FAQ on the Limitations on Subcontracting New Rules

July 27, 2016

By Kathryn V. Flood, Megan C. Connor and Pamela J. Mazza

We recently held a live seminar and a webinar on the new Limitations on Subcontracting (“LOS”) rule.  We reviewed the questions submitted during the sessions, and noticed that many of the same questions were being asked by attendees.  We hope this article addresses several questions you may also have on LOS.  We have grouped those questions by topic.  

Construction vs. Supplies vs. Services
We received a couple of questions asking for clarification on which LOS rule applies to different types of contracts.  As far as the SBA is concerned, there are four broad types of contracts for purposes of LOS:  (1) Services; (2) Supplies or Products (Manufacturing); (3) General Construction; and (4) Special Trade Contractors.  The NAICS codes and size standards are also sorted into these four general categories.  For instance, NAICS Code 541611, Administrative Management and General Management Consulting Services, is a services code.  NAICS Code 332322, Sheet Metal Work Manufacturing, is a supplies or products code.  NAICS Code 236210, Industrial Building Construction, is a construction code.  And NAICS Code 238220, Plumbing, Heating, and Air-Conditioning Contractors, is a special trade code.

On a general construction set-aside contract assigned a construction NAICS code, like 236210, under the new rule, the prime contractor cannot pay more than 85% 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 85% subcontract amount that cannot be exceeded.  Cost of materials are excluded and not considered to be subcontracted.  So, on a $3,000,000 general construction contract, of which $1,000,000 are materials, the prime contractor’s basis of calculation is $2,000,000, and the prime contractor cannot subtract out more than $1,700,000 or 85% to non-similarly situated entities.   

Similarly Situated Entities
We received a number of questions regarding Similarly Situated Entities (“SSE”), and how the new rule will include subcontracts to SSEs within the calculation of the prime contractor’s compliance with the applicable LOS.  In order to count as a SSE, a subcontractor must be eligible under the set-aside designation of the prime contract (i.e., a small business for a small business set-aside or a WOSB concern if the prime contract was set-aside for WOSBs).  In addition, the subcontractor must also be small under the NAICS code that the prime contractor assigns to the subcontract.  Under the SBA’s size regulations, prime contractors are responsible for assigning a NAICS code designation for subcontracts in instances where an agency may take credit for the subcontract award.  The NAICS code must best describe the product or service being acquired by the subcontract.  A SSE subcontractor must be small under this NAICS code, in addition to being an eligible participant for the socioeconomic program under which the prime contract was set aside.  

A SSE does not need to align with every status held by the prime contractor.  For example, if an 8(a) participant wins a contract for a small business set-aside procurement, it will be able to utilize SSE subcontractors that are small under the NAICS codes assigned to their respective subcontracts; these SSE subcontractors do not also need to be 8(a) program participants, since the prime contract is not set aside for 8(a) participants, but is simply a small business set-aside.

The SSE subcontractor also need not be a small business under the size standard assigned to the prime contract.  For example, an 8(a) prime contract is awarded under NAICS code 541519, Computer Related Services, with a size standard of $27.5 million.  The 8(a) prime contractor must be small under the $27.5 million size standard.  However, the 8(a) prime contractor may identify a portion of the work to be subcontracted that can best be described under NAICS code 541712, Research and Development in the Physical, Engineering, and Life Sciences (except Biotechnology), which has a size standard of 1,000 employees.  If NAICS code 541712 best describes the type of work performed under the subcontract, the 8(a) prime contractor may count towards its LOS percentage the work performed by an 8(a) subcontractor that is small under that size standard (1,000 employees), even though the prime contract has a size standard of $27.5 million.  

Additionally, under the new rules, SBA has clarified that a prime contractor and its SSE subcontractor will not be deemed affiliated based on the ostensible subcontractor rule.  There is also no requirement that the prime contractor must receive more of the contract value than its SSE subcontractor.  So, theoretically, nothing prevents a prime contractor from subcontracting a majority of the applicable LOS workshare to its SSE subcontractor.  

Please note that the ability to utilize SSEs in meeting the applicable LOS requirements does not impact the prime contractor’s ability to issue other subcontract awards to non-SSEs.  For example, an 8(a) joint venture prime contractor consisting of one 8(a) small business and a second small business must meet the 15% performance of work requirement for a construction contract through either its own contract performance or its own performance combined with the performance of another 8(a) small business that is also small under the NAICS code the prime contractor assigned to the subcontract.  Nothing prevents the 8(a) joint venture prime contractor from subcontracting the remaining 85% of this construction contract’s value to other, non-similarly situated subcontractors.  In addition, the new rule does not change the requirement that the 8(a) joint venturer must perform at least 40% of the work performed by the joint venture itself.  So, if the 8(a) joint venture prime contractor performs on its own only 10% of the required 15% for a construction contract and subcontracts 5% to a SSE 8(a) subcontractor, the 8(a) joint venturer must perform at least 40% of the 10% of the total contract value which is performed by the joint venture.  

