Subs or Employees?

Finley Perry understands both business models: For years, F.H. Perry Builder, near Boston, had 15 full-time employees. But during an early 1990s' recession Perry couldn't find work and had no choice but to lay off 75% of those people. When business picked up in 1993, Perry was reluctant to change. “I began to see myself as a management company as opposed to a trade company,” he says.

In recent years, many remodelers have taken up the subcontractor mantle — for trades in particular. But many feel just as strongly that having employees is the model to follow. There is, of course, no right or wrong way to run your business — just considerations of the strengths and challenges of each.

No one disagrees that maintaining full-time staff is expensive. For each employee an owner might spend anywhere from 30% to 130% or more in labor burden, depending on the number of benefits, such as payroll taxes, health insurance, workers' compensation, vacations, holidays, training, bonuses, and equipment and vehicle use. “I pay around $5,000 in general liability and workers' comp,” says Bob Lehner, owner of Lehner Brunton Remodeling, Warrenville, Ill., who has four employees in the office and subs out all trades. “We don't pay [subs'] federal taxes, FICA, or Social Security. Every sub is a 1099 or a corporation where they report their earnings. We save money in that regard.”

"[With no field employees] we don't pay federal taxes, FICA, or Social Security.” — Bob Lehner, owner, Lehner Brunton Remodeling

Photo Credit: Kevin O. Mooney

Any reputable subcontractor will pay those items for his or her workers and pass on those costs plus profit to you, but they won't be sustained by you year in and year out. “Our business is cyclical,” says Paul Floramo, general manager of Capstone Remodeling and Construction in Rochester, N.Y. “I don't want to have to worry daily about what my people will do and have the burden of overhead. Sometimes we have a dozen projects going and other times we have four.”

And, of course, employing fewer people makes payroll easier to manage. Dylan Wadlington of Wadlington Remodeling, in Pine Grove Mills, Pa., subcontracts every position, even the office manager, who sets her own schedule. “All I ask is that paychecks are ready to be signed Friday morning and that bills are paid on time,” he says. That kind of loose situation might be difficult with a large, full-time staff.

David Adams, owner of Design Builders & Remodeling, in Sandy Hook, Conn., has 25 employees, including office and showroom staff as well as an extensive group of tradespeople. Burden is high, but his upscale Connecticut market is strong enough and his $6 million volume large enough that Adams has been able to create separate divisions — a separate company in the case of plumbing — that support themselves. “I'll do roofing and drywall for other builders or just a roof [if it's not part of a larger project] for a previous client,” says Adams, in essence becoming a subcontractor himself.

By setting up divisions instead of companies, Adams doesn't pay separate insurance premiums for each trade, lowering costs. He has a standard builder's insurance liability and workers' compensation policy covering everyone at separate rates. But he does face higher risk. “If the plumber burns down the house, it's the company's problem,” he says. “It's risk versus cost, a decision each person must make.”

With subcontractors there are other insurance issues — such as whether or not they have up-to-date insurance. “We're required by the insurance company to audit subcontractors' insurance and make sure they meet minimums,” Lehner says. “We make sure they have certain limits on their liability and workers' comp. We ask to be additionally insured so we're not responsible for anything that could happen.”

Keeping up with this paperwork can be a burden (see February 2007 Ways+Means, “Keeping Subs Insured”), but the alternative could lead to legal issues or a government audit.

For many remodelers, the issue begins with finding workers. Adams, whose tony market does not encourage its youth to enter trades, finds it difficult to locate good subcontractors. “I started hiring employees out of frustration,” he says. Adams found that many subcontractors were excellent at their craft but were poor businesspeople. He has hired many of them as full-time employees. “There's one in particular who is one of my best,” Adams says. “Now he's home every night and weekend with his family and making the same amount of money [as when he was on his own]. He couldn't be happier, and I have him at my disposal.”

Lehner, who uses trade subcontractors, admits to frustration at times because he doesn't know all the workers in the subcontractor's company. “We interview people, review their [finished] work, watch their work [in progress], do a background check, check their insurance, make sure they're self-incorporated or a sole proprietor — to make sure they're a good fit with our company,” he says. And if “something falls apart or we see something we don't like, we start the process over again. We might go through two or three people.” All of which takes time. And if your best HVAC sub retires, as Lehner's did last summer, you may not find another for several months. For this reason and general scheduling issues, it's important to have reliable back-up subs.

