On May 18, 2023, the U.S. District Court for the District of Columbia (DDC) issued a decision with significant potential consequences for federal contractors and the U.S. Small Business Administration (SBA). SBA's Office of Hearings and Appeals (OHA) has long held that SBA must calculate contractors' annual receipts—which are used to determine whether companies meet federal size standards that dictate eligibility to perform many federal contracts and subcontracts—based on contractors' federal tax returns. But the DDC held that annual receipts may include revenue that contractors do not report in their tax returns. In other words, under the DDC's interpretation of SBA's regulations, contractors cannot always rely on their tax returns alone when calculating their annual receipts and certifying their size status.
The decision is noteworthy because federal contractors and SBA typically do rely on tax return data to calculate annual receipts. The DDC's decision suggests not only that such calculations may be incomplete, but that they could lead to False Claims Act (FCA) liability. Federal contractors and subcontractors should confer with counsel to determine whether to review their methodology for calculating annual receipts in light of this decision.
How Did a Size Protest Turn into an FCA Case?
When the defendant, CWS Marketing Group, submitted a proposal for a federal contract that was set aside for competition by small businesses only, CWS certified that it was a small business because its average annual receipts were below $7.5 million—the size standard for the relevant NAICS code at that time—over the prior three years. See United States ex rel. Bid Solve, Inc. v. CWS Mktg. Grp., Inc., No. 1:19-CV-1861-TNM, 2023 WL 3521616, at *1 (D.D.C. May 18, 2023). After CWS won the contract, a competitor (the plaintiff, Bid Solve) filed a size protest with the SBA alleging that CWS was not a small business because its average annual receipts exceeded $7.5 million. See id. The SBA Area Office disagreed and denied the protest, and OHA dismissed Bid Solve's appeal as untimely. See id.; Size Appeal of Bid Solve, Inc., SBA No. SIZ-5906 (2018).
Bid Solve then filed a complaint against CWS and its owners in the DDC, alleging that CWS had violated the FCA by fraudulently inducing SBA into awarding CWS a contract through false statements about CWS's size status. See Bid Solve, Inc., 2023 WL 3521616, at *1. Bid Solve argued that CWS had "misreported CWS's receipts by improperly subtracting certain expenses" for "flowthrough income" from its annual receipts. Id. at *1-*2.
CWS moved for summary judgment, arguing that its tax returns properly excluded the flowthrough income and that SBA's regulation at 13 C.F.R. § 121.104 required calculating CWS's annual receipts based on those tax returns, such that its receipts were lower than $7.5 million. See id.
How Does OHA Say Annual Receipts Should Be Calculated?
OHA has long held that Section 121.104 requires calculation of annual receipts based on information contained within federal tax returns when such returns are available.
For example, OHA has stated that "there is no authority for an area office to consider any evidence apart from tax returns (when they have been filed) when calculating a firm's average annual receipts" and that "[b]ecause tax returns must be used to calculate size unless those returns are unavailable, revenue data from other non-tax sources cannot be used to determine size or to question the results reached by the Area Office's examination of the Federal tax returns." Size Appeal of SC&A, Inc., SBA No. SIZ-6059 (2020) (internal quotation marks omitted).
OHA has explained that a prior amendment to Section 121.104(a) made "clear" that SBA "'bases its calculation of a concern's [receipts] solely on information contained in the concern's Federal income tax returns.'" Size Appeal of W. River Restoration Partners, SBA No. SIZ-5695 (2015). OHA has also stated that "the entire purpose of requiring decisions to be based upon tax returns" is "to ensure standardization and uniformity in the size evaluation process by relying on tax returns submitted to the IRS under well-understood rules and the penalty of perjury." See Size Appeal of Thomas Computer Sols., LLC, SBA No. SIZ-4841 (2007). OHA has noted an exception, however, where "an area office, the contracting officer or a protestor" has "reliable and relevant evidence that information on a tax return (or other information presented by a protested concern) is false," in which case "an area office may consider it." Id. (citing 13 C.F.R. § 121.1009(b)).
Why Did the DDC Interpret the SBA's Regulation Differently Than OHA?
In the CWS case, the DDC interpreted Section 121.104 differently than OHA. The court held that the regulation required including flowthrough income in CWS's annual receipts, even if CWS's tax returns properly excluded the flowthrough income.
Section 121.104(a) contains language suggesting that the calculation of receipts is limited to what appears in a contractor's tax returns. The regulation states that "[g]enerally, receipts are considered 'total income' . . . plus 'cost of goods sold' as these terms are defined and reported on Internal Revenue Service (IRS) tax return forms," and that "[t]he Federal income tax return and any amendments filed with the IRS on or before the date of self-certification must be used to determine the size status of a concern." 13 C.F.R. § 121.104(a); id. § 121.104(a)(1). But other language in the regulation is broader. For example, it defines "receipts" to mean "all revenue in whatever form received or accrued from whatever source" and then states that "reimbursements for purchases a contractor makes at a customer's request," a category that the DDC said included CWS's flowthrough income, "may not be excluded from receipts." Id. § 121.104(a).
In the DDC's view, Section 121.104(a) "provides a clear formula: receipts are 'all revenue . . . reduced by returns and allowances,' and 'the only exclusions from receipts are those specifically' listed in § 104(a). Tax returns may be used to calculate receipts, but they cannot override § 104(a)'s basic rules." Bid Solve, 2023 WL 3521616, at *3. Notably, the DDC concluded that, "[e]ven if the CWS's tax returns were prepared correctly, [CWS] still needed to" include its flowthrough income in its annual receipts under Section 121.104. See id. at *5 (emphasis added).
CWS submitted a declaration from an SBA size specialist "suggest[ing] that tax returns trump other information and that she is limited to reviewing tax returns when making size determinations" under SBA's regulations. Id. The DDC declined to defer to the declaration, in part because it did not represent SBA's "authoritative or official position." Id. (citing Kisor v. Wilkie, 204 L. Ed. 2d 841, 139 S. Ct. 2400, 2404 (2019)). The extent to which the DDC considered OHA's decisions above, or whether the DDC thought they represented SBA's official interpretation of Section 121.104(a), is not clear. Ultimately, the DDC may have rejected OHA's interpretation because the DDC found Section 121.104 to be "unambiguous," such that courts need not defer to SBA's interpretation of the regulation. See id.
How Should Contractors Approach Calculating Their Annual Receipts After This Decision?
The DDC's interpretation of SBA's regulations should be placed in context.
Most disputes concerning a contractor's size status are resolved by SBA, either when the contracting officer seeks SBA's input or through the size protest and appeal process. OHA's interpretation of Section 121.104 and how to calculate annual receipts therefore remains of paramount importance. Moreover, it is rare for size protests to escalate into FCA litigation, in part because an FCA claim must be founded on allegations or transactions that were not publicly disclosed. See 31 U.S.C. § 3730(e)(4). (Bid Solve based some of its allegations on the personal knowledge of one of its principals, the former controller of CWS. See Bid Solve, Inc., No. 1:19-CV-1861-TNM, ECF 45 (Amend. Compl.) ¶ 62.) Finally, the DDC's decision in Bid Solve does not bind other courts or SBA to adopt the same interpretation of the regulation.
Nonetheless, federal contractors and subcontractors should consider whether their tax returns reflect all revenue that could be considered "receipts" under Section 121.104. Unless and until SBA revises Section 121.104, any revenue that (1) does not appear on the tax return and (2) does not fall within one of the categories that Section 121.104(a) expressly permits contractors to exclude from receipts increases the risk of a competitor alleging that the company's receipts exceed an applicable size standard threshold.