Limitations on Subcontracting for Service Contractors: Compliance in Five Steps
During my years as a government contracts attorney, few subjects have caused more confusion for my clients than the FAR and SBA rules limiting subcontracting by small business prime contractors. So, in this post, I’m providing a five-step guide for service contractors on compliance with the SBA’s limitations on subcontracting in 13 C.F.R. 125.6.
While five steps may sound like a lot, three of those steps often don’t apply. In many cases, compliance is really a two-step process. Not bad! A couple of notes before we get started. First, this post covers compliance with 13 C.F.R. 125.6—not the FAR, DFARS, or any other regulation governing subcontracting limits. The limitations on subcontracting have been in a state of flux since 2013, when Congress made significant changes to the underlying statute, the Small Business Act. The SBA regulation is “correct,” in that it implements the Small Business Act, but as of this writing, the FAR has yet to catch up (although a proposed rule to do that is in the works). Bottom line: be sure you know which limitation on subcontracting applies to each of your contracts; if you’re unsure, ask your Contracting Officer. Second, while I’m an attorney by trade, this post is for your educational use only. As the disclaimer below reiterates, this post is not legal advice. YMMV*, as the Internet sometimes says. If you have questions about how these rules apply to your specific circumstances, you should consult with a government contracts attorney. With those caveats in mind, let’s dive into the five steps to compliance.
Step # 1 – Determine Maximum Subcontracting Percentage
A small business’s subcontracting on a federal set-aside contract is capped at a certain amount (unless the small business uses similarly situated entities, or “SSEs,” as we’ll discuss in Step #3). But that amount differs based on whether the prime contract is classified as general construction, specialty trade construction, manufacturing, or services.
For service contracts, the maximum subcontracting percentage is 50%. But construction contracts are subject to higher maximum subcontracting percentages, and manufacturing contracts allow prime contractors to comply using a special alternate method called the nonmanufacturer rule.
So, before assuming that the 50% rule applies, it’s important to double-check that the prime contract has been classified as a services contract.
Fortunately, that’s usually pretty darn easy. The Contracting Officer must designate a North American Industry Classification System or “NAICS” code for each prime contract. The NAICS code describes the principal purpose of the contract. The NAICS code can sometimes be found on the contract’s cover sheet (for example, contracts using Standard Form 1447 require the NAICS code to be entered in Box 8). The contract’s NAICS code should also be specified in the information box on the right-hand side of the acquisition’s listing.
Services contracts often begin with the digits “54.” This is the NAICS sector that includes contracts for “professional, scientific, and technical services.” For example, NAICS code 541310 encompasses architectural services. But Contracting Officers often assign service contracts NAICS codes from several other NAICS sectors, such as 53, 56, 61, and 62. If you’re uncertain how your prime contract is classified, you can review the NAICS Manual for detailed descriptions of each NAICS code.
Step #2 – Understand and Apply the Formula
Now you’ve confirmed that you’re performing a services contract, subject to the 50% limitation. But 50% of what?
Here’s how 13 C.F.R. 125.6 defines the formula used to calculate the appropriate percentage:
(1) In the case of a contract for services (except construction), it will not pay more than 50% of the amount paid by the government to it [sic] to firms that are not similarly situated. Any work that a similarly situated subcontractor further subcontracts will count towards the 50% subcontract amount that cannot be exceeded. Other direct costs may be excluded to the extent they are not the principal purpose of the acquisition and small business concerns do not provide the service, such as airline travel, work performed by a transportation or disposal entity under a contract assigned the environmental remediation NAICS code (562910), cloud computing services, or mass media purchases. In addition, work performed overseas on awards made pursuant to the Foreign Assistance Act of 1961 or work required to be performed by a local contractor, is excluded.
If you’ve grown accustomed to the outdated FAR formula, you may be scratching your head. Isn’t the percentage based on labor costs?
Not anymore—at least not under 13 C.F.R. 125.6 and pending FAR revision.
For many years, the FAR and SBA regulations prevented the prime contractor from subcontracting more than 50% of the “cost of the contract incurred for personnel.” This formula proved very difficult to use. To determine the total personnel costs incurred under the contract, the prime contractor needed a full breakdown of costs—not only its own costs but its subcontractors’ costs. Understandably, many subcontractors were hesitant (or outright refused) to provide that information, particularly when the subcontract was awarded on a firm, fixed-price basis. This left many prime contractors effectively unable to verify compliance.
When Congress amended the underlying statute in 2013, it simplified things. In most cases, for service contracts, compliance is now based simply on the total amount paid by the government—regardless of how the prime contractor spent that money. As I told clients back when I was practicing law, the formula is essentially “money in versus money out.”
