Employees or subcontractors: a legal question owners treat as a cost question

The real cost of an employee

Most owners underestimate this and then overestimate it in the opposite direction. The honest number is the fully burdened hourly cost.

Take a technician at $28 per hour base wage:

• Employer payroll taxes (Social Security, Medicare, federal and state unemployment): typically 8% to 12% → about $2.80
• Workers compensation, highly variable by trade and state: $1.40 to $6.00 — use $2.50
• General liability allocation: $0.60
• Paid time off, holidays: $1.60
• Health insurance contribution, if offered: $3.20
• Vehicle, tools, phone, uniforms, software seat: $4.50
• Training and onboarding, amortized: $0.90

Fully burdened: about $44.10 per hour — roughly 1.58 times the base wage.

But that is not the number to price against. The number to price against is the cost per billable hour, because employees are paid for drive time, loading, training and gaps. At 68% billable utilization, that $44.10 becomes $64.85 per billable hour. Pricing off the base wage is how service businesses end up busy and broke.

The real cost of a subcontractor

A subcontractor at $45 an hour, or at a per-job rate, appears simpler. The visible cost is the invoice. The invisible costs are real:

• Verification burden. Certificates of insurance collected and tracked for expiration, license verification, W-9s, 1099 filing. This is administrative time, and skipping it is how a sub's uninsured injury becomes your problem.
• Quality variance. You control the result, not the method — which is the point of the relationship and also the risk.
• Availability. A sub with three other clients is not yours on the day you need them most.
• No brand continuity. The customer meets a person who is not part of your company, in a truck that is not yours.
• Warranty exposure. When something fails a year later, the customer calls you regardless of who performed the work.
• Classification risk, which is the largest and least visible cost of all.

When subcontracting genuinely makes sense

There are situations where a contractor relationship is both legally sound and commercially correct:

Specialized trades outside your core business. A remodeler using licensed electricians and plumbers is the textbook case — separate trade, separate license, separate business, project-based.

Overflow capacity in peak season, where the volume genuinely does not justify a permanent position.

Geographic edges, where a local operator with their own business serves an area you cannot route into.

Genuinely independent businesses — with their own customers, own insurance, own equipment, own pricing, and multiple clients.

What these have in common is that the worker is running a real business. When the answer to "does this person have other clients, set their own price, and use their own tools?" is no, the arrangement is fragile no matter how it is documented.

A real comparison, in numbers

A service company needs 1,800 billable hours per year covered, at $135 per billable hour of revenue.

Employee route:

• Fully burdened cost per billable hour: $64.85
• Annual cost: $116,730
• Revenue produced: $243,000
• Gross profit: $126,270 (52%)

Subcontractor route, paid 55% of collected revenue, an arrangement common in several trades:

• Payment to sub: $133,650
• Administrative and verification cost: $3,600
• Callback and warranty allocation: $4,900
• Total: $142,150
• Gross profit: $100,850 (41%)

The employee produces $25,420 more gross profit annually — but requires a business capable of keeping them busy 68% of the time, carrying them through slow weeks, and managing them properly. The subcontractor costs more per dollar of revenue and transfers the utilization risk away from you entirely.

That is the honest trade: employees are cheaper per hour when you have volume; subcontractors are cheaper per week when you do not.

Structuring a subcontractor relationship properly

Where subcontracting is appropriate, the documentation and the practice both matter — and the practice matters more:

• A written agreement defining scope, deliverable, payment terms, insurance requirements, warranty obligations and indemnification.
• Current certificates of insurance, including general liability and workers compensation, tracked for expiration. In many states, an uninsured subcontractor's injury can become the hiring business's workers compensation claim.
• License verification where the trade requires it.
• Payment by job or deliverable, not by hour worked under supervision.
• No employee-style controls: no mandatory schedule beyond project deadlines, no required uniform bearing your brand, no performance reviews, no company handbook, no directing method.
• 1099 reporting handled correctly and on time.

If the operational reality requires you to control the schedule, the method, the appearance and the exclusivity, then what you need is an employee — and structuring it otherwise is the risk, not the savings.

Moving from subcontractors to employees

Many service businesses start with subcontractors because it is the only way to take work before there is enough of it, then reach a point where employment is both safer and more profitable. That transition is where a lot of avoidable damage happens, so it is worth planning rather than improvising.

Get advice before you change anything. Converting a long-standing contractor into an employee raises questions about the prior period, and how that is handled matters. A CPA and an employment attorney should shape the sequence, not react to it.

Start with one position, not the whole crew. The first employee is where you learn payroll, workers compensation classification, overtime rules, onboarding and supervision. Doing that once, deliberately, is far cheaper than doing it four times at once.