Additionally, in the Final Rule, the SBA eliminated the requirement that a prime contractor must formally enter into an arrangement with its SSE subcontractors, or submit their SSE subcontractors as part of their proposal.  The prime contractor must simply document the subcontractor’s representation of its SSE status at the time the subcontractor submits its proposal to the prime contractor.  Subcontractors may represent their size and status through SAM, or through a written representation to the prime contractor.  In order for the prime contractor to rely on the SAM representation, the subcontract should contain a clause which provides that the subcontractor verifies by submission of the offer that the size or socioeconomic representations and certifications in SAM (or any successor system) are current, accurate and complete as of the date of the offer for the subcontract.  

The SSE subcontractor’s size and status representation function similarly to a prime contractor’s representation.  The SSE subcontractor’s size and status is to be determined at the time it submits its proposal to the prime contractor, and the SSE subcontractor makes its size and status representations.  However, similar to size and status representations made by prime contractors, the representations made by the SSE subcontractor may not be valid for the “life” of the contract.  The prime contractor should be aware of any “triggering events” that the SSE subcontractor undergoes that would subsequently require it to recertify its size or socioeconomic status, such as merger or acquisition. Also, if an 8(a) concern graduates or otherwise leaves the 8(a) program, an agency’s ability to continue to take 8(a) credit for subsequent option periods is dependent upon the type of contract that is being performed (i.e., a multiple award contract awarded as a total 8(a) set-aside versus a multiple award contract competed amongst small businesses where the 8(a) contractor represented its 8(a) status).  Presumably, this rule will also apply to 8(a) representations made by SSE subcontractors.  

Definition of “Subcontract”
Subcontracts are defined as that portion of the contract performed by a business concern, other than the prime contractor, under a second contract, purchase order, or agreement for any parts, supplies, components, or subassemblies which are not available commercial off-the-shelf items, and which are manufactured in accordance with drawings, specifications, or designs furnished by the contractor, or by the government as a portion of the solicitation.  Bonding is typically not considered a subcontracting cost.  Travel is also not typically considered a subcontracting expense, unless the prime contract contains a travel coordination component.  

Assigning NAICS Codes to Subcontracts
Under the SBA’s rules, a prime contractor is required to assign a NAICS code to a subcontract when the subcontract may be “counted” towards small business credit awarded to agencies.  This may occur when a large prime contractor reports awards made to small businesses under the prime contractor’s small business subcontracting plan.  This rule now also applies to subcontracts issued to SSE subcontractors, which are counted towards the prime contractor’s compliance with the LOS. This NAICS code must best describe the principal purpose of the subcontract.

Mixed Contracts:  Providing Services & Supplies to the Government
One of the benefits of the new LOS rule is that it provides guidance as to how to handle mixed contracts.  Under the prior rule, there was no guidance from the SBA and, instead, contractors were bound solely by the type of NAICS code assigned to its prime contract.  Now we know that the SBA only wants contractors to be concerned with their compliance under the principal purpose of the contract.

For instance, for a $2,000,000 contract in which a prime contractor must staff store rooms (services) from which the government purchases inventory (products), the contracting officer assigns the contract 561210, Facilities Support Services, which is a services code.  That means that the prime contractor cannot pay more than 50% of the amount paid by the government to it to firms that are not similarly situated.  Let’s say the services portion of the contract is $1,500,000 and the products portion is $500,000.  Under the new rule, we exclude the products portion for purposes of the calculation, leaving $1,500,000 for the services cost.  This means that the prime contractor cannot pay more than $750,000 (50% of $1,500,000) to a non-SSE.

Definition of “Cost of Materials”
In the new rule, the SBA pointedly decided not to change the definition of “cost of materials” so the prior definition still applies under the new rule:  “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 items 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.”  13 C.F.R. § 125.1.  Transportation may be included as “cost of materials” on a supplies contract if the transportation costs are handling and shipping costs.  But on a services contract, like environmental remediation services, transportation costs are not cost of materials and are not excluded under the LOS calculation.

How to Handle Products (Materials) on a Services Contract
We noticed that one of the attendees provided a helpful summary of how to handle the cost of items (like products or materials) in a services contract:  “materials (products) under a service contract should be priced as a direct cost vs. an indirect cost as indirect cost, such as, O/H and G&A is considered as part of the service calculations.”  We agree.  Price any items you must furnish under a services contract as a direct cost because then they may be excluded from your LOS calculations, but do not include these costs as G&A or overhead because then you must included them in your calculation.

