The limitations on subcontracting, or LOS, is a fundamental requirement of set-aside contracting. Historically, however, the LOS has not received as much attention as other set-aside compliance obligations that are more regularly the focus of audits, enforcement actions, and protests. But that changed with recent high-profile audits by the Small Business Administration (SBA) and Department of War (DOW) that are putting a spotlight on LOS compliance.
In particular, a DOW memorandum issued in January 2026 shows it is investigating LOS compliance on set-aside contracts valued greater than $20 Million. DOW’s goal is to identify “improper subcontracting practices” and their audits are underway, with an expected completion date by the end of February 2026. Given this climate, small business contractors—and especially those working with DOW—need to ensure they understand the LOS and take reasonable steps to ensure compliance.
DOW’s review is aimed at set-aside contracts above $20 Million that support the warfighter. DOW is scrutinizing these contracts to determine LOS compliance. If DOW determines that a contractor is not meeting the applicable LOS, this may result in termination of the contract (among other potential penalties).
From what we have seen with the DOW audits so far, some are based on bad data or DOW’s misunderstanding of the LOS. Contractors subject to these reviews need to be prepared to supply accurate and correct data to demonstrate why the data DOW is using may be wrong, and to educate their DOW counterparts on the applicable LOS requirement and how it works.
One key point for LOS compliance is there can only be one applicable LOS per contract. The applicable LOS is based on the NAICS code assigned to the contract. If the contract is assigned a services NAICS code, the services LOS applies. The services LOS is commonly referred to as the “50% rule” and it requires the small business prime contractor (together with any similarly-situated subcontractors) to receive at least 50% of the amount the government pays for the services. For a services contract subject to the services LOS, there is no LOS applicable to any supplies that the government may also be purchasing via the contract. Conversely, if a contract is assigned a supply NAICS code, the applicable LOS is for manufacturing (or the nonmanufacturer rule) and there is no LOS applicable to any services that the government may also be purchasing.
There are many other aspects of LOS compliance that can be difficult for agencies and contractors to understand and apply. This includes determining the period of measurement and how to calculate compliance, which may vary based on the type of contract and the options the contracting officer selected in the solicitation. Another common point of confusion for contractors is how to treat individuals who are 1099s. Under SBA’s rules, 1099 independent contractors must be treated as subcontractors for purposes of LOS compliance. And then there is the nonmanufacturer rule, which remains one of the most-often confused requirements in all of federal contracting. If you work on supply procurements, you should be prepared to educate government personnel on how the nonmanufacturer rule works, such as when SBA grants a waiver or for multi-item procurements.
Whenever a contractor faces a government audit, it is always a best practice for the contractor to ensure it has robust internal policies and procedures addressing issue(s) the government is investigating. Robust internal policies and procedures not only help to ensure you meet your compliance obligation, but they can also help to show your good faith efforts to comply if your compliance efforts fall short. The LOS is no different. PilieroMazza recommends developing or enhancing your existing policies and procedures for LOS compliance and include this as part of your employee training. Among the procedures we recommend are to ensure you consider LOS compliance at the point you decide whether to pursue a set-aside contract and at regular intervals during contract performance to ensure you remain on target over the life of the contract.
In short, the LOS is multifaceted and a key requirement of set-aside contracting. With the recent spate of high-profile government audits designed to ensure that small businesses are complying with the LOS, now is the time for small business contractors to take proactive steps to get ahead of any audits or data calls. Doing so in advance may well be the difference maker in preventing a termination or other enforcement action.
If you have any questions about DOW’s review, determining your LOS compliance, or implementing internal policies and procedures for the LOS, please contact the authors of this client alert, Jon Williams or Adel Mansour, members of PilieroMazza’s Government Contracts Group.
