One of the small business contracting reforms from the 2013 National Defense Authorization Act includes changes to the Small Business Administration’s (SBA) limitations on subcontracting rule. Previously, the SBA regulations and Federal Acquisition Regulation (FAR) clause (FAR 52.219-14 “Limitations on Subcontracting”) required a small business prime contractor to perform a certain percentage of the cost of total direct labor of the contract with its own personnel. The percentage required was based on whether the contract was primarily for supplies, services, construction or specialty trade construction. On May 31, 2016, the SBA issued a final rule changing the manner in which compliance with the requirement will be determined. The final rule adopts a more straightforward "amount paid" calculation:

In order to be awarded a full or partial small business set-aside contract 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 to it by the government to firms that are not similarly situated.
  2. 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 to it by the government to firms that are not similarly situated. The cost of materials is excluded and is not considered to be subcontracted. 13 C.F.R. §125.6(a)(1)-(2).

The percentage is 85% for general construction contracts and 75% for specialty trade construction contracts.

For a contract that includes both supply and services components, the contract’s NAICS code for the procurement will control. For example, for a contract principally for services, but which also requires supplies, the small business prime contractor or its similarly situated subcontractors cannot subcontract more than 50% of the services to other than small concerns. However, the small business prime contractor can subcontract all of the supply components to any size business.

What is a “Similarly Situated” Subcontractor?

Pursuant to the final rule, a small business prime contractor does not need to include the amounts subcontracted to a “similarly situated” subcontractor in determining the percentage of work being subcontracted. This change from the previous rule allows a small business prime contractor to take credit for work performed by a "similarly situated" subcontractor without violating the limitations on subcontracting.

A “similarly situated” subcontractor is a small business that falls into the same size or socioeconomic category (e.g., SDVOSB, 8(a), WOSB, HubZone, VOSB, etc.) for purposes of set-aside contracts. The "similarly situated" subcontractor does not have to be small for the industry code assigned to the prime contract, but must be small for the industry code assigned to the subcontract. Lower tier subcontracts to businesses that are not "similarly situated" will be treated like a subcontract to a large business and count against the limitations on subcontracting.

Nonmanufacturer Rule

The nonmanufacturer rule is an exception to the limitations on subcontracting rule. According to the rule, for small business set aside contracts for manufactured items, the small business prime contractor must either manufacture the items itself or provide the products of other small business manufacturers, unless the small business has sought a waiver for items that are not manufactured by a small business.

Under the final rule, if 50% or more of the estimated contract value for a multiple-item procurement is composed of items manufactured by small businesses, a nonmanufacturer rule waiver is not required because "[t]here is no requirement that each and every item acquired in a multiple-item procurement be manufactured by a small business." 13 C.F.R. §121.406(e)(1). However, if 50% or more of the estimated contract value is composed of items manufactured by other-than-small businesses, a nonmanufacturer rule waiver is required. 13 C.F.R. §121.406(e)(2). And, if a nonmanufacturer rule waiver is granted on a multiple-item procurement, the prime contractor must still meet the limitations on subcontracting for the nonwaived portion of the contract. Id. 13 C.F.R. §125.6(a)(2)(ii)(B).

Miscellaneous

Penalties: Penalties for violations of the limitations on subcontracting rule are severe. They include suspension, debarment, administrative remedies and a minimum penalty of $500,000 or the dollar amount spent by the violating contractor in excess of the permitted levels of subcontracting, whichever is greater. There is no "good faith" or safe harbor exception for violations.

Affiliation: There is a rebuttable presumption of affiliation based on economic dependence where a firm derives 70% or more of its revenue from another firm over a three-year period. 13 C.F.R. §121.103(f)(2). Previously, the regulations did not specify a particular percentage for an automatic finding of economic dependence affiliation. For joint ventures, all members of the joint venture must individually qualify as small under the NAICS code assigned to the procurement to be exempt from the joint venture affiliation rules, regardless of the size of the procurement. 13 C.F.R. § 121.103(b)(9); (h)(3)-(4). This is consistent with the new "similarly situated" subcontractor exemption, which would allow for such a team to perform the work as subcontractors.

Contracts valued between $3,000 and $150,000 are exempt from the limitations on subcontracting requirements. And, although the final rule was effective on June 30, 2016, these changes will require revisions to the relevant FAR provisions before they are implemented.