Technically, anyone hired to perform work or services under a contract is called a contractor (with a small c). But on a construction project, there’s a big difference between a Contractor and a subcontractor. It’s important to understand how these roles are unique, how they work together to effectively complete a project, and the payment challenges each of them face.
Most large projects are actually a collection of different, smaller projects, each with its own construction agreement and terms. There are a ton of moving parts, which makes coordination and communication critical. Each particular part of a project requires a certain skill set, and they require numerous different trade specialties and participants to finish the relevant tasks.
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What is a Contractor?
In construction, a Contractor is a company hired by the homeowner or property owner directly. This party is often called the Prime Contractor, Original Contractor, or General Contractor (GC), but most contracts simply refer to the “Contractor.”
Sometimes, a Contractor completes all of the work on a project with their own crew. But on a typical construction project, the Contractor will hire subcontractors to perform specialized tasks under a subcontract. Contractors also hire suppliers to provide materials necessary in the construction.
What is a Subcontractor?
A subcontractor is anyone who provides labor or services on a construction project that was hired by someone other than the owner. (Of course, subcontractors are contractors too, just the lowercase kind.)
On a residential construction project, common subcontractors are carpenters, plumbers, or electricians. They are often self-employed or small business owners that specialize in a particular niche in the construction industry.
They perform a portion of the work that contributes to the overall project. As a result, they often help reduce project risks, because they bring expertise that the General Contractor may not have.
However, subcontractors aren’t defined by their business size. Subcontracting can be done by an individual who installs windows, or a multi-national corporation that does commercial or industrial electrical work.
What ultimately defines a sub is that they sign a subcontractor agreement. A subcontractor agreement divvies up the scope of work in the original contract and reassigns part of that existing contract from the Prime Contractor to a subcontractor.
Similarities between Contractors & Subcontractors
In some ways, contractors and subs are very similar in construction. They all contribute work to a property improvement using their own equipment and tools.
From the perspective of a property owner, a contractor and subcontractor simply refers to a person or company who is not an employee. This designation gives the owner less responsibility to the Internal Revenue Service (IRS) under employment laws and tax laws.
The owner doesn’t need to provide health insurance or other benefits to the contractor or sub, and they don’t have to bother with payroll taxes or some other legal requirements.
Contractors and subcontractors are entirely separate legal entities that collaborate to accomplish a project.
On most construction jobs, GCs and subs will both require a proper license to perform their work. And they will have to run their businesses independently from the property owner.
As a result, both contractors and subcontractors need to provide their own liability insurance. If they have employees, they manage their own health insurance and other benefits.
Differences between Contractors & Subcontractors
Generally, the key distinction between contractors and subcontractors comes down to the contractual relationship. Prime Contractors have “privity of contract” with the owner.
That sounds like a fancy legal term, but it’s pretty simple. In construction, having privity of contract simply means that the person was hired by the property owner.
Subs are often hired by the prime contractor, although a subcontractor can also hire another subcontractor.
But this distinction fails to fully define the roles of each — so, let’s dig deeper!
Common Characteristics of General Contractors
A prime or general contractor is the keystone on any given construction project. The prime is the general of your construction force.
Their main function is to seek out contracts and to provide the necessary coordination and oversight to complete the project on budget and on time.
This means they will focus mostly on the customer/owner and bigger picture issues. They will manage the day to day oversight, coordinate vendors and subs, and act as the central point of communication between parties on a project.
It’s worth pointing out a few vernacular issues, though. A “prime” or “direct” contractor is a contractor that has a contract directly with the property owner.
A “general” contractor refers to a contractor in charge of hiring subcontractors and coordinating their work, keeping the job on track for timely and on-budget completion.
Often, these terms are interchangeable, meaning, on many projects, the general contractor is hired by the owner, so they’ll also be considered a “prime” or “direct” contractor.
However, it’s also possible that a general contractor could be hired by a developer, a construction manager, an architect, or some other person on a project.
Regardless, one of the most valuable tools for any successful general (or prime/direct) contractor is their network of reliable subcontractors. Back in the day, many contractors were a one-stop-shop. They handled every aspect of a project, mostly in-house.
As time has gone on, the construction industry has moved more towards specialization. Back then, one contractor may have performed a variety of different functions and taken care of the project all by themselves, top to bottom.
Today, these contractors more commonly hire others to perform specialized work. Which is where our subcontractors come into play.
