One of the most common questions I get from clients and prospective clients is how their small business should comply with the limitation on subcontracting.
In this post, I’ll unpack the limitation a bit.
A word of caution before we get too far down the rabbit-hole: there are currently two limitations on subcontracting. One under the SBA’s regulations, and another under the FAR (well, two if you include the construction-specific limitation).
Though the FAR is in the process of being updated to correspond to SBA’s limitation, there are some important differences between them. This post, however, will address only the SBA’s limitation on subcontracting. Make sure you understand which limitation applies to your contract.
What is the limitation on subcontracting?
The limitation on subcontracting is—as its name suggests—a limit on the amount of work that a prime contractor can subcontract out to non-similarly situated entity.
A similarly situated entity is a company that (1) shares the prime contract’s socioeconomic designation and (2) is a small business under the NAICS code assigned by the prime contractor to its subcontract. (That’s right—a prime contractor should assign a NAICS code to its subcontracts.)
When does the limitation on subcontracting apply?
The limitation applies to just about every small business set-aside award. Specifically, it applies to any small business set-aside contract with a value greater than the simplified acquisition threshold and to any socioeconomic set-aside contract (regardless of value).
How much work can you subcontract?
The actual limitation on subcontracting depends on the type of work being solicited.
- For general services contracts, the prime contractor cannot pay more than 50% of the amount paid to it by the government to firms that are not similarly situated. Stated differently, the prime contractor (together with any similarly situated entities) must perform at least 50% of the work, measured by the amount paid to the prime by the government. Certain direct costs (like airline travel or cloud computing costs) might be excluded from the calculation.
- For general construction contracts, the prime contractor cannot pay more than 85% of the amount paid to it by the government to firms that aren’t similarly situated. For specialty trade construction projects, the limitation is reduced to 75%. Cost of materials are excluded from both calculations.
- For supply contracts, the prime contractor cannot pay more than 50% of the amount paid to it by the government to firms that aren’t similarly situated. Keep in mind that supply and manufacturing contracts might also implicate SBA’s nonmanufacturer rule—a fairly complicated topic that we’ll address in future posts.
What happens, though, if your contract calls for a little bit of services and a little bit of supplies? In that case, the contracting officer is supposed to assign the NAICS code that most closely corresponds to the project’s principal purpose, which is determinative as to the limitation on subcontract that applies. Importantly, the limitation applies only to the corresponding portion of work—meaning that, if services predominate, the services limitation will apply, and only to the services portion of the work. Only one limitation can apply per contract.
What about joint ventures?
I’m often asked whether small business joint ventures have to comply with the limitation on subcontracting. Yes! As the prime contractor, the joint venture entity will be subject to the same limitation as any other small business.
A second consideration also applies to joint ventures: the performance of work requirement. This mandates that the managing member to the joint venture (that is, the business upon whom the joint venture’s eligibility is based) perform at least 40% of the work that the joint venture performs.
For joint ventures, compliance with both the limitation on subcontracting and performance of work requirement can be tricky. First, the JV should meet the limitation on subcontracting, because this will dictate how much work it will perform. Then, based on that amount, the managing member should aim to perform at least 40%.
As an example, take a joint venture performing a general services contract. The joint venture can subcontract out 50% of the work to non-similarly situated entities. Assuming the joint venture performs the remaining 50% itself (that is, it doesn’t subcontract out any work to similarly situated entities), then the managing member will have to perform at least 40% of the 50% of work performed by the joint venture (or 20% of the contract total).
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There you have it: a quick primer on one of the more befuddling concepts in small business contracting. Confusing as it is, though, it’s important that small businesses understand the limitation on subcontracting and ensure a plan for compliance before they bid on opportunities. Violating the limitation comes with severe penalties, so it’s best to avoid any issues.
Keep in mind that the limitation on subcontracting and performance of work requirement have nuances not discussed in this post. If you have any questions about compliance, please reach out.