Summary
In September, a new Rule issued by the Federal Acquisition Regulation (“FAR”) Council finally went into effect aligning the Small Business Administration’s (“SBA”) and the FAR’s Limitations on Subcontracting Rule ending years of ambiguity on this very important point of compliance for all small business government contractors. Now that the FAR Council has added this needed clarity, small business government contractors should take the time to ensure their compliance house is in order as the consequences non-compliance can be severe. This article outlines the recent background of the Limitations on Subcontracting Rule, provides details on the rule itself, and explains the significant penalties for contractors who fail to properly comply.
Background: Dueling Rules and Years of Confusion
At its essence, the Limitations on Subcontracting Rule (the “LOS Rule”) is a self-performance requirement for government contractors performing on small business and socioeconomic set-aside contracts. The LOS Rule mandates that a small business (or WOSB, HUBZone, 8(a), SDVOSB, etc.) prime contractor self-perform a certain percentage of the contract effort. The LOS is the companion rule to another self-performance requirement, the Non-Manufacturer Rule (subject of a future article—stay tuned!). The Limitations on Subcontracting Rule is outlined both at 13 C.F.R. § 125.6 and the FAR clause at FAR 52.219-14 LIMITATIONS ON SUBCONTRACTING (Sep 2021). Believe it or not, for the past five (5) years (!!!) and until this September, those two regulatory provisions were completely inconsistent with one another causing a major compliance headache for small business government contractors.
Generally, small business government contracting policy is first mandated by statute then implemented in the SBA’s small business regulations found at Title 13 of the Code of Federal Regulations. Additionally, these policies are further implemented in the FAR at FAR Part 19 (and related FAR solicitation provisions and clauses at FAR Part 52). These FAR provisions direct federal government contracting personnel on the processes and procedures for conducting small business contracting and provide contractually-binding standard clauses for federal government contracts related to small business contracting issues. The SBA and FAR provisions are generally required to mirror one another. However, because different agencies are responsible for the rulemaking process under each set of regulations, this can lead to inconsistencies. And the LOS Rule provides an example of one of the most glaring inconsistencies between the SBA regulations and the FAR in recent memory.
In the 2013 National Defense Authorization Act (“NDAA”), Congress mandated major changes to the LOS Rule including a different method of calculating self-performance and excepting subcontracting to “similarly situated” entities (both described in more detail below). In 2016, the SBA implemented these changes in its rules. The FAR Council (the government entity responsible for maintaining the FAR), however, failed to include these changes in the FAR. Until September of this year, small business government contractors had to contend with the fact that the SBA’s rule and the FAR clause included in their contracts were not consistent with one another.
Finally, in December 2018, the FAR Council issued a proposed rule to bring its provisions into conformity with the SBA’s 2016 final rule. On August 11, 2021, the FAR Council issued its own final rule with an effective date of September 10, 2021. Now, new solicitations and contracts should include a FAR Limitations on Subcontracting clause consistent with the SBA’s rules. With this background in mind, below is an outline of the LOS Rule’s requirements.
Generally, small business government contracting policy is first mandated by statute then implemented in the SBA’s small business regulations found at Title 13 of the Code of Federal Regulations. Additionally, these policies are further implemented in the FAR at FAR Part 19 (and related FAR solicitation provisions and clauses at FAR Part 52). These FAR provisions direct federal government contracting personnel on the processes and procedures for conducting small business contracting and provide contractually-binding standard clauses for federal government contracts related to small business contracting issues. The SBA and FAR provisions are generally required to mirror one another. However, because different agencies are responsible for the rulemaking process under each set of regulations, this can lead to inconsistencies. And the LOS Rule provides an example of one of the most glaring inconsistencies between the SBA regulations and the FAR in recent memory.
In the 2013 National Defense Authorization Act (“NDAA”), Congress mandated major changes to the LOS Rule including a different method of calculating self-performance and excepting subcontracting to “similarly situated” entities (both described in more detail below). In 2016, the SBA implemented these changes in its rules. The FAR Council (the government entity responsible for maintaining the FAR), however, failed to include these changes in the FAR. Until September of this year, small business government contractors had to contend with the fact that the SBA’s rule and the FAR clause included in their contracts were not consistent with one another.
Finally, in December 2018, the FAR Council issued a proposed rule to bring its provisions into conformity with the SBA’s 2016 final rule. On August 11, 2021, the FAR Council issued its own final rule with an effective date of September 10, 2021. Now, new solicitations and contracts should include a FAR Limitations on Subcontracting clause consistent with the SBA’s rules. With this background in mind, below is an outline of the LOS Rule’s requirements.
The LOS Rule: Self-Performance Requirements and “Similarly Situated Entities”
As mentioned previously, the Limitations on Subcontracting Rule is a self-performance requirement to ensure that government funds set aside for small business contracting do not simply pass through small businesses to ineligible contractors. Generally, the LOS Rule provides that a small business (or WOSB, HUBZone, 8(a), or SDVOSB) contractor shall pay no more than a certain percentage of the total revenue it receives from the government to subcontractors that are not “similarly situated.” That percentage is based upon the type of prime contract as follows:
Contract Type |
Applicable Percentage |
Services (except construction) |
50% |
Supplies |
50% |
General Construction |
85% |
Special Trade Contractors |
75% |
A “similarly situated” entity is simply an entity that shares the same socio-economic status (if applicable) and is also a small business, as required by the prime contract. So, essentially, the LOS Rule considers subcontracts to “similarly situated” entities exactly the same as work performed by the prime for purposes of the self-performance requirement. Importantly, in order to count, the work being performed by the “similarly situated” entity must be performed with its own employees.
