Limitations On Subcontracting: Important New SBA Rule Takes Effect June 30, 2016

The SBA has issued a final rule implementing the changes to the limitations on subcontracting enacted by Congress in the 2013 National Defense Authorization Act.

The SBA’s final rule takes effect June 30, 2016–and will significantly change the way the limitations on subcontracting are calculated and enforced moving forward.

The SBA’s final rule makes a number of important changes regarding the limitations on subcontracting.  Below are the highlights.

Similarly Situated Entities 

First, as directed by Congress, the SBA’s regulations will allow prime contractors to take credit for the work performed by “similarly situated” subcontractors.  The SBA explains that the regulation “creates a shift from the concept of a required percentage of work to be performed by a prime contractor to the concept of limiting a percentage of the award amount to be spent on subcontractors.”  The SBA continues:

[T]he NDAA prohibits subcontracting beyond a certain specified amount for any small business set-aside, 8(a), SDVO small business, HUBZone, or WOSB/EDWOSB contract. Section 1651(b) of the NDAA creates an exclusion from the limitations on subcontracting for “similarly situated entities.” In effect, the NDAA deems any work done by a similarly situated entity not to constitute “subcontracting” for purposes of determining compliance with the applicable limitation on subcontracting. A similarly situated entity is a small business subcontractor that is a participant of the same small business program that the prime contractor is a certified participant and which qualifies the prime contractor to receive the award. Subcontracts between a small business prime contractor and a similarly situated entity subcontractor are excluded from the limitations on subcontracting calculation because it does not further the goals of SBA’s government contracting and business development programs to penalize small business prime contract recipients that benefit the same small business program participants through subcontract awards.

The SBA recognizes that simply looking at whether a subcontractor is “similarly situated” could lead to potential problems because “[i]f all that was looked at was the first tier subcontract, that first tier subcontractor could in turn pass all of its performance on to a large or otherwise not similarly situated entity through a second subcontract.”  The SBA explains how it will address these concerns:

SBA will apply the limitations on subcontracting collectively to the prime and any similarly situated first tier subcontractor, and any work performed by a similarly situated first tier subcontractor will count toward compliance with the applicable limitation on subcontracting. Any work that a similarly situated first tier subcontractor subcontracts, to any entity, will count as subcontracted to a non-similarly situated entity for purposes of determining whether the prime/sub team performed the required amount of work. In other words, work that is not performed by the employees of the prime contractor or employees of first tier similarly situated subcontractors will count as subcontracts performed by non-similarly situated concerns.

As you may recall, the SBA’s proposed rule set forth what I began calling the “mandatory teaming agreement” requirement.  In its proposed rule, the SBA put forth the suggestion that, in order to take advantage of the “similarly situated entity” concept, the prime contractor and its prospective “similarly situated” subcontractors would be required to execute written teaming agreements containing certain mandatory provisions.  This idea came under fire from some small business advocates.  My friend Guy Timberlake, for example, pointed out that there is no similar requirement for large primes to execute written teaming agreements in order to claim small business subcontracting credit.

In response to public comments on the proposed rule, “SBA has decided not to require a written agreement in order for a prime contractor to rely on the work to be performed by similarly situated entities.”  The SBA points out that the “similarly situated entity” concept has already been in use for many years in the SBA’s SDVOSB and HUBZone programs, without a requirement for a teaming agreement, and “[t]here is no evidence that this long-standing policy has been difficult to understand or administer . . ..”  The SBA also writes that it is “concerned that requiring a written agreement would cause an administrative burden on small business concerns . . ..”

The SBA also had second thoughts about a proposal to require prime contractors using the “similarly situated entity” concept to report on their compliance at some regular point in time.  The SBA writes that “[u]pon further review, SBA believes that this proposal would create a disincentive to utilize this new statutory authority.”  The SBA has decided not to require compliance reports from primes that are using “similarly situated” subcontractors.

In another important important change from the proposed rule, the SBA will not require that a similarly situated entity be small under the NAICS code assigned to the prime contract.  Rather, the subcontractor may qualify as a similarly situated entity if it is small under the NAICS code assigned to the subcontract.  This can be a very important distinction, because prime contractors are responsible for assigning NAICS codes to their subcontracts–and sometimes the correct subcontract NAICS code carries a significantly larger size standard than the NAICS code assigned to the prime contract.

For example, consider a prime contract for architect and engineering services, set aside under NAICS code 541310 (Architectural Services) with a corresponding $7.5 million size standard.  Under the SBA’s proposed rule, a subcontractor would be similarly situated only if the subcontractor was small under that size standard.  But let’s say that the subcontractor is an engineering firm, and the prime contractor assigns NAICS code 541330 (Engineering Services) to the subcontract.  That NAICS code carries a $15.0 million size standard.  Under the final rule, a $12.0 million engineering firm would qualify as “similarly situated” because it is small for purposes of its subcontract–even though it exceeds the size standard for the prime contract.

The new regulation defines a similarly situated entity as follows:

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.

The final rule, of course, implicitly emphasizes the importance of assigning NAICS codes and size standards to subcontracts–something many primes (large and small alike) aren’t doing.