So he wouldn't get caught flat when he owned his Martinsville, Ind., company, Mike Weiss says he had every subcontractor who came to him fill out “an information folio with contacts, EIN or Social Security number, company name, and supplier and builder references. When we needed someone we had [forms] ranked by trade and, if possible, by competency. We took the ones who'd been on file the longest and interviewed them. That's how we hired them.”

Since subcontractors work for many general contractors simultaneously, scheduling is tricky. Floramo gives subs four- to six-weeks' notice before a job. Weiss says he advised subs as soon as the company took on a new job “so they could dummy in the spot on their production schedule. We always consulted our subs when we were doing our schedule, because we needed to know their crew size and what they estimated the duration of the job would be.” For in-house scheduling, Wadlington uses whiteboards showing “jobs in progress, who's on a job, what needs to be done, one week out, two weeks out, start and finish date for every sub. We put the sub in the potential schedule and keep amending it as we go through the job,” he says.

"It's risk versus cost, a decision each person must make.” —David Adams, owner, Design Builders & Remodeling

Photo Credit: Tracey Kroll

One benefit to having to schedule subcontractors, says Perry, is that his project managers must plan ahead. “Our schedules and budgets [in part because subs charge a lump sum] are better.”

With employees, scheduling can be easier but it still needs to be done carefully. Bob Bell, of Bell's Remodeling, in Duluth, Minn., has just two employees. “We do everything except electrical and plumbing,” he says. And Bell's does one job at a time, so the crew is always busy. He hasn't laid off anyone in 11 years. For Bell, scheduling jobs is part of a conscious effort to maintain a small company that's tight with its clients. “Once I start a job, clients know I'll be there every day until we're done,” says Bell, who runs about 50 jobs a year ranging from installing a storm door to building a $200,000 addition. “Some of our jobs are small, and you couldn't get a sub to do that. I have fewer scheduling problems and more control.”

It may be possible to keep a longer backlog — six to nine months — with employees since you know their schedule, but Lehner says he's able to keep a three- to five-month backlog, which seems like a reasonable amount of time for most remodelers.

One other thing that needs to be scheduled and budgeted for is the punch list, since it can be difficult to get subcontractors to return to a job. Some remodelers put it into the sub's contract. Other remodelers who rely heavily on subs have a “gofer” and/or clean-up person on staff. Peggy Fisher, co-owner of the Fisher Group in Annandale, Va. (which tries not to use subcontractors), says that another remodeler suggested that if she did use subs she should “put at least 10% more into the subcontractor budget to clean up after them.”

With employees, it's difficult to make sure everyone works to capacity every day; you certainly don't want to make it a practice of hiring, laying off, and re-hiring. The Fisher Group cross-trains employees so that if the company's full-time “electrical installer has a ton of work, someone can help him pull wires,” Fisher says.

Although subs are thought of as experts in their field, “any tradesman can be state-of-the-art if they go to trade shows, read magazines, and work with other tradesmen in the industry. They're not isolated [as employees] any more than other tradesmen,” says Adams, who encourages and pays for employees to obtain education.

Yet Wadlington believes that the level of craftsmanship is much higher among those who are self-employed. “I like entrepreneurial personalities,” he says. “There's a different pool to pull from those who want to be employees and those who want to be self-employed.”

Getting people to do a job to an owner's standards may ultimately be what pushes owners in either the direction of subs or employees. “Our employees are invested in their work,” Fisher says. And because of that “they will return to a site to answer questions. They know who they are working with every day and they prep for and support one another. … They've developed a shorthand you only get when you've worked with people for a long time who are all invested in the outcome. And the clients are happier.”

Many remodelers who were interviewed for this story, who are using subcontractors, don't see company culture as much of an issue but do spend a lot of time developing relationships, bringing people in early, and investigating to make sure the subs they choose are the kind of people who take pride in their work. Communication is important. “Subs are people too,” Weiss says. “They respond to professional management the way everyone else does. They're such an important part of what we do as GCs that it's absurd not to cultivate them.”

Wadlington reviews The Journal of Light Construction (a sister publication of REMODELING) best practices guide as well as an adapted version of the National Association of Home Builders' subcontractor guidelines with his subcontractors. “This way we have a common understanding,” which helps keep people accountable, he says. Plus, says Wadlington, whose business is near Penn State University, “We're in a small town. We see these people all the time; there is some honor involved.”