Price the change before you make it. Rebuild your rates against the fully burdened cost per billable hour rather than assuming the existing pricing absorbs it. In most cases it does, because employee utilization improves margin — but it should be verified, not hoped for.

Expect a productivity dip. A new employee, even an experienced one, produces less for the first weeks while learning your process, your paperwork and your customers. Budget six to ten weeks before judging the decision.

Keep the bench. The subcontractors you no longer use full time remain valuable for overflow, specialized work and geographic edges — provided the relationship is genuinely independent. Ending those relationships badly removes the flexibility that made growth possible in the first place.

One further consideration that rarely appears in the cost comparison but decides the long-term shape of the business: who owns the customer relationship. An employee in a company shirt, in a company truck, following a company process, produces a customer who belongs to the business. A subcontractor working under their own brand produces a customer who may not. In trades with high repeat and referral value — anything with maintenance cycles, service plans or neighbor-to-neighbor recommendation — that difference compounds over years and is frequently worth more than the per-hour margin either model produces. It is also the reason many owners who start with subcontractors eventually move to employees for core work even when the arithmetic is close.

Five mistakes that cost the most

Choosing classification by cost. It is determined by the relationship, not by preference, and the penalties for getting it wrong can exceed years of the savings.

Pricing off the base wage. The fully burdened cost per billable hour is 2.3 times the base wage at typical utilization.

Hiring before utilization supports it. Fixed cost against unstable demand is how good companies get into trouble.

Not tracking subcontractor insurance. An expired certificate is discovered at exactly the worst moment.

Treating subs like employees. Uniforms, schedules and supervision are the exact evidence used to reclassify.

The five numbers to decide on

• Fully burdened cost per billable hour, recalculated annually.
• Billable utilization, which determines whether employment is viable at all.
• Gross margin by labor type, employee versus subcontractor, on comparable work.
• Callback rate by labor type, since warranty cost is where the difference often shows up.
• Weeks of committed backlog, the honest measure of whether you can carry a permanent position.

The strongest service businesses usually end up with both: a core of employees carrying the base load and the brand experience, and a bench of genuinely independent specialists for overflow and specialized trades. What they do not do is let a tax preference decide a legal question — because that is the one mistake in this area that does not stay small.

Frequently asked questions

Can I just decide to pay my workers as 1099 contractors?

No. Whether a worker is an employee or an independent contractor is determined by the nature of the relationship under federal and state law, not by what the parties agree to call it, and a signed agreement using the words independent contractor is not a defense. The federal common-law analysis looks at behavioral control, meaning whether you direct how the work is done rather than only the result; financial control, meaning whether the worker has their own equipment, unreimbursed expenses, opportunity for profit and loss and access to the general market; and the nature of the relationship, including whether it is open-ended and whether the work is a core permanent part of your business. Several states apply a stricter ABC test that presumes employment unless the work is outside the usual course of the hiring entity's business. Consequences of misclassification include back taxes, penalties, interest, unpaid overtime and workers compensation exposure, so the decision belongs with a CPA and an employment attorney licensed in your state.

What does an employee actually cost per hour?

Considerably more than the wage, and the number that matters is the fully burdened cost per billable hour rather than per paid hour. Starting from a $28 base wage, employer payroll taxes typically add 8% to 12%, workers compensation adds anywhere from a little over a dollar to six dollars depending on trade and state, and general liability, paid time off, any health contribution, vehicle, tools, phone, software and amortized training add several dollars more. That produces a fully burdened cost of roughly $44 per paid hour, about 1.58 times the wage. But employees are also paid for drive time, loading, training and gaps, so at 68% billable utilization the real figure is close to $65 per billable hour — about 2.3 times the base wage. Pricing off the wage instead of this number is one of the most common reasons service businesses stay busy and unprofitable.

When does subcontracting make sense for a service business?

In four situations, all of which share one feature: the worker is genuinely running their own business. Specialized trades outside your core work are the clearest case, such as a remodeler engaging licensed electricians and plumbers on a project basis. Overflow capacity in peak season, where the volume does not justify a permanent position, is the second. Geographic edges, where a local operator with their own business serves an area you cannot route into, is the third. And genuinely independent businesses with their own customers, insurance, equipment and pricing are the fourth. If the honest answer to whether the person has other clients, sets their own price and uses their own tools is no, the arrangement is fragile regardless of documentation. Where subcontracting does apply, current certificates of insurance must be collected and tracked, since in many states an uninsured subcontractor's injury can become the hiring business's claim.