At a recent conference an audience member asserted that the FAR (Federal Acquisition Regulations) did not define subcontractors and she felt free to put the costs wherever she wished on an incurred cost proposal, specifically under Other Direct Costs. I assumed she meant consultants providing direct services on a job or contract, but I did not argue with her and we agreed to disagree.
Subsequent to this, I gave up documenting FAR definitions of subcontracting after the fifth one. All of these included the term “services”. I will quote, cite, and discuss some of the specific definitions in a bit, but first I want to broaden the issues to the needs of government contractors, especially small business government contractors.
Not only does the FAR define subcontractors, it is an area of intense regulation and receives serious attention from DCAA to include an ever evolving “Schedule J” on DCAA’s model incurred cost electronically (ICE). It is in a contractor’s interest to avoid this greater scrutiny while complying with existing statutes, case law, and regulations (notice I did not say guidance, as in DCAA’s Contract Audit Manual or Information for Contractors).
I will also note that some contractor approaches can lead to unnecessary complications and even visits from the IRS wanting more money.
Traditionally, direct costs are recorded in five broad accounts: Direct Labor, Direct Travel, Materials, Other Direct Costs, and Subcontractors. Over the years. I observed contractors recording what the FAR and I define as subcontractor costs, in all five accounts to include Materials and Direct Travel. There is actually an accounting tax argument for recording subcontractor travel costs under direct travel (see my presentation: Meals & Entertainment Rules – Or How to Avoid Inviting Government Auditors to Your Lunch . I prefer to track subcontractor Meals and Entertainment (M&E) as part of the Subcontractor account, but I acknowledge the argument.
Despite what many DCAA auditors might argue, there is no requirement to use these five main direct cost account groups, but I am going to assume their use because of my vain hope as a taxpayer, that we can reduce costs by reasonable acceptable conventions. Adopting these five major accounts for tracking direct costs is such a convention. Further, these are the five the government cares about.
Now to some of the definitions:
“Subcontract” means a contract or contractual action entered into by a prime contractor or subcontractor for the purpose of obtaining supplies, materials, equipment, or services of any kind under a prime contract.
“Subcontractor” (1) means any person, other than the prime contractor, who offers to furnish or furnishes any supplies, materials, equipment, or services of any kind under a prime contract or a subcontract entered into in connection with such prime contract; and (2) includes any person who offers to furnish or furnishes general supplies to the prime contractor or a higher tier subcontractor.
“First-tier subcontract” means a subcontract awarded directly by the contractor for the purpose of acquiring supplies or services (including construction) for performance of a prime contract. It does not include the contractor’s supplier agreements with vendors, such as long-term arrangements for materials or supplies that benefit multiple contracts and/or the costs of which are normally applied to a contractor’s general and administrative expenses or indirect costs.
“Subcontract” means any contract, as defined in FAR Subpart 2.1, entered into by a subcontractor to furnish supplies or services for performance of the prime contractor a subcontract. It includes, but is not limited to, purchase orders, and changes and modifications to purchase orders.
“Subcontract” means any agreement or arrangement between a contractor and any person (in which the parties do not stand in the relationship of an employer and an employee)—(1) For the purchase, sale, or use of personal property or nonpersonal services that, in whole or in part, are necessary to the performance of any one or more contracts; or (2) Under which any portion of the contractor’s obligation under any one or more contracts is performed, undertaken, or assumed.
“Subcontractor” means any person who holds, or has held, a subcontract subject to E.O. 11246. The term “first-tier subcontractor” means a subcontractor holding a subcontract with a prime contractor.
So much for the FAR not defining subcontractors and the definition not covering ‘services’ provided by consultants and other professionals. Having said this, it is critical to remember that FAR definitions typically apply to the section where they are found. For example, the last definition is found in the Equal Employment Opportunity section which is why it further defines subcontract as non employment.
This is where the FAR experts, Contracting Officers, DCAA auditors, and other government employees can spend too much time parsing the FAR in an attempt to twist it into what they mean. A few years ago, a DOE pricing specialist in a vain attempt to prove that the contract was enforceable before the FAR, ended up accidentally accusing the contractor of criminal fraud. Context is critical to pulling out FAR clauses.
