Affiliation is a dirty word to small business federal government contractors. For good reason: it can turn a small business into a large one and destroy its eligibility for socioeconomic programs and set-aside contracts. Proactive small business contractors, therefore, routinely audit their affiliation risks and, if necessary, take actions to fracture that affiliation.
One of the ways a company might try to fracture affiliation is to sell a division or business line to a third party. Because this division is sold, the company might be tempted to assume that its corresponding revenues are not considered as part of the affiliation analysis (under the former affiliate rule).
A recent OHA decision, however, instructs that a division or line of business does not qualify under the former affiliate rule.
By way of background, affiliation exists when one company has the power to control another or a third party controls both. Determining small business eligibility, the SBA will aggregate the size of the small business with any of its affiliates. If the combined size is under the applicable size standard, the company is a small business; if it exceeds the applicable size standard, however, the small business will be found to be other-than-small.
The former affiliate rule, however, provides some relief to this potential size penalty:
The annual receipts of a former affiliate are not included if affiliation ceased before the date used for determining size. This exclusion of annual receipts of such former affiliate applies during the entire period of measurement, rather than only for the period after which affiliation ceased. However, if a concern has sold a segregable division to another business concern during the applicable period of measurement or before the date on which it self-certified as small, the annual receipts used in determining size status will continue to include the receipts of the division that was sold.
13 C.F.R. § 121.104(d) (as updated on January 6, 2019).
In MicroTechnologies, LLC d/b/a MicroTech, SBA No. SIZ-6039 (2019), the OHA considered the applicability of the former affiliate rule to the sale of a division within a company. Responding to a size protest, MicroTech argued that it was an eligible small business under the $15 million size standard because it sold certain business units and, under the former affiliate rule, the receipts from those units should be excluded from the calculation of its receipts. The Area Office, however, concluded that there was not sufficient evidence that the sale was completed, so it included the division’s receipts with MicroTech’s. As a result, MicroTech was found to be other-than-small.
MicroTech appealed the Area Office’s determination. It argued that, because it sold the division before the date of self-certification, the division’s receipts should have been excluded from the size calculation.
The OHA disagreed. First, the OHA did not fault the Area Office for questioning the validity of the division’s sale as of the date of the self-certification. Doing so, the OHA noted that the purchase agreement did not reference the sale of a division, but a contract. Therefore, there was no evidence that MicroTech actually divested itself of the division.
Regardless of whether the sale had actually taken place, the OHA disagreed that the former affiliate rule would apply. It repeated prior decisions “that a division or line of business within a concern is not a ‘former affiliate,’ and therefore cannot be excluded from the challenged firm’s receipts or employee count.”
The OHA found support for this position in a recent SBA rulemaking, which directly addressed the applicability of the former affiliate rule to the sale of a division:
Even if a division is later sold, its receipts were always part of the receipts directly received by the concern itself, and SBA believes that those receipts should remain a part of the concern’s receipts after the sale for purposes of determining the concern’s size.
Because MicroTech sold (or purported to sell) a corporate division, the former affiliate rule was not applicable. The OHA denied its appeal.
By now, astute readers are probably asking themselves, “If a division or line of business doesn’t qualify as a former affiliate, what does?” Good question. But in its rulemaking, the SBA helps explain that buying or selling a separate legal entity (as opposed to a division within a company) should be treated differently.
In practice, the SBA acknowledges that distinguishing the sale of a division from the sale of a subsidiary elevates form over practice. Still, it maintains that the distinction is important because the receipts of a division “were always part of the receipts directly received by the concern itself” even if the division is later sold; a subsidiary’s receipts, however, would accompany that subsidiary in any transaction, making it appropriate to decouple those receipts from the parent company.
Beyond being a dirty word, affiliation can be a complicated topic. If you have any questions about affiliation risks, please email us or give us a call at 785-200-8919.