“We ask to be named ‘additionally insured' so we're not responsible for anything that could happen.” —Bob Lehner

The key to accountability, Floramo says, is “being fair to [subs] and paying them in a timely manner. And then, I get some priority for my work. When I need them, I'm put to the top of the ladder.”

Company culture is both a catalyst for and a watchdog of accountability. Perry doesn't have an issue with company culture with his subs and says that having employees who are a good fit maintains company culture. Subs who don't make the grade don't get asked back.

Says Fisher of the few times her company has used subs, many of whom in her area don't speak English, “We've taken to posting some of the basic jobsite etiquette in Spanish, things like ‘Don't throw cigarette butts in the yard,' even if we have had a discussion with the owner of a subcontracting company. If we can use our own employees we have better buy-in and understanding that we don't park on the owner's azalea bushes or pour paint buckets in their garden.”

Whether you choose to use subcontractors or to hire employees — or see yourself as a management company or a trade company —the choice is one you must feel comfortable with. Some people don't want the pressures of a large payroll, while others, such as Adams, say that they feel less stress supporting employees than they do searching for subcontractors.

“I started hiring employees out of frustration [with subs].” —David Adams

The important thing is communication — letting people know what's expected of them and giving them feedback during and after a project. Client satisfaction and your bottom line depend on it.

In the late 1980s, Tom Peters (not his real name) owned a framing contractor business in Georgia. He had four employees — three project supervisors and one forklift operator whom he treated like a subcontractor. “I knew it was stupid,” he admits now, but at the time he wanted to save money. That employee complained to the IRS. Not long after, the agency came knocking at Peters' door.

Often, a worker complaint such as this one is “a hot-button issue that can trigger an audit,” says Washington, D.C., attorney D.S. Berenson, who previously served in the IRS' Office of Chief Council.

After the complaint, an owner may receive Form SS8, which embodies the so-called 20 common law factors used to classify workers — as employees paid under a W-2 form or as contractors paid on a 1099 form. (This applies to all workers, not just installers; however, there are special laws pertaining to workers such as sales reps.) If you complete this form, says Berenson, “you'll lynch yourself.” Instead, contact a tax attorney or someone well-versed in these issues and have him or her prepare a position paper and do a pre-audit analysis to determine a course of action. “If you have a defensible position, your attorney needs to make that defensible position to the IRS,” Berenson says. “You want to try to nip this in the bud and not trigger a complete audit.”

Unfortunately for Peters, who contacted both his CPA and his attorney (not a tax attorney), the IRS began an audit, delving into two years of records. Not only did the IRS interview the original complainant, it spoke with all of Peters' subs and employees, “including Texas-based wall and truss crews, some of whom had 15 to 20 employees of their own,” he says. The verdict: Peters owed $426,000 in withholdings, penalties, and fines.

Once the reclassification process begins, it's a bit late to build up a defensive wall, Berenson says. Ideally, you want to be proactive. There are a number of protocols and procedures you can put in place to guard against a reclassification audit. The three most important are:

• Installers must be under a written agreement setting forth their understanding of the tax relationship they have with the company. The agreement should clearly state that the person is an independent contractor who will file his or her own taxes and has no right to have monies such as Social Security withheld.
• The installer should be hired as an entity, not as an individual. “When a field agent reviews your payroll, they'll pull things made payable to Johnny Jones. There's a good chance that if the 1099 is made payable to Jones Installation Inc., they won't pull it,” Berenson says.
• Make sure the installer carries insurance (workers' compensation, auto, liability, etc.), and, if you're in a state that requires licensing, make sure they have that too.

• “There are other bricks you can put in a defensive wall, such as how you handle distribution memos, or tools and trucks,” Berenson says. “But if you have these three foundation bricks you've gone a long way toward protecting yourself.”

  Peters' story has a relatively happy ending. For reasons he can only speculate, the case closed without him having to pay anything (except attorney fees), even for the one worker who was clearly misclassified. “But for a whole year I felt exposed. I was frightened,” he says. “The tension and stress were unbearable.”

  Not long after, Peters dissolved his business and moved to another state. He now owns a successful small remodeling company, and he has built up his wall of defense. “We don't employ anybody as a sub unless they can provide a certificate of insurance. He has to be able to prove he works for other contractors and not just for me. A one-man show like a wallpaper hanger has to sign a four-page form in which he attests to the fact that he sets his own hours and all the other things the IRS asks for,” Peters says. “All it takes is one time for someone to complain. It can turn your world upside down.”