Common Characteristics of Subcontractors
If the GC is the general of the project, subcontractors are the soldiers. The subs are the ones in the trenches, getting the small objectives accomplished for the larger scale plan of attack.
A sub can be a company or an individual. But keep in mind that as a sub, you are not an employee. Rather, you typically are an independent contractor (or you’re employed by one).
That’s really important for labor and tax law purposes, among other reasons. But even though you are not an employee, the GC does retain certain rights based on their relationship with the subcontractor. In California and Maryland, the GC even has the right to inspect the books of their subcontractors.
Compared to the general contractor, a subcontractor’s work is more narrowly focused. These are your specialists, highly trained in a certain trade such as drywall, plumbing, HVAC, roofing, etc.
Due to their expertise in a specific field, they are especially good at product and service delivery. They know exactly what materials they need, where to get them and the time required to accomplish their task, not to mention access to potentially expensive tools or equipment.
This helps GCs mitigate risks and reduce the overall costs of the project.
Why it matters: Contractors and subs get paid differently
The division between contractors, subcontractors, sub-subcontractors, and suppliers all matters a lot. First, let’s look at how the different levels of contractors creates payment problems on construction projects. Then, we’ll look at how it affects contractors and subcontractors differently. Finally, we’ll move to some of the tools introduced to ease these payment problems.
Contractors’ Payment Challenges
One of the most common headaches contractors have to manage on the road to payment is the collection of lien waivers. In order for the contractor to receive payment, often, the property owner (or lender) will require the general contractor to collect lien waivers from all of the subs and suppliers who have done work on the project.
Typically, payment chain visibility will get pretty murky after the first-tier subcontractors. This makes sense – when a subcontractor hires a supplier or another subcontractor, the contractor might not necessarily know. Still, those lower tiered parties will have the right to file a lien.
In order for payments to be released, the contractor will often need to collect lien waivers from everyone along the payment chain. Even after everyone has been identified and contacted, gathering paperwork from that many different sources can be like herding cats.
Another big one is retainage. As we’ll discuss in a second, retainage is typically a bigger obstacle for lower-tiered parties than it is for a prime or general contractor. However, retainage is still regularly withheld from contractors. When an owner has their hands on the retainage funds, a contractor might have to bend over backward to collect it.
It’s common for owners to request changes and potentially even discounts in exchange for releasing all or a portion of retainage. As construction margins grow slimmer, retainage becomes a bigger problem.
Already, it’s not that uncommon for retainage to represent the entire profit margin on a job (or at least a significant margin of it). That means contractors run the risk of breaking even or even losing money on the job if their customer plays games with retainage funds.
Subcontractors’ Payment Challenges
For a sub or a supplier, when funds are making their way through the payment chain (much more on the payment chain below), it can feel like a game of Plinko. Whether or not payment actually makes it all the way down into their hands might be a matter of luck. Unfortunately, these challenges can cause a lot of strain on a subcontractor’s cash flow.
The higher the party is in the payment chain, the closer they are to the money. In order for a subcontractor or supplier to receive payment, the owner has to make good on their promise to pay the contractor, then that contractor has to make payment too.
Adding any other links to the payment chain only complicates things further. If there’s a dispute between any two parties higher on the chain, or if the owner decides work isn’t up to snuff, a sub or supplier can be left empty-handed, feeling helpless.
The Likelihood of Slow Payment
What’s more, even where payments are winding their way through the payment chain, there’s the issue of slow payment. Construction is notorious for payments moving at a glacial pace.
It’s not uncommon at all for a sub to go a month, 45 days, even 60 days before receiving payment for their work. This credit-heavy system places an excruciating burden on a subcontractor or supplier.
In order to keep working, often, the project costs will come out of pocket until payday. In an industry with razor-thin margins, that creates a LOT of risk.
The Threat of Non-Payment
Unfortunately, the threat of non-payment in the construction industry is all too real. And the further down the payment chain you go, the greater the risk of non-payment becomes.
Because the subs are among the furthest away from the money that originates at the top of the payment chain.
And since the money has to flow down through the entire payment chain, passing through each participant and tier on its way to pay the subs, that just presents more of an opportunity for things to go wrong, whether it’s misappropriation of project funds, missing or late paperwork (such as preliminary notices or lien waivers), or something else.
Subs Have to Wrangle Retainage, too
Finally, there’s the issue of retainage. A sub or supplier’s customer can withhold retainage as a sort-of insurance policy throughout the life of the project. This retained amount usually represents 5-10% of the amount owed to the sub for their work.
