Monitoring and Responding to Subcontractor Insolvency to Keep Work on Schedule

Each subcontractor performing work on the critical path presents a risk of disruption of the project schedule.  All of the prime contractor’s supervisory personnel should continuously watch for signs of subcontractor insolvency to avoid the diversion of progress payments by a subcontractor to pay non-project debts.  If a problem is detected early, the prime contractor can better assure that sub-subs and suppliers with potential lien claims receive payment out of the subcontract balance by using joint checks, this is the most direct method to prevent an insolvent subcontractor from diverting progress payments to non-project debts.

A subcontractor’s insolvency often first comes to light when sub-subs and suppliers begin calling the prime to complain they are not being paid.  At that point, the prime should take control over the insolvent subcontractor’s progress payments by making joint check payments to sub-subs and suppliers.

•  Wages, Payroll Taxes, and Union Trust Fund Contributions

An insolvent subcontractor’s weekly payrolls often are the first obligations that the prime must finance by making advances against progress payments.  If the prime has to advance the subcontractor’s net payroll, the prime also should advance funds to cover trust fund payroll taxes, which the prime can become liable to pay under IRS regulations.

•  If the sub’s payroll is substantial, the prime should require the sub to establish a separate payroll account with a third party payroll service to assure payroll taxes are union fringe benefits are paid.

• The prime also should insist on receiving wage summaries and time cards to document hours worked on the project and assure payroll taxes and union fringe benefits are properly calculated.

•  The prime also should obtain copies of all tax deposits, tax returns and union reports.

•  If withholding and social security taxes are not funded, the IRS can collect these trust fund taxes from the prime or other third parties who fund net payments

(a) Under Internal Revenue Code Sec. 3505(a), a person who directly pays wages to a subcontractor’s employees is liable for withholding taxes attributable to the wages.  Thus a prime should not make direct wage payments to a subcontractor’s employees.

(b) Under Internal Revenue Code Sec. 3505(b), a person who supplies funds to a subcontractor to pay wages, and has actual notice that the employer cannot pay required withholding taxes, can be held liable for the withholding taxes.  Thus a prime who advances funds for net payroll also should advance to the subcontractor’s payroll account additional funds needed to cover trust fund withholding taxes.

(c) As a result of this statutory liability, a prime can be held liable by the IRS to pay payroll taxes on a subcontractor’s net wages funded by the prime even if the prime has paid the entire subcontract balance to the subcontractor.  Thus a prime funding net payroll also should include in each advance for payroll the additional amount needed to cover withholding taxes attributable to the net payroll.

• Payments to Sub-Subs and Suppliers

When a subcontractor becomes insolvent, lower tier sub-subs and suppliers should be paid by joint checks.  The use of joint checks assures that the insolvent subcontractor does not divert progress payments to non-project debts.  Joint check payments also cannot be intercepted by a subcontractor’s lender and applied to outstanding credit line balances.

• The prime should first obtain from the insolvent subcontractor a certified statement which lists all unpaid project debts and all estimated future expenses required to finish the project.  This will help the prime to determine whether the remaining unpaid subcontractor balance is adequate to cover lienable claims and completion costs.

•  Before paying any lower tier creditor, the prime should determine that any required materialman’s notices have been furnished and analyze whether any other potential legal defenses exist.

(a) A prime should investigate potential legal defenses before further subcontract funds are paid out.

(b)  Failure to assert potential legal defenses can result in a claim by the lower tier creditor that the prime has waived its defenses and that the lower tier creditor was induced to continue performance by the prime’s course of dealing to fund payments due to the lower tier creditor.

• Joint check agreements should be signed for each joint check payment by the prime, subcontractor, and joint payee to confirm consent by all parties to the amount of the payment.

(a) A partial release of lien rights also should be signed by the joint payee for the amount of the joint check payment.

(b) The joint check agreement should include language stating there is no contractual relationship between the prime and the joint payee and that the prime’s agreement to make the joint check payment does not create any right by the joint payee to obtain any further payment from the prime.

(c) The prime also should avoid making any verbal or written communications to the lower tier creditor which may be construed as a guarantee of payment of all further amounts due under the sub-subcontractor, supplier’s purchase order.

(d) It is generally not advisable for a prime to make a direct payment to a lower tier creditor without an agreement signed by the subcontractor.  If a subcontractor will not agree to joint check payments, it is preferable to have a private owner or a public works surety pay the lower tier creditor and take an assignment of the creditor’s lien rights.

Monitor progress of work.

A general should confirm on a regular (if not daily) basis that work by a sub is being done on schedule. Poor productivity raises a red flag about possible management or financial problems.

•  Record keeping and field communication – The general should keep accurate records of deliveries of materials to the sub to confirm proper work progress and to check subsequent progress billings. The general also should note onsite workers to confirm skill levels and work force. This also will protect against subsequent overstated claims for materials and labor.

•  Subcontractor over-billings – To protect against a subsequent default, approved progress payments should not exceed the value of the actual percentage of work completed by the sub.

•  Communications with sub-subs and suppliers – Onsite supervisors should be alert to potential problems. Unhappy sub-subs and suppliers may disclose slow payment and poor subcontract administration. If a sub appears to be falling behind on payments to lower-tier creditors, obtain a current list of all accounts payable for the project.

By taking these steps, the general can detect problems and take corrective action while the general still retains sufficient subcontract balance to pay the sub’s lower tier creditors.  Requiring major subcontractors to post payment/performance bonds also will provide further protection against a catastrophic default.