Finally, the SBA is keeping, as proposed, language from its proposed rule that will exempt prime contractors and their “similarly situated” subcontractors from affiliation under the ostensible subcontractor rule.  The SBA notes that all of the public comments it received approved of this change (I did too).

All in all, I am very pleased with the SBA’s final implementation of the “similarly situated entity” concept.  The use of similarly situated entities can be a very important competitive tool for small businesses, especially in a competitive landscape which may soon begin to get crowded with new “universal” mentor-protege JVs.  I am glad that the SBA worked to streamline its rule and reduce the initially-proposed administrative burdens on small businesses.  Additional compliance tools, like mandatory teaming agreements, can always be implemented later if there is shown to be a need.  But for now, let’s see how small businesses do without these extra burdens.

Service and Supply Formulas

The SBA is adopting, largely as proposed, its changes in the formulas used to calculate compliance with the limitations on subcontracting for services and supply contracts.  The services formula will shift from a “labor cost” calculation to an “amount paid” calculation.  Similarly, the new rule shifts the formula for supply contracts from a “cost of manufacturing” calculation to an “amount paid” calculation.  The new rule provides:

(a) General. In order to be awarded a full or partial small business set-aside contract with a value greater than $150,000, an 8(a) contract, an SDVO SBC contract, a HUBZone contract, a WOSB or EDWOSB contract pursuant to part 127 of this chapter, with a value greater than $150,000, a small business concern must agree that:

(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 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.

(2)(i) In the case of a contract for supplies or products (other than from a nonmanufacturer of such supplies), it will not pay more than 50% of the amount paid by the government to it 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. Cost of materials are excluded and not considered to be subcontracted.

The final rule also includes additional provisions regarding the nonmanufacturer rule, which I’ll explore in a separate post.  The final rule doesn’t change the percentages for general construction and specialty trade construction contracts (but allows construction contractors to avail themselves of “similarly situated” subcontractors, just like other primes).

“Mixed” Contracts

The final rule clarifies that the Contracting Officer’s selection of the NAICS code determines which subcontracting limitation applies.  This is an important consideration in so-called “mixed” contracts, such as those calling for both supplies and services.  The SBA explains that “the CO must first determine which category, services or supplies, has the greatest percentage of the contract value, and then assign the appropriate NAICS code.”  The corresponding limitations on subcontracting will then apply “only to that portion of the requirement identified as the primary purpose of the contract.”  The SBA continues:

Therefore, where a procurement combines supplies and services, the limitations on subcontracting apply only to subcontracts that correspond to the principal purpose of the prime contract. For a contract principally for services, but which also requires supplies, this means that the prime contractor or its similarly situated subcontractors cannot subcontract more than 50 percent of the services to other than small concerns. However, the prime contractor can subcontract all of the supply components to any size business.

This is the correct interpretation of the 2013 NDAA, and should ease the minds of “mixed” contractors–some of whom were concerned that they would be unable to subcontract more than 50% of the amount paid by the government–period–under a mixed contract.

Set-Aside Contracts Between $3,500 and $150,000

In its proposed rule, the SBA proposed to exempt small business set-aside contracts between $3,500 and $150,000 from the limitations on subcontracting requirements.  The SBA noted in its proposal that the FAR only requires the use of the limitations on subcontracting clause, FAR 52.219-14, in acquisitions above the simplified acquisition threshold.  Thus, the SBA stated, its proposed rule “would merely adopt what the FAR has done.”

After reviewing public comments (most of which were favorable), the SBA has retained this approach.  The final rule specifically exempts small business set-aside contracts between $3,500 and $150,000 from the limitations on subcontracting.  But be warned: the exemption applies only to small business set-asides.  Contracts between $3,500 and $150,000 that are awarded as 8(a), HUBZone, SDVOSB or WOSB set-asides will still be subject to the limitations on subcontracting.


Finally, the SBA retains a proposed rule provides that violations of an applicable subcontracting limitation may result in a variety of significant penalties, including suspension, debarment, administrative remedies, fines, and even imprisonment.  If a fine is imposed as a result of a violation, the fine will be “the greater of either $500,000 or the dollar amount spent in excess of the permitted levels for subcontracting.”

The SBA received a number of comments on this proposal, requesting that the SBA lower the penalties and/or allow a good faith exception.  As the SBA notes, “[m]ost of these commenters were concerned that by violating the limitations on subcontracting by even $1, possibly due to a miscalculation or a change in the Service Contract Act wage rates, a prime contractor could be exposed to a minimum fine of $500,000.”

Unfortunately, the SBA doesn’t have the statutory discretion to make the requested changes.  The SBA notes that its penalty provision “mirrors the language” of the 2013 NDAA.

In this regard, the SBA didn’t have much of a choice–but I agree with the commenters.  The statutory (and now regulatory) penalty is potentially excessive, and prevents the SBA from exercising its discretion to–for example–excuse an unintentional violation.  If I don’t miss my guess, the SBA will end up being a little creative on the enforcement end in order to avoid putting well-meaning companies out of business.


Minus the penalty provision (where, again, the SBA lacked much wiggle room) the final rule on the limitations on subcontracting is a well-thought-out implementation of the 2013 NDAA.  The similarly situated entity concept, in particular, offers important opportunities for small businesses to team up and pursue larger projects.  I’m looking forward to seeing the final rule in practice in the near future.