Subcontracting: How It Works, Benefits, Definition, and Taxation

What Is Subcontracting?

Subcontracting is the practice of assigning, or outsourcing, part of the obligations and tasks under a contract to another party known as a subcontractor.

Subcontracting is especially prevalent in areas where complex projects are the norm, such as construction and information technology. Subcontractors are hired by the project's general contractor, who continues to have overall responsibility for project completion and execution within its stipulated parameters and deadlines. This can create a subcontractor risk for compliance.

How Subcontracting Works

Using the construction industry as an example, when a government body or a company wants to build or make repairs to infrastructure, it would usually award the contract for the job to a contractor. The contractor is a business owner who negotiates the deal and works on a contractual basis for an agreed-upon fee. Sometimes the work to be done is in a specialized field such as electrical, plumbing, insulation, or more recent areas like energy optimization and smart wiring infrastructure, which requires the contractor to contract out to another party. In this case, the contractor will be subcontracting the work to a specialized subcontractor.

A subcontractor is a type of contractor who works in a specialized area and could be a freelancer, independent contractor, or vendor. While the contractor maintains relationships with clients (e.g., corporations or the government), the subcontractor works with a contractor, providing their specialized skill set in exchange for a contractual fee. The subcontracting individual or company reports to the primary contractor, who is responsible for managing the contracted work from initiation to completion.

Why Subcontract?

There are several reasons why subcontracting is carried out. Subcontracting is very useful in situations where the range of required capabilities for a project is too diverse to be carried out by a single general contractor. In such cases, subcontracting parts of the project that do not form the general contractor's core competencies may assist in keeping costs under control and mitigate overall project risk. It may even grant some defense in a vis major situation.

Also, some large government contracts or contracts that impact local community development may require the primary contractor to hire a certain number of subcontracting entities from the community as part of the contract. Additionally, a business may decide to subcontract some mundane but necessary jobs to free up time and resources to attend to other profitable undertakings.

Finally, it is less expensive for a contractor to hire the services of a subcontracting firm or freelancer than it is to hire an employee since the primary contractor is not responsible for paying workers’ compensation benefits, vehicle and commercial general liability insurance, health insurance, full-time salaries, and Social Security taxes for independent contractors or subcontractors. From a management point of view, outsourcing is a variable cost that occurs only when the work is needed whereas hiring full-time employees is a fixed cost that occurs whether the work is available or not. That is called operating leverage. It is high when the fixed cost structure is high and vice versa. 

In order to be given a subcontract, a business must be in good standing with its home state stipulations, such as having an up-to-date file for its tax returns. For tax purposes, a subcontracting company is required to register with the Internal Revenue Service (IRS) to receive an Employer Identification Number (EIN). The EIN will be used by the primary contractor to report to the IRS all business income paid to the subcontracting company.

Subcontracting and Taxes

According to the IRS, subcontractors are small business owners who are responsible for the self-employment taxes that cover both Medicare and Social Security taxes. Subcontractors may qualify for certain tax deductions that can be claimed on their business expenses. These expenses have to be ordinary and necessary for the operation of a self-employed business. This means that a subcontractor would not be able to claim a deduction on an expense they would normally make without the business.

Some examples of deductions that can be claimed include home office deductions, such as rent and utilities, costs of traveling to a job, and costs of courses or certifications that directly relate to the business profession.

The IRS scrutinizes the income reported by a contractor and uses a relationship criterion to verify whether the subcontractor is indeed an independent contractor or an employee. A couple of measures used by the IRS to conclude on the relationship between both parties include determining who sets the rules, who provides the tools and materials used for the job, and who pays for business expenses.

If the primary contractor sets the rules for how the project is to be done, provides the tool needed to complete the project, and pays for any business expense incurred by the subcontractor, the IRS will treat the subcontractor as an employee. If this happens, the primary contractor will be required to pay Social Security tax and benefits.