Drop-ship arbitrage

A few months ago, we talked about how a draft of the NASA SEWP VI solicitation created some sturm und drang in the govcon community due to its choice of NAICS code 541512. By moving from an employee-based NAICS code (541519) to a revenue-based NAICS code (541512), it created some risk that companies who received too much revenue under SEWP VI would no longer qualify as small businesses. As I wrote then:

[T]he very weird lesson here is that government contractors — even extremely successful ones — need to take seriously the risk of growing too big to compete.

Now, the SEWP VI solicitation is live on the street. Sure enough, it is using NAICS code 541512.

Today, though, I want to peel back another layer of the NAICS arbitrage onion. And, y'all, this one is cray cray. And flashing lights disclaimer: I cannot stress enough that I am not giving legal advice here or elsewhere.

Recall that NAICS code 541512 has a revenue limit of $34 million. Ok, what does a revenue limit really mean exactly? To answer that question, we have to look to the SBA's definition of "receipts" in 13 CFR 121.104(a). It's a long subsection, but the relevant points are that:

  1. Receipts mean "all revenue in whatever form received or accrued from whatever source";
  2. There are a handful of general exceptions—capital gains/losses, taxes, intra-firm transactions—and some very specific exceptions for types of firms (including real estate brokers and travel agents); and
  3. All other revenue is included!

On paper, it's a pretty simple definition.

For example, if I get paid $100 to do work and I pay a subcontractor $49, my receipts are $100, not $51. Similarly, if I buy $10 in widgets and get paid $20 when I sell them, I still have $20 in receipts. The regulations seem clear: "[a]ll other items, such as subcontractor costs, reimbursements for purchases a contractor makes at a customer's request, investment income, and employee-based costs such as payroll taxes, may not be excluded from receipts."

Indeed, just about a year ago, in a case called BidSolve, a federal judge opined that the rule was "unambiguous."

But, well, I guess, there's a wrinkle? The regulations also say 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 the regulations also say 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" (emphasis added).

In other words, according to that language, if there is a tax return, you have to use what's on the tax return to determine size status. "Must be used" is pretty clear.

At some point, some clever tax lawyers and accountants decided that the IRS's definition of "total income" and "cost of goods sold" were more generous to vendors than the SBA's regulation. As those lawyers and accountants saw it, under the tax laws and certain accounting principles, an IT value-added reseller could disregard revenue from sales as if they were "drop shipments."[1] This approach—which I will now call "drop-ship arbitrage"—meant that the money allocable to the original technology provider never shows up on the tax records, even if they show up on their financial systems.

On that theory, if the government paid me $100 for licenses to a SaaS product and I paid the SaaS company $92 and only kept $8, my receipts for tax purposes would only be $8, not $100. In other words, even if the SBA rules say that "reimbursements for purchases a contractor makes at a customer's request" count as receipts, for tax purposes I can ignore them.

Could this work? Well, that federal judge didn't think so. As he wrote:

Tax returns may be used to calculate receipts, but they cannot be used to skirt § 104(a)’s clear guidance. Even if the [defendant's] tax returns were prepared correctly, Defendants still needed to calculate receipts using § 104(a)’s basic formula: receipts are “all revenue . . . reduced by returns and allowances,” and “the only exclusions from receipts are those specifically” listed in § 104(a).

But that was 2023. A few weeks ago, the SBA's Office of Hearings and Appeals dropped a bomb just in time for the SEWP VI solicitation in a matter called "Size Appeal of: Colossal Contracting, LLC".

Colossal Contracting, as you can guess, is a IT value-added reseller that uses NAICS code 541512 and self-certified as a small business. In 2023, the SBA determined that Colossal was not a small business based on its tax returns from 2017 to 2021. Then, after amending its 2020 tax return and filing its 2022 tax return, Colossal applied for certification as a small business.

Now, it might be surprising to know that Colossal claimed a small business status under 541512 despite receiving over $340 million in awards during Fiscal Year 2022. But by now you can guess what happened: Colossal did the drop-ship arbitrage and its tax records showed a lower amount for cost of goods and total income. According to Colossal's accountant:

[I]t is common practice for concerns that identify as value-added resellers to calculate net revenue by disregarding the cost of goods sold. [The accountant] illustrated the net revenue method by providing a spreadsheet listing [Colossal's] receipts, costs, and revenue associated with [Colossal's] value-added reselling business. The spreadsheet indicates that Colossal's cost of goods sold was approximately [XXXXX] in 2021 and [XXXXX] in 2020. Thus, if the value-added reseller cost of goods sold is included in determining [Colossal's] receipts, [Colossal's] [exceeds] the applicable $34 million size standard.

How did that work out for Colossal? In January 2024, the SBA denied Colossal's small-business claim, citing the federal judge's opinion.

But then Colossal appealed, arguing that the SBA erred by looking beyond the tax returns and looking at the receipts under net-revenue method. Could Colossal use its tax records to, in the words of the federal judge, "skirt § 104(a)’s clear guidance?"

The answer is yes. Yes, they could.

On appeal, the Office of Hearings and Appeals ruled that "considering the plain language of 13 C.F.R. § 121.104(a), OHA's case precedent, and the relevant regulatory history, I must conclude that the Area Office clearly erred in the instant case by utilizing information beyond Appellant's tax returns to determine receipts."

According to OHA, "if tax returns are available for the years under review, such returns must be used to calculate a concern's receipts, to the exclusion of any extrinsic financial information."

Full stop. Look at the tax records. End of story.

So, where does that leave us? According to a federal judge, the rule's plain language means you count everything, including value-added reseller cost of goods, to determine size status. According to OHA, the rule's plain language means you count whatever the tax returns say, which can — in practice — exclude value-added reseller cost of goods. In other words, ¯\_(ツ)_/¯.[2]

Will this all hold up in subsequent litigation? Will the SBA need to update its regulations to provide clarity? Beats the heck out of me. I'm not your lawyer.

What I do know, though, is that there are a bunch of companies about to bid on NASA SEWP VI that are likely going to be paying lawyers and accountants a princely sum of money to explore doing their own drop-ship arbitrage.

[1] The idea of a drop shipment is one "where items bought from an online store are shipped directly to customers by the supplier or manufacturer." In a drop shipment, the item is never under the "control" of the seller, because the original supplier handles the shipment and fulfillment.

[2] Oh sure, lawyers will tell you that there are nuances here and ways to distinguish BidSolve and Colossal. I'm not suggesting that lawyers can't lawyer their ways out of this box. But I am saying that the federal judge and OHA both appear to think that the language is plain in opposite directions.

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