At the end of December 2014, the Small Business Administration issued a proposed rule to implement provisions of 2013’s National Defense Authorization Act which require significant modifications to the subcontracting limitations for small business concerns. Specifically, the modifications concern the Limitations on Subcontracting Rule (13 C.F.R. 125.6). The proposed changes may leave small businesses having to rethink how they do business.

Currently, the Limitations on Subcontracting Rule limits how many subcontracting obligations prime contractors can relegate to outside entities, for example large companies that do not qualify for set-aside government contracts. The proposed rule suggests changes that would require companies to change how they determine subcontractor compliance, certify compliance in the bidding process, and impose serious fines for delinquencies.

As of now, the compliance ratios are based on the costs of the project and require the prime contractor to incur at least 50% of the cost and personnel expenses of each subcontractor’s part of the project. Section 125.6 provides different cost-based ratios to determine that 50% which are determined by the type of contract and type of set-aside.

The proposed rule would shift the calculations to an income-based metric. Prime contractors would be required to keep in-house a certain percentage of project income–including passive income–from set-aside contracts paid by the government. It would also limit distinctions based on the type of set-aside. Service and supply contracts would allow no more than 50% of contract income to be passed on to subcontractors. Construction would allow no more than 85%, and specialty trade would allow no more than 75% of income to be passed on.

There are two important exceptions to the proposed rule. The first is for “similarly situated entities.” Bearing in mind the philosophy behind the set-aside program, prime contractors will be allowed to contract out to companies who also qualify under the same set-aside category, but the financial considerations of that relationship would not be counted toward the income limit. But sub-contracts made with much larger entities that do not qualify for set-asides will still be counted toward the income limit. The second major exception is that the rule would not apply to contracts valued under $150,000, which smaller companies–that qualify for set-asides–are more likely to bid on.

Ultimately, this rule change closes a loophole under the current 125.6 rule that only accounts for the first prime-sub contractor relationship when assessing and accounting for all levels of a contractor’s subcontractor relationships. Presently, companies can get around the subcontractor limitation through sub-subcontracting out under the prime subcontractor. The new rule forces companies to address the new limitations in their contract bids for set-asides by: Certifying that they can satisfy the rule’s income conditions, identifying any similarly situated entities they plan to subcontract through, and noting what percentage they plan to subcontract to which entities. The contracting officer’s approval would be needed to make any post-award changes.

This new rule change would also impose steep penalties for failure to comply with the Limitations on Subcontracting Rule. Violators would be subject to “the greater of either $500,000 or the dollar amount spent in excess of the permitted levels for subcontracting.”

The Small Business Administration’s proposed changes may seem daunting to companies that have carefully structured their business relationships to be in compliance with current law. However, the changes will do much to ensure the future viability of the SBA’s set-aside programs. When smaller, disadvantaged prime contractors subcontract out the bulk of projects to large corporations, they are defeating the purpose of the set-aside structure.

The proposed changes are available for public comment through February 27, 2015. Comments on the Limitations on Subcontracting Rule section 125.6 may be made on the regulations.gov website.