Should You Be Paying Subcontractors Directly?

As everyone who works in the construction industry will be well aware, making payments is an important yet often complicated process.

The industry relies heavily on subcontractors to complete projects efficiently, and whether you’re a contractor, developer or project manager, one crucial decision is how to pay these people.

Since the 1970s, the majority of payments to all in the construction sector have gone through the Construction Industry Scheme, or CIS. Created as a way to ensure payments remain transparent and the right amount of tax is always paid, one question that people often ask is whether the scheme needs to be used or whether payments can be made directly to subcontractors.

At Contractwise, we’re payroll audit experts, protecting contractors and subcontractors, ensuring CIS compliance and removing the risk of HMRC reclassification.

In this article, Contractwise will explore the topic of paying subcontractors directly, explaining the advantages, risks and why using the Construction Industry Scheme is often the best solution.

Ways of Paying Subcontractors

No matter how you’re planning to pay your subcontractors, there are different ways they may charge for their work. It is up to you to decide on this method before any work is carried out and the most common methods include:

• Hourly rate: Many subcontractors are paid based on the number of hours worked. This is particularly common in jobs where the duration of the work is uncertain, such as maintenance, repairs or ongoing construction. This method means it is easy to track working hours and is suitable for tasks with a defined scope. However, it can lead to disputes over the number of hours worked.

• Payment by project: Some subcontractors are paid per project rather than hourly. In this arrangement, a fixed price will be agreed upon before the work starts, based on estimated labour and material costs. This option proves certainty for both parties, but if the project takes longer than expected subcontractors may not be fairly paid.

Other arrangements include retainer agreements, milestone payments and percentage of project cost payments.

Should You Be Paying Subcontractors Directly?

How you pay your subcontractors is completely up to you. However, while it may seem more straightforward to pay subcontractors directly, it can actually create more problems down the line with tax compliance, cash flow management and administrative tasks.

Benefits Of Paying Subcontractors Directly

If managed properly, there are some benefits to paying subcontractors directly:

• Simplicity: Direct payments can be a quick and easy way to settle invoices, particularly for short-term projects.

• Control: You have full oversight of a subcontractor’s payment schedule and can ensure timely payments.

• Negotiation flexibility: Direct payments allow you to more freely negotiate payment terms that suit both parties.

• Avoid third-party fees: You won’t have to pay fees to payroll companies or intermediaries.

The Risks of Paying Subcontractors Directly

While there may be some benefits to paying a subcontractor directly, this option comes with a whole host of risks that can create significant legal and financial problems.

• Tax and HMRC compliance issues: If you fail to deduct the correct tax and National Insurance contributions, HMRC will impose penalties. Furthermore, the classification of workers (subcontractors vs employees) can also lead to liabilities.

• Cash flow challenges: Paying subcontractors directly can create cash flow issues if payments are not aligned.

• Inconsistent payment records: Without a proper system, tracking payments and reconciling accounts becomes difficult, increasing the risk of errors.

• Lack of legal protection - If disputes arise over work quality or non-payment, having a structured payroll system can provide you with additional security.

For these reasons and many more, using the Construction Industry Scheme is the best way to make subcontractor payments. Those who don’t face the risk of HMRC reclassifying subcontractors as employees as well as the fines and financial liabilities.

If just one subcontractor is reclassified as an employee with an average weekly pay of £1,000, the liability would surpass £9,500 in a year. For a group of 15 self-employed subbies, this liability would escalate to over £136,000. These amounts exclude HMRC fines, unpaid interest charges, or the legal costs associated with challenging HMRC.

Paying Subcontractors through the Construction Industry Scheme (CIS)

The Construction Industry Scheme (CIS) is a government initiative that ensures subcontractors in the construction sector pay the correct taxes. It is one of the best ways to manage subcontractor payments efficiently and legally.

The CIS process works as follows:

Register As A Contractor

If you’re someone who hires subcontractors to carry out construction work, it is mandatory for you to register with CIS no matter how you plan to make payments. Subcontractors can also register but it’s not mandatory. However, those who don’t register will face a higher tax deduction rate.

Verify Subcontractors

Before making any payments, you must verify each subcontractor with HMRC. HMRC will then confirm whether they are registered and inform you of the correct tax deduction rate:

• 20% for registered subcontractors

• 30% for unregistered subcontractors

• 0% (gross payment status) for those who meet certain criteria.

Deduct The Correct Tax

Based on HMRC’s verification, you must deduct 20% or 30% from the payment before paying the subcontractor. These deductions must be submitted to HMRC as part of your monthly CIS returns.

File Monthly CIS Returns

Contractors must all file a monthly CIS return that details all payments and deductions. Failure to do so will result in penalties from HMRC.

Provide Payment and Deduction Statements

Contractors must issue payment and deduction statements to subcontractors so they can claim deductions in their tax returns.

End-of-year Tax Reconciliation

Subcontractors can claim back any overpaid tax when they file their self-assessment returns at the end of the financial year.

Using CIS to pay subcontractors is the best choice for a whole host of reasons:

• Ensures tax compliance: Reduces the risk of penalties and fines from HMRC.

• Streamlines payroll management: Keeps payment records organised and simplifies tax filing.

• Reduces cash flow risks: Helps subcontractors manage their tax obligations throughout the year.

• Protects contractors: Demonstrates compliance with tax laws, reducing the risk of being held liable for unpaid subcontractor taxes.

While paying subcontractors directly may seem convenient, it comes with significant risks. The Construction Industry Scheme provides a structured and legally compliant way to handle these payments, and Contractwise is here to help make the process as easy as possible. Contact our team today to learn more about our range of services.