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DiversityBusiness.com Magazine Article/- How does a company know that it is a “small business” for purposes of contracting with the Federal government? Currently, the U.S. Small Business Administration (SBA) is the agency that sets size standards, or size caps, based on either a company’s number of employees (“employee- based” size standard) or a firm’s annual receipts (“receipts-based size standard). Generally, the size status for manufacturing industries is employee-based in that a company’s size is determined by calculating the average employment of the company, including the employees of its domestic and foreign affiliates, based on the number of persons employed on a full-time, part-time, temporary, or other basis, during each of the pay periods of the preceding 12 months.

For service and construction companies, the SBA, for the most part, uses a receipts-based standard whereby it determines size by averaging a firm’s annual receipts, including the receipts of its domestic and foreign affiliates (less returns and allowances, sales of fixed assets, and inter-affiliate transactions) for the previous three years.

With regard to the employee-based standard, the SBA recently proposed a change in how the number of employees in a firm would be calculated. The proposal was soundly criticized by the small business community, however, and the SBA abandoned the proposal and is now re-thinking its options. As this article suggests, the SBA’s basic idea in seeking a new way to calculate employees was a good one and should be pursued.

With just a few simple adjustments as outlined in this article, the SBA can have a new, workable approach to the problem, while muting criticism from the small business community, and having a system in place that will benefit both the government and industry.

On July 27, 2007, SBA requested public comment in the Federal Register on the agency’s proposed rule to change the current method, as described in the existing regulations, for calculating the number of employees to determine whether or not a business is “small.” That current rule states in relevant part that:

“(1) The average number of employees of the concern is used (including the employees of its domestic and foreign affiliates) based upon numbers of employees for each of the pay periods for the preceding completed 12 calendar months.”

The SBA’s proposed rule states in part that:

“Average annual number of employees means the total number of employees of the concern (including the employees of its domestic and foreign affiliates) for the preceding 3 calendar years divided by 3;”

The following provision in the proposed rule is what caused most of the concern from the small business community:

“SBA will use a concern’s IRS Form W-3, Transmittal of Wage and Tax Statement, and any corrections thereof, to calculate average annual number of employees. For purposes of counting employees obtained from a temporary employment agency, professional employer organization, or leasing concern, SBA will use contractual documents or invoices between the parties showing the number of individuals provided to the concern.”

The Problem
The criticism of the proposed rule focuses on the fact that the SBA would use IRS Form W-3 to calculate the number of employees based upon block “c” of the form, “Total Number of Forms, W-2.” The IRS form identifies/counts unique IDs (individuals/employees). Small business critics noted that such a unique ID method was a dramatic change from the method currently used, in which a small business simply takes a count of persons on the payroll at the applicable points in time (a “snapshot” method), and recomputes the average over the 12-month period immediately preceding. The snapshot method neutralizes much of the effect of turnover and actually counts jobs, while the unique ID approach magnifies employee turnover in a punitive fashion by counting individuals.

As one commenter to Federal Register notice put it, the proposed extended 3-year period, the adverse effects of turnover – both positive and negative – will further exacerbate the punitive effect of using this calculation base. A small business experiencing positive growth will lose any inherent “offset” effect by its inability to average its employee base month-to-month or pay period to pay period, while a small business which has lost significant amounts of business will still be required to count all of its former employees into its size standard calculations for an extended period, thus delaying its ability to recover from its business downturn.

Another commenter to SBA’s Federal Register notice pointed out that while the SBA currently counts every employed person, the inflationary impact of that decision is greatly mitigated, because the number of employees is counted for each pay period and then averaged. Therefore, if a company employed four different individuals for a particular position during a year, each pay period would have just one employee for that position, except for the few pay periods where there is an overlap. When the number of people for this position are averaged over twenty-six pay periods, that average will still be approximately one employee. In contrast, the proposed regulations will measure every person employed by the concern at any time during the year. Thus, if a firm employs four different individuals for a particular position during a year, it would be deemed to have four employees, even though there was just one position and one fulltime equivalent employee.

