuit against the subcontractor. Typically, the owner will pressure you to get the job done, and you'll have to get the subcontractor to finish the roof. Of course, the property owner can sue you if the house isn't finished by the date specified in your contract with the property owner (the prime contract). In such a case, you can file suit against the subcontractor for breaching your contract with him if the roof is why the house isn't complete.

But, what if the house is completed and the property owner refuses to pay? Usually, both you and the subcontractor can file a "mechanic's" or "materialman's" lien against the owner's property. Basically, with a properly filed lien, you can file a lawsuit to "foreclose" the lien and force the property owner to pay what he owes for your services or labor. Also, with such a lien, it's virtually impossible for the owner to sell or refinance the home without first paying the lien.

Who, when and how a mechanic's lien can be filed is usually specified by state law, and those laws vary significantly from state to state. So, be sure to check the laws in your area to make certain you file the lien properly.

Often, the contract relationships between property owner, prime contractor, and subcontractor and their remedies for breaches can be complicated. So, if you're a party to a contract-subcontract relationship and you're being sued for breach of contract, it's a good idea to get some advice from an experienced business law attorney.

Questions for Your Attorney

• How do I file a mechanic's lien, and how much does it cost?
• How do I treat the payments that I make to a subcontractor for federal tax purposes?
• A company keeps hiring me as a subcontractor, and sometimes I feel like I'm an employee. Is there a point when I stop being a subcontractor and start being an employee?