If your small business performs federal government contracts, chances are, you’ve already calculated your small business’s compliance with the applicable limitation on subcontracting (LoS) a time or two. But whether you’re new to the LoS equation–or you’ve long since mastered that math–knowing which costs you can exclude from your calculations is vital. Indeed, such can impact everything from the accuracy of a bidder’s regulatory compliance representations and certifications to a contractor’s critical contract performance and subcontracting decisions. In fact, under current SBA affiliation regulations, LoS compliance can even provide a defense to certain contract-specific findings of affiliation. But calculating LoS compliance and determining exactly which costs to include and exclude on a given contract is not always easy or straightforward. And that’s why we so frequently get this question and break down the answer in this article.
As an initial matter, if you need a refresher on (or are brand new to) the concept of the LoS and/or how the LoS generally applies and is enforced in federal contracting, take a quick beat to go review our “Back to Basics” article on the LoS before reading any further. And since that article so effectively breaks down the LoS in plain language, I won’t go into much detail on the generalities of the LoS here. Instead, I will just give a brief big picture overview of the governing LoS regulations here.
The LoS rules are set forth both in the FAR and in SBA’s small business regulations–which are now substantively almost identical (thank goodness, after basically a decade of the two sets of rules’ conflicting terms finally being resolved by the FAR council and revisions). Specifically, FAR 52.219-14 contains the LoS clause for insertion into federal contracts. And similarly, SBA’s small business regulations on the LoS are found at 13 CFR § 125.6.
Both of these rules establish LoS applicability to small business federal contracts over the simplified acquisition threshold and all socioeconomic set-aside federal contracts. And both spell out the various limitations for services, supplies, specialty trade, and construction contracts. Further, as relevant here, less so individually–and more so in the aggregate–these two LoS rules provide an (unfortunately somewhat convoluted) list of everything contractors calculating their compliance with the LoS are allowed to exclude from such calculations. Generally, that list consists of the following: (1) for services contracts, other direct costs (provided they are not the acquisition’s principle purpose and are not provided by small businesses); (2) for supplies, construction, and specialty trade contracts, costs of materials; (2) work subcontracted to similarly situated entities (SSEs); (3) for mixed contracts, the supplies portion of contracts with services NAICS codes and the services portion of contracts with supplies NAICS codes; and (4) work performed overseas on awards under the Foreign Assistance Act of 1961 or work required to be performed by a local contractor.
(1) Other Direct Costs Not the Acquisition’s Principal Purpose & Not Provided by Small Businesses (Services Contracts).
Under the section of SBA’s LoS regulations setting the services contract subcontracting limitation, it states:
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.
(2) Costs of Materials (Supplies, Construction, Specialty Trade Contracts).
Under the sections of SBA’s LoS regulations setting the subcontracting limitations for supply, construction, and specialty trade contracts, it further states in each such section: “Cost of materials are excluded and not considered to be subcontracted.”
And though what consists of “cost of materials” may be straightforward on most contracts, just in case it isn’t so clear for others, the term is defined elsewhere in SBA’s small business regulations as follows:
Cost of materials means costs of the items purchased, handling and associated shipping costs for the purchased items (which includes raw materials), commercial off-the-shelf items (and similar common supply items or commercial products that require additional manufacturing, modification or integration to become end items), special tooling, special testing equipment, and construction equipment purchased for and required to perform on the contract. In the case of a supply contract, cost of materials includes the acquisition of services or products from outside sources following normal commercial practices within the industry.
(3) Work Subcontracted Similar Situated Entities (SSEs).
Since the FAR’s council’s updates to the FAR’s LoS regulations, both those rules and those in SBA’s LoS regulations now spell out the ability to “exclude” work subcontracted to an SSE under federal contracts. But it is actually important to note a distinction here from the other more true-to-label “exclusions” discussed in this article. Rather than actually excluding or not counting SSE subcontracted work, the contractor actually does count such work–it just counts toward the contractor’s compliance with the applicable LoS.
For example purposes, we will look at the rule for services contracts discussed in the FAR’s LoS regulations. But notably, the corresponding SBA’s LoS rule says essentially the same exact thing. The FAR rule requires the prime contractor on such contracts to agree that it “will not pay more than 50 percent of the amount paid by the Government for contract performance to subcontractors that are not similarly situated entities.” And it adds, “[a]ny work that a similarly situated entity further subcontracts will count towards the prime contractor’s 50 percent subcontract amount that cannot be exceeded.”
Also, both the FAR’s and SBA’s LoS regulations contain basically this same SSE language in the other sections providing the limitations for supplies contracts (except for those applying and subject to the nonmanufacturer rule instead), as well as those for construction and specialty trade construction contracts.