Again, construction is an industry where margins are tight. So, taking 5-10% off the top can leave a sub or supplier breaking even throughout the life of the job, waiting for their profit margin to come in the form of released retainage.
Worse yet, it’s not all that uncommon for a higher-tiered party to abuse the retainage process. Some bad actors will drag their feet on releasing retainage, and some will force subs to accept less than what they’re owed.
In either situation, manipulating retainage that was originally properly withheld is a battle many subs and suppliers face that contractors typically won’t.
The “Payment Chain” problem
It’s impossible to tackle the construction industry’s payment problems without first understanding why the very nature of construction projects led to the issues that have made payment in construction historically so complex and difficult.
Each party on a construction project is not only interconnected through the work done on the project jobsite but also through the financial aspects of the project.
Everyone, from the lender and GC to the sub-sub’s suppliers, is intertwined in an intricate flow of payment and security rights. We call this the “payment chain.”
Read more: The Payment Chain Explained
A prime or general contractor is typically its own separate entity. That is, the contractor is a business that must look out for its own interests. That’s not earth-shattering, but it is an important foundational piece here.
Because then you’ll have all of the subcontractors, and they are also their own separate entities who are, first and foremost, looking out for their own interests.
This continues down the line of the payment chain to the sub-subcontractors, suppliers, laborers, etc.
Each party on a construction project must look out for themselves when it comes to payment. At the same time, in order for everyone to do their job and get paid, everyone must cooperate.
Now, the contractor receives payment first from the owner. That contractor is responsible for making sure money gets where it needs to go for those parties down the chain.
At the same time, the contractor wants to be sure that all work has been satisfactorily completed before they make payment, and they want to limit any potential liabilities (more on that below). That’s perfectly reasonable!
However, some parties take it overboard. That’s where payment has the potential for becoming a weapon.
Because a contractor holds the money, potentially, that contractor can force other parties to do things they might not want to do – like doing change orders on the fly or taking a discount.
But it’s not just contractors who can do this. No, any party who holds the payment due to another party might resort to bullying others on the payment chain (and often, without much consequence).
That’s why our legislators and courts have come to the aid of lower-tiered parties.
Tools to Help Contractors and Subcontractors Get Paid
With the risk of nonpayment also comes some tools that can help keep that risk at bay. We’re talking about mechanics liens, bond claims, prompt payment rules, and last but not least, retainage laws. We could talk about any one of these topics for days (and at times, we probably have). Instead, here are some articles discussing each tool.
- Ultimate Guide to Getting Paid in Construction
- How to File a Lien – Overview for Any State
- The Basics Of The Payment Bond Claim Process
- How To Make A Claim Under Prompt Payment Laws
There are plenty of other options, too. The takeaway here is that no one on the payment chain is helpless. If payment hasn’t been made, chances are, the unpaid party can take some action to enforce payment. It only takes one lien or one lawsuit to put an entire project on the brink of disaster.
That’s true even for contractors, subs, and suppliers that don’t have a dog in the fight. These disputes have a ripple effect that can affect a job top to bottom and can even spread issues onto other job sites.
Thus, keeping a project free and clear of payment disputes should be the top priority for everyone along the payment chain – including both contractors and subcontractors. That’s where collaboration comes into play.
To Overcome Payment Challenges, Contractors and Subcontractors Must Collaborate
The tools listed above can be very helpful when payment disputes pop up. But they’re all supposed to be fall-back options. There are plenty of opportunities to keep issues from arising and to save contractors, subs, and suppliers from the headaches, time, and money it could cost to force someone else’s hand. The easiest (and cheapest) way to make sure you don’t find yourself in a construction payment dispute in the first place.
While each party along the payment chain will have their own interests, generally, everyone wants the same thing: to do their job, get paid, (briefly) admire what they built, then move on to the next job site. Since everyone has a common goal, getting the details in line shouldn’t be all that hard.
We’ve found that one of the best things contractors and subcontractors can do to collaborate and keep the project going smoothly is to regularly communicate early and often, and to remain transparent throughout the job.
By setting clear expectations from the start (and truly communicating them), fewer issues will pop up throughout the life of the job. By regularly checking in and giving status reports, subcontractors can be sure that their customer understands how the job is progressing.
After all – one of the biggest reasons for payment disputes is late-notice change orders or disputes over project specs. If a subcontractor and their customer are in regular communication, these things are less prone to occur.