An example may help. Let’s assume you’re an architecture firm, and you’ve been awarded a small business set-aside contract classified with NAICS code 541310. You want to award a major subcontract to a large engineering firm. How much can you subcontract?
Start by using the total amount paid by the government to you, the prime contractor. For example, let’s assume the government will pay you the nice, round sum of $1 million.
Next, you simply apply 50% to that total. Here, that leaves us with $500,000. That’s your cap—the maximum you can subcontract to anyone except SSEs. Since you have no similarly situated subcontractors, you are capped at $500,000 in subcontracting. You will need to self-perform at least $500,000 of the work. One final note: in my experience, a large majority of service contractors believe that they are required to self-perform 51%, not 50%. This is not, and never has been, the requirement. That said, there is absolutely nothing wrong with treating 51% as your self-performance floor. Doing so builds in a little margin of error to help ensure compliance.
Step # 3 – Address “No Small Business Subcontractor” Services (If Applicable)
You’ll notice I said that “in most cases,” the limitation is a simple “money in versus money out” calculation. But in a few cases, the SBA allows certain subcontractor’s costs to be excluded from the calculation. One of those cases occurs when particular subcontracted services aren’t provided by small businesses, meaning that you have no choice but to subcontract with a large company. In such a case, the SBA will allow an exception when two factors are met.
First, the excluded costs cannot be the principal purpose of the acquisition. Second, you must be able to demonstrate that small businesses “do not provide the service.” The SBA offers four examples of such services, such as airline travel. But the SBA has clarified that these are only examples and not the entire universe of excluded services. SBA also allows the exclusion of “work performed overseas on awards made pursuant to the Foreign Assistance Act of 1961 or work required to be performed by a local contractor.”
If you think a certain subcontractor’s costs should be excluded, you should compare the subcontractor’s scope of work to the principal purpose of the acquisition, which is reflected by the Contracting Officer’s assigned NAICS code. If, for example, the Contracting Officer assigns NAICS code 541611 (Administrative Management and General Management Consulting Services), air travel wouldn’t be the principal purpose of the acquisition, even if providing those consulting services required significant travel.
When subcontractor costs are excluded, you simply subcontract those costs from the total before applying the 50% formula. For example, let’s say that you win a $1 million contract under NAICS code 541611 and will spend $100,000 on airfare. Subtract $100,000 from $1 million, to arrive at $900,000. Then apply 50% to that total to arrive at a non-SSE subcontracting cap of $450,000.
Step # 4 – Address Mixed Contracts (If Applicable)
The “50% of the amount paid” has one more exception: if the prime contract is a so-called “mixed” contract, a portion of the amount paid is excluded from consideration.
A mixed contract is one that “combines services and supplies.” When the government buys services and supplies under the same prime contract, the Contracting Officer selects a NAICS code reflecting the predominant purpose of the contract. If the Contracting Officer picks a services code, the 50% formula applies, but only to the services portion of the contract. (If the Contracting Officer selects a manufacturing NAICS code, the limitations on subcontracting for manufacturing apply. That discussion is outside the scope of this article).
The SBA kindly provides an example right in the regulation itself:
A procuring agency is acquiring both services and supplies through a small business set-aside. The total value of the requirement is $3,000,000, with the services portion comprising $2,500,000, and the supply portion comprising $500,000. The contracting officer appropriately assigns a services NAICS code to the requirement. Thus, because the supply portion of the contract is excluded from consideration, the relevant amount for purposes of calculating the performance of work requirement is $2,500,000 and the prime and/or similarly situated entities must perform at least $1,250,000 and the prime contractor may not subcontract more than $1,250,000 to non-similarly situated entities.
As the example demonstrates, if you are awarded a mixed contract designated with a services NAICS code, you simply exclude the supply portion of the contract before applying the 50% formula.
Step # 5 – Address Similarly Situated Subcontractors
The old SBA regulations required that a small business self-perform a certain percentage of the prime contract. But, from a policy standpoint, it makes little sense to penalize small businesses for subcontracting to other small businesses. So, the updated Small Business Act and current SBA regulations call for work performed by SSEs to be excluded from the calculation.
Again, remember that this post discusses 13 C.F.R. 125.6. In the coming months, the FAR will be updated to conform with the SBA’s regulations, but the outdated FAR provisions on the books, as of this writing, do not always allow for the exclusion of work performed by SSEs. Be careful.