Along these lines, we do not think “software as a service” could be excluded.  The new LOS rule does not provide for an exclusion for the cost of materials in a services contract.  However, it is clear that the SBA is trying to capture any costs tied to the services in the calculation.  So on a services contract in which the government is paying the prime contractor, at least in part, for the creation of software, the costs of that creation should be included in the LOS calculation.

However, if your contract requires you to deliver a software product, you could exclude this.  For instance, let’s say a contractor is awarded a contract for $1,000,000 to design a computer system and is required to provide and install 20 licenses for an off-the-shelf software product, which has a cost of $100,000.  The contracting officer has properly assigned NAICS Code 541512, Computer Systems Design Services, to the contract because the principle purpose is services.  But it is a mixed contract, so to determine the LOS calculation, we exclude the cost of the product portion, leaving $900,000, of which the prime contractor cannot pay out more than $450,000 to non-SSEs.

Effective Date of New LOS Rule and Incorporation into FAR
The new LOS rules became effective on June 30, 2016.  As is usually the case in the realm of small business contracting, there will be a lag time until the FAR “catches up” with the new SBA regulations.  However, these new rules are based on statute, which governs both the SBA and the FAR regulations.  Therefore, contractors should expect agencies and the SBA to follow the new rules, even though the FAR has not yet been updated.  

The current FAR clause governing LOS may be found at FAR 52.219-14.  It has not yet been updated to incorporate the new LOS calculations as articulated in the SBA’s new rules.  For example, the language of the FAR still states that it only applies to small business and 8(a) set-aside contracts, even though the new rule now applies to all small business and socioeconomic set-asides.  The language also states that the calculation will be based on “cost of contract performance incurred for personnel,” rather than total contract value, and does not provide for the utilization of SSE subcontractors.  We strongly urge contractors to seek clarification from their contracting officers that the new LOS calculations apply, even if a solicitation incorporates FAR 52.219-14, which has not yet been updated.  

Environmental Remediation
We received some interest from environmental remediation companies and to summarize the issue we see, often the large dollar items on an environmental remediation contract are transporting and storing hazardous material.  Under the old LOS rule, these were not “costs of personnel” or labor costs and, therefore, prime contractors had few problems complying with the requirement to perform more than 50% of the work.  But under the new rule, the costs of transporting and storing hazardous material are part of the prime contractor’s calculation.  If these costs are more than 50% of the total value of the contract, the prime contractor has to either do this work itself or have a SSE perform it.  And this may be very difficult for small environmental remediation companies.  

So if you are an environmental remediation company and you would like to learn how to get involved in asking the SBA to reconsider this issue, please email Pam Mazza at pmazza@pilieromazza.com.

Recertification
Contractors are required to recertify their small business size or socioeconomic status after undergoing a “triggering” event, such as merger or acquisition, or contract novation.  If a firm is no longer able to claim small business or socioeconomic size status due to the triggering event, the agency is typically no longer able to claim small business or socioeconomic credit for that award going forward.  Under the new rule, recertification is also required if, after submission of a proposal, the offeror has undergone such a triggering event.  A contractor is able to recertify by providing written notice to the contracting officer, as well as updating the company’s SAM certifications.  

Affiliation and ANCs/Tribes/NHOs
We received a couple of questions about whether the new rule had any impact on affiliation for firms owned by Tribes and ANCs.  In the new rule, SBA has clarified that SBA will not find affiliation between two concerns owned by an Indian Tribe, ANC, Native Hawaiian Organization or Community Development Corporation based solely on the contractual relations of the two concerns.

Nonmanufacturer Rule & Software Resellers
A question arose about the nonmanufacturer rule and software resellers.  Whether the rule applies to resellers depends on the NAICS code assigned to the contract.  For instance, NAICS Code 541519, which includes Information Technology Value Added Resellers, is a services code, so the nonmanufacturer rule would not apply to a contract assigned this code.  Instead, the prime contractor could not pay out more than 50% of the services portion of the total contract value to a non-SSE  However, if a supplies/product/manufacturing code is assigned to the contract and the prime contractor is not the manufacturer, then it would need to comply with the nonmanufacturer rule.

JV Affiliation Exception
The new rules provide an exception for affiliation for joint venturers when each venturer is small under the size standard assigned to the prime contract. 

New Mentor-Protégé Program
We received many questions concerning the new mentor-protégé program.  The new rule about the program was published on Monday.  You can find information about it here on our website.

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We hope you enjoyed the webinar and have a better understanding of the new rules.  Please do not hesitate to contact us if you have any additional questions or if we can assist with anything in regards to the new rules.

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