SBA’s Rationale for the Proposed Rule Change
The SBA’s rationale for changing the rule in the first place was because it considers the current method to be burdensome to small businesses. Under the current system of calculating employees, for example, a firm’s size can fluctuate from pay period to pay period, necessitating a new calculation after each pay period. Furthermore, the time period for calculation would be similar to the method used for calculating receipts for size purposes, which are a firm’s average annual receipts over the firm’s last three (3) completed fiscal years. For those businesses with fiscal years that end at the calendar year, both employment and receipts averages would be calculated at the same time. The SBA felt this would be especially useful if a firm is operating under more than one NAICS Code and the standard for determining size is “receipts-based” for one and “employees-based” for the other.

In addition, the SBA saw this policy as being helpful to small businesses because it would coincide with the current regulatory requirement for a firm to update its size status on an annual basis in the Central Contractor Registration (CCR) as well as with On-Line Certifications and Representations (ORCA) databases. Presently, this must be done at least once a year, plus every time a firm’s small business size status changes, which could occur many time during the year using the current employee calculation method. The SBA indicated that this is especially burdensome on small businesses that have different pay periods for different types of employees, i.e., bi-weekly paydays for salaried employees and monthly paydays for salaried employees.

There is a solution to meeting the goal of the SBA and the concerns of the small business community. First, the SBA should not use W-3’s to calculate the number of a firm’s employees. As stated by the commenters, the results would give a skewed picture of the actual size of a firm, often to the detriment of the small business. It is recommended that the SBA’s existing method of calculating employees be continued, however, the rolling average would be over 36 months of the three previous calendar years. This should meet both the interests of the SBA in making the process less burdensome for small businesses, while at the same time not requiring firms to use IRS Form W-3’s in calculating the average number of employees.

This procedure would require somewhat more administrative work for companies initially, because they would have to average their employees over more pay periods, depending on whether they paid their employees monthly or bi-weekly. In the long run, however, it would require no extra administrative burden at all. The SBA and the firm would know the size of the company at all relevant times, since their employee size average for the previous 3 completed years would be readily available. As a result, in the case of size protest, or whenever their size is called into question, a firm would not have to hurriedly pull together all of its their pay period information on employees for the immediate preceding 12 months, because its average number of employees over the previous three (3) calendar years would be a matter of record.

Moreover, this approach would satisfy the SBA’s aim to have the time period for calculation of employees to be similar to the method used for calculating receipts for size purposes, which are a firm’s average annual receipts over the firm’s last three (3) completed fiscal years. For those businesses with fiscal years that end at the calendar year, both employment and receipts averages could be calculated at the same time.

This method would also meet the SBA’s aim of being helpful to small businesses because it coincides with the currently regulatory requirement for a firm to update its size status on an annual basis in the CCR and ORCA databases. As stated previously, firms must presently do this once a year, plus every time a firm’s small business size status changes, which could occur many times during the year using the current employee calculation method.

Most importantly, the new method should substantially reduce size protests from disgruntled bidders in small business/8(a) set aside competitions, since a firm’s size would be more readily known. Under the current system, when a company protests its loss of a contract to the SBA, based upon the fact that the winning firm has more employees than the size standard allows, the protestor is usually guessing or speculating that the business selected for the contract award is not a small business. The basis for such protests is usually based upon the number of employees the protestor perceives the winning firm to have on its payroll at the time such firm submits its competitive proposal or offer when responding to a “solicitation” , or “Request for Proposals (RFP)” by a Federal agency, rather than considering the firm’s average employees over a certain time period. The approach recommended in this article will make a firm’s size more transparent to the public prior to the time it competes for a contract. Therefore, size protests will not be filed as readily, thus, saving months of time in transition disruption, and the delayed performance of contracts.

Put simply, the approach to calculating employees described above meets both the desires of the SBA to make the system for calculating employees less burdensome for small businesses and meets the concerns of small businesses by not using W-3’s to calculate the number of employees for firms, which might cause many firms to become “other than small” prematurely. Moreover, it will reduce the disruption, expense, and inconvenience of size protests based upon a firm’s number of employees. The suggested approach is a method that will work and should be implemented without undue delay.

(The author is a Partner in the law firm of Barton, Baker, McMahon & Tolle, LLP in McLean, Virginia and specializes in Government Contracts Law. He is the former Associate Administrator for Small and Disadvantaged Business Utilization for the National Aeronautics and Space Administration (NASA).

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