Let us use an example to illustrate how this rule works. ABC, Inc. is a SDVOSB and is beginning performance on a SDVOSB set-aside contract for non-construction services. Because the contract was 100% set aside for SDVOSBs, the Limitations on Subcontracting Rule applies. ABC, Inc. plans to split the work under the contract as follows:
Let us use an example to illustrate how this rule works. ABC, Inc. is a SDVOSB and is beginning performance on a SDVOSB set-aside contract for non-construction services. Because the contract was 100% set aside for SDVOSBs, the Limitations on Subcontracting Rule applies. ABC, Inc. plans to split the work under the contract as follows:
Contractor |
Percentage of total revenue received paid to contractor: |
ABC, Inc. (SDVOSB prime contractor, self-performing) |
40% |
123, LLC (SDVOSB subcontractor) |
20% |
XYZ, Inc. (non-SDV owned small business subcontractor) |
40% |
Total: |
100% |
Here, ABC, Inc. is compliant with the LOS Rule. Because ABC, Inc. is paying only 40% (i.e., no more than 50% because the contract is for non-construction services) of the total revenue it received from the government to subcontractor XYZ, Inc. (a non-similarly situated entity), it meets the rule’s requirements. As another SDVOSB, 123, LLC is a similarly-situated entity, so the 20% subcontracted to it does not count. Finally, note that although XYZ, Inc., is a small business, it is not a similarly situated entity because it is not also a SDVOSB. If the procurement was simply a small business set-aside, then XYZ, Inc. would have also been considered a similarly-situated entity.
Finally, below are some common questions/issues that arise under the LOS Rule:
As outlined above, the LOS Rule is deceptively simple on the surface, but its application raises a multitude of different questions, and some of these questions can have rather complex answers!
Finally, below are some common questions/issues that arise under the LOS Rule:
- In addition to set-aside, partial set-aside, and sole source contracts, the LOS Rule also applies to contracts that were given the HUBZone price evaluation preference unless such preference was waived or the awardee is other than small.
- The LOS Rule is not the same as the Ostensible Subcontractor Rule. The latter is a basis for finding affiliation between a small business prime offeror and its subcontractor and is based on the small business prime contractor’s proposal. It is an issue generally reviewed and resolved in a Size Protest. Conversely, the LOS Rule is a self-performance compliance requirement measured throughout contract performance. However, it should be noted that SBA will not consider a subcontract to an ostensible subcontractor as a subcontract to a “similarly situated” entity for purposes of the LOS Rule.
- The LOS Rule is not the same as a small business Joint Venture’s performance of work requirements. In the case of a small business Joint Venture, the Joint Venture itself as a whole must comply with the LOS Rule. Then, internal to the Joint Venture’s workshare, the Joint Venture members must meet the applicable performance of work requirement, if any.
- Despite the incorrect, oft-used phrase “1099 Employee,” Independent Contractors are not employees. Notwithstanding separate employee misclassification concerns, contracting to an Independent Contractor is considered a subcontract under the LOS Rule, and it should therefore be treated as such.
- The LOS Rule does not apply to small business subcontractors performing under a large business’s small business subcontracting plan (but review the terms of your subcontract carefully!).
- The period of time used to measure compliance is the contract’s base period then each subsequent option period. For a set-aside order under a full-and-open Multiple Award Contract, it would be the order’s period of performance.
- The prime contractor is responsible for assigning the applicable NAICS code to its subcontracts. Such NAICS code should describe the “principal purpose” of the subcontract itself, so therefore, it does not have to follow the prime contract’s assigned NAICS code if the specific, subcontracted work is different.
As outlined above, the LOS Rule is deceptively simple on the surface, but its application raises a multitude of different questions, and some of these questions can have rather complex answers!
Consequences for Non-Compliance with the LOS Rule
There can be multiple, devastating consequences for failing to comply with the LOS Rule. Because the LOS Rule forms a material part of the prime contract, the Government could find the prime contractor to be in default. Similarly, compliance is evaluated in the contractor’s rated performance. FAR 42.1503 specifically outlines LOS compliance as an area that may be addressed on a Contractor Performance Assessment Reporting System (“CPARS”) report. Non-compliance can also form a basis for False Claims Act violations and contractor debarment. Last, the SBA has outlined that violation of the rule can lead to fines that would be “the greater of $500,000 or the dollar amount spent, in excess of permitted levels, by the entity on subcontractors.” (emphasis added).
Conclusion
Contractors performing under small business contracts should take steps now to review compliance and make necessary course corrections before it is too late. Prime contractors should also implement best practices in reviewing their subcontractors’ size and status representations and include terms in subcontracts to address these issues. A solid compliance program that takes the all-important LOS Rule into account will help small business government contractors avoid significant fines and even worse!
Let’s TalkThis article is for informational purposes only and does not constitute legal advice. For specific legal advice on any of the issues discussed above, please consider contacting ReavesColey government contracts attorneys Brad Reaves at [email protected] and Paul Hawkins at [email protected].
