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Subcontractor is a person who is awarded a portion of an existing contract by a principal or general contractor. Subcontractor performs work under a contract with a general contractor, rather than the employer who hired the general contractor. Determining whether someone is a subcontractor depends on the facts in each case, but is generally determined by whether control over the manner and methods of the work is retained by the employer.
Building construction is a common example of how the contractor-subcontractor relationship works. The general contractor takes prime responsibility for seeing that the building is constructed and signs a contract to do so. Then they retain subcontractors to perform specialty work such as installing plumbing, laying carpet, making cabinetry, and landscaping. Usually each subcontractor is paid a somewhat lesser sum than what the contractor receives for the work. If the owner refuses to pay the general contractor for work a subcontractor has performed, the subcontractor has the right to file a mechanic's lien against the property for the cost of the unpaid work.
The following is an example of a State Statute ( Oklahoma) defining Sub contractor:
According to 61 Okl. St. § 222 a Subcontractor means any entity that has a direct contract with a prime contractor to perform a portion of the work under a construction contract; and sub-subcontractor means any entity that has a direct contract with another subcontractor to perform a portion of the work under a construction contract.
Strictly speaking, "subcontracting" is practiced only by a contractor, namely an individual or a company working for another entity under a contractual agreement. If the contractor then hires out some of the work to yet another organization, it is said to have subcontracted the work out. Subcontracting is most common in the construction industry: builders often subcontract plumbing, electrical work, drywalling, painting, and other tasks. But many other sectors engage in contract work as well, most notably government contractors of all kinds. The whole industry that supplies the U.S. Department of Defense typically operates under contract and uses many subcontractors in turn.
In recent times the term has come to be used in a more general sense to refer to any kind of work contracted or "farmed" out. Outsourcing tasks and functions has become a common tactic used to lower costs. Companies that operate on their own behalf selling goods and services to the public may also engage in contracting or "subbing" some of the work. In such cases no contract is in existence, hence the prefix "sub" is unnecessary; it is often used anyway and thus the commonly used abbreviation, "subbing." In the discussion that follows both kinds of contract relationship will be included, thus also the use of so-called independent contractors and hiring free-lancers.
Contracting and subcontracting are institutional expressions of the division of labor or of specialization. Such forms are used for the simple reason that they cost less than providing the service in-house. Certain types of work require specialized and often expensive tooling and skills not required in a company on a daily basis; to provide such services in-house would not be cost-effective. By specializing in a particular function, equipping it and staffing it to serve a large clientele, service organizations can achieve scale effects simply not available to the ordinary business. An example of this is payroll services under which a small firm can contract out its payroll administration to a company for a small fee; the company gets excellent service, guaranteed conformity to tax law, and saves money. Saving money is also at the root of the more questionable practice of laying off people and then hiring them back as "independent contractors" at fees that cost less than their previous salaries, payroll tax, plus fringes. Such forms are frowned upon by government and are sustained only so long as the supply of such labor exceeds the demand. The chief disadvantages of using contractors are diminished control over the function and less ability to predict its future costs.
A contractor who behaves and is treated like an employee is an employee from the viewpoint of the U.S. Internal Revenue Service (IRS). The IRS applies a 20-part test in order to determine whether a certain worker should be classified as an employee or an independent contractor. The main issue underpinning the test is who sets the work rules: employees must follow rules set by their bosses; independent contractors set their own rules. An individual who sets his or her own hours, receives payment by the job, and divides his or her time between work for several different employers would typically be classified as an independent contractor. Other criteria involve who provides the tools and materials needed to complete the work. An individual who works at an employer's facility and uses the employer's equipment may be considered an employee—unless the individual is providing software consulting, for instance; one who works at a separate location and provides his or her own equipment would be classified as an independent contractor. Finally, an independent contractor usually pays his or her own business expenses and takes the risk of not receiving payment when work is not completed in accordance with a contract; an employee is usually reimbursed for business-related expenses by the employer and receives a paycheck whether his or her work is completed or not.
A small business may be on either side of this equation: providing contractual services or purchasing such services. As a seller, the business must retain its independence; as a buyer, the business must avoid directing the contractor in such detail as to qualify him or her as an employee. Problems often arise when the seller wishes to be a contractor, has chosen that path willingly, but is using the buyer as his or her first customer, having worked there many years. In such cases the old relationship may be habitual.
Small business owners may be highly experienced in using subcontractors because subs are a natural part of their industry—as in construction. In cases where a large company provides a service, such as a payroll firm, the relationship is again clear and unambiguous—as is, for instance, working with an outside accountant in business for him or herself. Nor are problems likely to arise when surges in business must be accommodated by hiring temporary workers from a temp firm. In yet other cases, such as buying advertising services, the relationship is traditional and not viewed as contracting out a service—even when the relationship is on-going rather than singular. Most companies working with ad agencies also have an internal advertising manager. Problems for the small business arise when it works with independent contractors, usually individuals, who carry out tasks that either have been or could be done in-house. Problems also arise when the business works in such close partnership with a contractor that interactions between the contractor's employees (and executives) and the company's own staff arise.
The skilled small business owner will, of course, avoid any contracting arrangements that may be seen by his or her own people as exploitive. The owner who makes use of people down on their luck in order to avoid having to pay their payroll taxes, for example, will likely pay a high price for this in another the form: eroding morale and key people quitting to seek their fortunes elsewhere. But it is sometimes difficult to hire talented individuals because they do not wish to work for the company as employees. If that is the case, the company's own employees should be informed of the fact.
More difficult are situations where a very useful contractor becomes a problem. An example might be a sales organization working closely with a small manufacturer—effectively lifting the manufacturer's sales. Close contact between the contractor and elements of the company may lead to situations where employees start to wonder "who's in charge around here?" In this case the sales contractor, well-meaning in every way, may become too assertive in asking for changes in product or in packaging. Such situations can be avoided by setting clear rules early, monitoring interactions, and maintaining open communications at all times. Situations of this sort also arise in companies where two different internal functions develop conflicts—engineering versus market, marketing versus accounting, etc. The same solutions apply whether the function is contracted or internal—but an external provider of a service will invariably appear as more threatening or annoying to the company's own people.
Apart from these issues, working with contractors has exactly the same requirements as working with any vendor. Aims must be clear, specifications well-developed, sourcing should be as competitive as possible, and the purchasing decision must be a careful blend of price and quality.
Hartman, Francis T. Ten Commandments of Better Contracting. ASCE Publications, 2003.
Moskin, Morton. Commercial Contracts: Strategies for Drafting and Negotiating. Aspen, 2005.
Stanberiy, Scott A. Federal Contracting Made Easy. Management Concepts, 2004.
Walker, Anthony. Project Management in Construction. Blackwell, 2002.
Waxman, Shelly. All Anybody Needs to Know About Independent Contracting. iUniverse, 2003.