The FAR’s rule further defines an SSE, for purposes of the LoS, as
a first-tier subcontractor, including an independent contractor, that—(1) Has the same small business program status as that which qualified the prime contractor for the award (e.g., for a small business set-aside contract, any small business concern, without regard to its socioeconomic status); and (2) Is considered small for the size standard under the North American Industry Classification System (NAICS) code the prime contractor assigned to the subcontract.
And in SBA’s same definition regulations where cost of materials is defined (as referenced and linked above), it also states:
Similarly situated entity means a subcontractor that has the same small business program status as the prime contractor. This means that: For a HUBZone contract, a subcontractor that is a certified 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 SDVOSB contract, a subcontractor that is a certified SDVOSB; for a VOSB contract, a subcontractor that is a certified VOSB; for an 8(a) contract, a subcontractor that is a certified 8(a) BD Program Participant; for a WOSB or EDWOSB contract, a subcontractor that is a certified WOSB or EDWOSB. 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.
One important aspect of SSE to keep in mind though, as detailed in the blog on the subject linked above, is that to qualify as an SSE, a contractor must meet the prime contract’s socioeconomic set-aside designation and must also be considered small for the NAICS code assigned to the subcontract. There is often confusion on the later requirement, as it is not the prime contract’s NAICS code’s size that governs qualification as an SSE, it is the one assigned to the subcontract itself that the subcontractor is performing under. Sometimes, that NAICS code is different than the prime contract’s where the subcontractor’s specific work and scope of work better qualifies under a more specific or different NAICS code than the prime contract.
(4) Portion of Mixed Contract Not Represented by Contract’s Assigned NAICS Code.
SBA’s LoS regulations have an entire section dedicated to mixed contracts. There, SBA’s regulations state:
Where a contract integrates any combination of services, supplies, or construction, the contracting officer shall select the appropriate NAICS code as prescribed in § 121.402(b) of this chapter. The contracting officer’s selection of the applicable NAICS code is determinative as to which limitation on subcontracting and performance requirement applies. Based on the NAICS code selected, the relevant limitation on subcontracting requirement identified in paragraphs (a)(1) through (4) of this section will apply only to that portion of the contract award amount. In no case shall more than one limitation on subcontracting requirement apply to the same contract.
SBA’s rules even contain three examples to elucidate this point, as follows:
Example 1 to paragraph (b). 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 supply portion comprising $2,500,000, and the services portion comprising $500,000. The contracting officer appropriately assigns a manufacturing NAICS code to the requirement. The cost of material is $500,000. Thus, because the services portion of the contract and the cost of materials are excluded from consideration, the relevant amount for purposes of calculating the performance of work requirement is $2,000,000 and the prime and/or similarly situated entities must perform at least $1,000,000 and the prime contractor may not subcontract more than $1,000,000 to non-similarly situated entities.
Example 2 to paragraph (b). 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.
Example 3 to paragraph (b). A procuring activity is acquiring both services and general construction through a small business set-aside. The total value of the requirement is $10,000,000, with the construction portion comprising $8,000,000, and the services portion comprising $2,000,000. The contracting officer appropriately assigns a construction NAICS code to the requirement. The 85% limitation on subcontracting identified in paragraph (a)(3) would apply to this procurement. Because the services portion of the contract is excluded from consideration, the relevant amount for purposes of calculating the limitation on subcontracting requirement is $8,000,000. As such, the prime contractor cannot subcontract more than $6,800,000 to non-similarly situated entities, and the prime and/or similarly situated entities must perform at least $1,200,000.
But in the FAR’s LoS regulations, there is not a separate section dedicated to mixed contracts like SBA’s LoS regulations contain. Rather, those regulations just note under the services contracts section, “[w]hen a contract includes both services and supplies, the 50 percent limitation shall apply only to the service portion of the contract.” And they similarly state under the supplies contracts section, “[w]hen a contract includes both supplies and services, the 50 percent limitation shall apply only to the supply portion of the contract[.]”
(5) Overseas Work Under Foreign Assistance Act of 1961 or Subject to Local Contractor Hiring Requirements.
Finally, SBA’s LoS regulations state, “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.”
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So, as you can see here, it is not always simple to calculate a contractor’s compliance with the LoS under SBA’s rules or the FAR’s. Nor it is always easy to know exactly what to exclude from such calculations–or similarly, to count toward the prime’s compliance “bucket” or against it (i.e., as work “subcontracted” to a non-SSE). But knowing what both SBA’s and the FAR’s LoS rules say about the various items that can and should be excluded–and about SSE’s and how to count their work–can certainly help the process.
Questions about the LoS or this post–or need help calculating your own compliance or that of your team member? Email us. Need legal assistance? Call us at 785-200-8919.
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