But sometimes, the only regulatory guidance is stranded in strange places. The ONLY guidance on how to withdraw an incurred cost proposal properly is found under “Indirect Cost Rates” (FAR 42.7) but under the section about waving penalties (42.709-5)
Now, having said that, the first three definitions appear numerous times in the FAR and could be argued to create a general definition. Let us look at some of the general conclusions we can draw from these definitions:
- Subcontracts, for government contracting purposes, only apply to direct costs. Many DCAA auditors attempt to apply subcontractor regulations and procedures to costs charged as indirect. Notice one definition specifically addresses this. Professional and consultant costs are covered under FAR 31.205-33. This FAR section seems to assume such charges are indirect; but is not specific about consultants as a direct charge, and not burdening them with the additional definition as a subcontractor.
- There does not have to be a contract, note the term ‘contractual action’ in the first definition and the inclusion of purchase orders in other definitions.
- Your weekly trip to Walmart for office supplies does not make Walmart a subcontractor. Any contractual action, to include the right of return, does not create a subcontractor relationship. Again, I am not a lawyer, but I do believe this is a bit of a grey area. A recent example of this was the IRS attempt to force business to issue 1099s to everyone. Fortunately, Congress corrected the situation. Vendors such as Walmart are not subcontractors, but a plumber that provides services on multiple contracts is a subcontractor even if one of the definitions would appear to make this an exception.
As a final look at the regulations, let us look at the requirements reference subcontractors for the contractor’s incurred cost proposal found at FAR 216-7(d) :
(J) Subcontract information. Listing of subcontracts awarded to companies for which the contractor is the prime or upper-tier contractor (include prime and subcontract numbers; subcontract value and award type; amount claimed during the fiscal year; and the subcontractor name, address, and point of contract information).
Complicating Your Life
Now if we are all depressed about the definition of a subcontractor and recovering from our dashed hopes of trying to avoid the extensive subcontractor requirements, let us look at a couple of other common actions small business contractors take with subcontractor costs that can actually complicate their lives.
- Treating subcontractors as Direct Labor – This is fairly common. For example: Jane, your 1099 ‘employee’ works alongside the regular employees and is invited to all of the parties. Your customer may even require her to fill out a timesheet just like the regular employees. This treatment does presents a couple of challenges.
- First, since you treat Jane as an employee and charge her time to Direct Labor; the IRS will decide she is an employee and will send you a bill for her payroll taxes, interest, and penalties. There is now even a section on Jane’s tax return to tell the IRS about this.
- Second, as if the first issue was not enough, it makes a bit of a challenge to reconcile your payroll to your labor costs, as required by regulation and on the Schedule L of the DCAA model ICE. If you segregate the 1099 costs in their own account under Direct Labor, you identified them as nonemployee and we are back to the subcontractor identification.
- Third, there is the issue of rates and comparative rates in competitive bidding. If you are including 1099 labor in your fringe and G&A base, an appeal could argue that your rates are artificially low and even deceptive. Additionally, we all know how many contracting officers hate paying G&A on subcontracts and will award only a special ‘handling’ or ‘management’ rate for the subcontractor part. I am sure they would be happy to discover what they consider subcontractor costs in Direct Labor.
- Fourth, many contracts require contractors to notify the contracting officer about any subcontracts and if a significant portion of your Direct Labor could be seen as actually subcontractors, this could present a problem to include allowability of the costs.
- Another common approach is to classify all ‘consultants’ as Other Direct Costs. This decision would raise the same issues raised above as to rates and notification. Also, the common sense definition of Other Direct Costs are costs that cannot be easily categorized as Labor, Travel, Materials, or Subcontractors. DCAA might conclude that consultants would fail this categorization as Other Direct Costs.
- Spreading the Joy – I mentioned the tax argument for segregating the subcontractor M&E costs and some of those engineers might express a desire to separate out the material costs from the subcontractor’s invoice.
These temptations are easily addressed by adding subaccounts to the subcontractor account for travel and materials, if you wish.
Ah, the joy of government contracting. Again, there are excellent reasons why contractors attempt to reduce the government (DCAA) involvement in subcontractor management. Both the regulation and guidance are extensive, to include a requirement to flow down clauses on employee texting while driving. Unfortunately, this is the nature of the beast and any attempts to reduce the government’s involvement in the contractor’s employment of subcontractor needs to be carefully planned and compliant with statute and regulation.