With that in mind, what the heck is an SSE, anyway? Let’s hop back over to 13 C.F.R. 125.1, which says:
Similarly situated entity is a subcontractor that has the same small business program status as the prime contractor. This means that: For a HUBZone requirement, a subcontractor that is a qualified HUBZone small business concern; for a small business set-aside, partial set-aside, or reserve a subcontractor that is a small business concern; for a SDVO small business requirement, a subcontractor that is a self-certified SDVO SBC; for an 8(a) requirement, a subcontractor that is an 8(a) certified Program Participant; for a WOSB or EDWOSB contract, a subcontractor that has complied with the requirements of part 127. In addition to sharing the same small business program status as the prime contractor, a similarly situated entity must also be small for the NAICS code that the prime contractor assigned to the subcontract the subcontractor will perform.
It’s a long definition, but there are two components.
First, an SSE must have the socioeconomic status required by the prime contract. As the regulation says, this means, for example, that if the contract requires 8(a) status, a subcontractor must be 8(a)-certified to qualify as an SSE.
To determine a potential subcontractor’s socioeconomic status, you can usually check SAM. For VA SDVOSB and VOSB contracts, you should look at the VetBiz database. While not required, it’s often wise to adopt a belt-and-suspenders approach by requiring the potential subcontractor to certify, in its written subcontract, that it has the appropriate socioeconomic designation.
Second, an SSE must be “small for the NAICS code that the prime contractor assigned to the subcontract the subcontractor will perform.” In my experience, this second piece often (to use the official legal terminology) blows people’s minds. Most contractors believe that the NAICS code assigned to the prime contract—and the associated size standard— automatically flows down to subcontractors. Not so.
When it comes to subcontracts, the prime decides the appropriate NAICS code based on the principal purpose of the subcontract. (If you’re not sure what NAICS code fits best, you should review the definitions in the NAICS Manual). Each NAICS code, in turn, carries a single size standard designated by the SBA. Those size standards can be found in the SBA’s regulations at 13 C.F.R. 121.201.
Service contractors must be careful because the size standard for a subcontractor may be larger or smaller than the size standard assigned to the prime contract.
Let’s go back to our architect—the one awarded a $1 million small business set-aside contract under NAICS code 541310. That NAICS code carries an $8 million size standard. But if the architect wants to subcontract the engineering work, the appropriate NAICS code for the subcontract is 541330 (Engineering Services). NAICS code 541330 carries a $16.5 million size standard. This means that our architect could award a subcontract to an engineering firm with $15 million in average annual receipts and count that subcontract as an award to an SSE—even though the subcontractor is far too large to have been awarded the prime contract.
In the architect’s case, the rule is helpful because it expands the universe of potential subcontractors that qualify for SSE status. But it’s easy to see that the rule can also work the other way. Let’s assume that the prime contract was assigned NAICS code 541330, and the prime contractor wants to subcontract the architectural work. The appropriate NAICS code for the subcontract is 541310, with its $8 million size standard. In this case, a $9 million subcontractor would not qualify as an SSE, even though the subcontractor falls well below the prime contract’s size standard.
You can often find potential subcontractors’ size certifications in SAM, but you should also require the subcontractor to certify in writing that it is small under the appropriate NAICS code and size standard. In my experience, many primes forego the certification altogether or simply ask the subcontractor to certify itself as small without answering the all-important question: “small compared to what?” These oversights could lead to significant problems if the SBA or Contracting Officer audits your compliance.
Assuming you have one or more SSEs, the SBA’s regulations say that the work they perform is “not considered subcontracted” for purposes of determining compliance. While the regulation itself is a little fuzzy about whether SSE work is simply excluded (like the supply portion of a mixed contract) or counts as though it were performed by the prime, the FAR Council’s proposed rule makes clear that “Work performed by similarly situated entities is counted as if it were performed by the prime contractor in determining compliance with the limitations on subcontracting.”
So, let’s go back to our architectural firm with the $1 million prime contract. The total self-performance number is $500,000. But let’s say that the prime contractor subcontracts $300,000 to an SSE engineering firm. That work counts as though the prime performed it, leaving the prime with a self-performance requirement of only $200,000.
One final but important note. The work performed by an SSE only counts toward the prime’s workshare if the SSE performs that work with its own employees. Any work the SSE sub-subcontracts to anyone else—regardless of whether that lower-tier entity is itself an SSE—doesn’t qualify.
Some Final Thoughts
The limitations on subcontracting for service contracts can be confusing, and the penalties for non-compliance can be harsh. By following these four steps (and seeking outside help, including legal advice, if appropriate), small government contractors can help ensure that they stay on the right side of these important rules.
*Your Mileage May Vary.
Disclaimer:
Nothing contained in this article is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This article is intended for educational and information purposes only. Although the author strives to present accurate information, the information provided in this article is not guaranteed to be accurate, complete, or up-to-date. Reading this article does not establish an attorney-client relationship with the author.
About the Author
