I’m a government contracts lawyer these days, but when I was much younger, I was a would-be prime contractor. During my senior year of high school, I took a part-time job at the Grand Forks Herald, my hometown newspaper in North Dakota. Flush with cash (at least compared to where I’d been before), I then attempted to subcontract my household chores—things like taking out the trash and feeding the dog—to my younger brother.
My parents put the kibosh on that one, explaining that as a member of the family, I needed to personally contribute some labor to it (as a dad now, I can see where they were coming from). But imagine I had been successful, paying Pete, say, $20 weekly to toil on my behalf for the Koprince household. Could I have told the IRS, come tax season, that the money I paid Pete didn’t count toward my income, because I passed it through to him?
“Of course not,” you’re probably saying, and you are right. And, on a much larger scale, the same is true when it comes to a small government contractor’s subcontract costs. As the SBA Office of Hearings and Appeals has held, all of a company’s receipts—with very limited exclusions—count toward its size under a revenue-based SBA size standard. Just because you subcontract a portion of a government contract to another company does not mean that the money you pay your subcontractor doesn’t count toward your own receipts.
For SBA purposes, a small business’s size under a revenue-based SBA size standard is its three-year average annual receipts, calculated by adding the business’s “total income” to “cost of goods sold” as reported on the firm’s tax returns (a different formula applies if the company has not been in business three years). Although the applicable SBA regulation allows for certain limited exemptions, including an “inter-affiliate transaction” exclusion designed to prevent double counting of revenues, subcontractor costs ordinarily cannot be excluded. SBA OHA explicitly confirmed the absence of a subcontractor costs exclusion in Size Appeal of Southeastern Protective Services, Inc., SBA No. SIZ-5152 (2010).
In Southeastern Protective Services, the SBA’s Area Office held that a company exceeded the size standard under its primary NAICS code. The company filed an SBA size appeal with SBA OHA, arguing in part that the SBA should have excluded amounts paid to subcontractors when calculating the company’s size.
At first blush, the company’s argument has some appeal: after all, if a small business is awarded a $10 million prime contract, but subcontracts away $4 million of the work, the small business does not have use of the $4 million for its own purposes. Of course, the same could be said of the money the small business uses to pay its monthly telephone bill or make its lease payments, or pay virtually any other bill or cost.
SBA OHA made short work of the company’s argument, nothing that “the regulation plainly provides” that subcontractor receipts cannot be excluded. Simply because a small business spends money it receives—whether on subcontractors or otherwise—does not entitle the small business to deduct the money from its receipts.
So what could the small business in Southeastern Protective Services have done to preserve its small business status? If a small business is approaching a size ceiling, one tactic it can take to postpone the inevitable is to joint venture its prime contract work, rather than using prime/sub relationships. When the prime contractor is a joint venture, the SBA will only count against each joint venturer the proportion of the prime contract receipts that joint venturer receives, rather than the entire amount received by the joint venture.
To see how this works in practice, let’s return to the example above of a $10 million prime contract. If a small business uses a prime/sub relationship, the entire $10 million counts toward the small business’s size. But let’s say that instead of subcontracting 40% of the work, the prime and its partner enter into a joint venture, agreeing to split the work and the profits 60/40. Now, the prime contractor is only responsible, from a size perspective, for its share of the joint venture’s receipts–$6 million.
Of course, joint ventures can bring their own headaches and complications. Chief among them is the fact that, outside of the SBA’s 8(a) mentor-protégé program, it is impossible under current law for a small business to joint venture with a large company to perform a set-aside contract. But a small business can often joint venture with another small company, and the joint venture can usually subcontract to a large business. Although subcontract costs cannot be excluded from annual receipts, with a little forethought and creativity, a small business may be able to avoid (or at least postpone) hitting its size standard ceiling.
Of course, no solution is perfect. Flashing back in time, I did not propose that my brother and I form a joint venture to ensure that the household trash made it to the garbage cans. However, I am guessing my parents would have scratched their heads, said “nice try,” and sent me on my way to perform my “prime contract” at the 100% level.