“Disadvantaged” Small Businesses: Definitions and Designations for Purposes of Federal and Federally Funded Contracting Programs
Released: 2015-12-18T00:00:00

T his report discusses what constitutes a "disadvantaged" small business for purposes of federal and federally funded contracting programs and how firms are certified or otherwise designated as such. Three primary categories of disadvantaged small businesses are currently eligible for various contracting programs under federal law: (1) small businesses participating in the Small Business Administration's (SBA's) Minority Small Business and Capital Ownership Development Program (commonly known as the 8(a) Program) (8(a) participants); (2) "small disadvantaged businesses" (SDBs); and (3) "disadvantaged business enterprises" (DBEs). These firms are characterized as "disadvantaged" because they are at least 51% unconditionally owned and controlled by socially and economically disadvantaged individuals or groups. Members of certain racial and ethnic groups are presumed to be disadvantaged, and other individuals can prove personal disadvantage by a preponderance of the evidence. Veterans and persons with disabilities are not presumed to be disadvantaged for purposes of these programs. However, there are separate contracting programs for them. Disadvantaged groups include Indian tribes, Alaska Native Corporations, Native Hawaiian Organizations, and Community Development Corporations. In FY2014, the federal government awarded $34.7 billion in contracts or subcontracts to SDBs, including $16.3 billion in contracts to 8(a) participants. Similar data about contracting with DBEs is not publicly available.

Contracting opportunities for disadvantaged small businesses are perennially of interest to the Members and committees of Congress because of small businesses' widely asserted role in job creation. Also, there has been concern that the recession of 2007-2009 disproportionately affected disadvantaged small businesses, and that such businesses have been slow to recover. A separate report, CRS Report R43573, Federal Contracting and Subcontracting with Small Businesses: Legislation in the 113th Congress , by [author name scrubbed], discusses recently enacted and introduced legislation pertaining to the 8(a) and SDB programs.

Categories of Disadvantaged Small Businesses

8(a) Participants

Small businesses that are at least 51% unconditionally owned and controlled by "socially and economically disadvantaged individuals" or groups are eligible for the Minority Small Business and Capital Ownership Development Program. Implemented by the SBA under the authority of Sections 7(j) and 8(a) of the Small Business Act, as amended, this program is commonly known as the 8(a) Program, and participants in it are often called 8(a) participants or 8(a) firms.

Social Disadvantage

Owners of 8(a) firms must be "socially disadvantaged," or have been subjected to "racial or ethnic prejudice or cultural bias within American society because of their identities as members of groups and without regard to their individual qualities." Members of the following racial and ethnic groups are presumed to be socially disadvantaged:

Black Americans; Hispanic Americans; Native Americans (Alaska Natives, Native Hawaiians, or enrolled members of a Federally or State recognized Indian Tribe); Asian Pacific Americans (persons with origins from Burma, Thailand, Malaysia, Indonesia, Singapore, Brunei, Japan, China (including Hong Kong), Taiwan, Laos, Cambodia (Kampuchea), Vietnam, Korea, The Philippines, U.S. Trust Territory of the Pacific Islands (Republic of Palau), Republic of the Marshall Islands, Federated States of Micronesia, the Commonwealth of the Northern Mariana Islands, Guam, Samoa, Macao, Fiji, Tonga, Kiribati, Tuvalu, or Nauru); Subcontinent Asian Americans (persons with origins from India, Pakistan, Bangladesh, Sri Lanka, Bhutan, the Maldives Islands or Nepal); and members of other groups designated from time to time by SBA....

Persons who are not members of these groups must establish individual social disadvantage by a preponderance of the evidence, including (1) at least one objective distinguishing feature contributing to social disadvantage, such as race, ethnic origin, gender, or physical handicap; (2) personal experiences of substantial and chronic disadvantage in American society; and (3) negative impact on entry into or advancement in the business world because of this disadvantage.

Economic Disadvantage

Owners of 8(a) firms must also be "economically disadvantaged" in that their "ability to compete in the free enterprise system has been impaired due to diminished credit and capital opportunities as compared to others in the same or similar line of business who are not socially disadvantaged." Economic disadvantage is not presumed for any individual owners. Rather, all individuals upon whom an 8(a) firm's eligibility is based must describe their economic disadvantage in a narrative statement and submit personal financial information to the SBA. This information generally includes, among other things, income for the past three years, personal net worth, and the fair market value of all assets. An individual's net worth, excluding ownership interest in the 8(a) firm and equity in his or her primary personal residence, must be less than $250,000 at the time of application to the 8(a) Program, and less than $750,000 thereafter. The value of retirement accounts was historically not excluded when the net worth of prospective 8(a) participants was calculated, but the SBA amended its regulations in February 2011, allowing the value of retirement accounts to be excluded in certain circumstances.

Formerly, the SBA also compared the financial condition of firms applying to the 8(a) Program to the financial profiles of small businesses in the same primary industry classification, or similar line of business, that were not owned by socially and economically disadvantaged individuals when determining economic disadvantage. However, in the February 2011 amendments, the SBA removed this provision from its regulations on the grounds that the provision caused "confusion," although the SBA noted that it would continue to review the financial condition of 8(a) applicants in determining whether they have "potential for success."

Applications to the 8(a) Program

Firms must apply to participate in the 8(a) Program and generally may not receive contracting or other federal assistance based upon 8(a) status until the SBA approves their application. The application form requires submission of various materials including, but not limited to, financial statements, federal personal and business tax returns, and personal history statements.

Once accepted into the 8(a) Program, firms must inform the SBA in writing of any changes in circumstances that adversely affect their eligibility. Each firm must also complete an annual review, which requires submission of (1) certifications that the firm meets the eligibility requirements and no changes in circumstances adversely affect its eligibility; (2) personal financial information for each disadvantaged owner; and (3) a financial statement for the firm, among other things. Depending upon the firm's annual gross receipts, its financial statement may need to be audited by an independent public accountant, as Table 1 illustrates.

Maximum Nine-Year Term in the 8(a) Program

Firms may participate in the 8(a) Program one time, for a period of no more than nine years. Once a firm has exited the program after participating in it for any period of time, it is generally ineligible for further participation. Additionally, socially and economically disadvantaged individuals may confer eligibility for the 8(a) Program upon only one firm over their lives. In contrast, disadvantaged groups (i.e., Indian tribes, Alaska Native Corporations (ANCs), Native Hawaiian Organizations (NHOs), and Community Development Corporations (CDCs)) may confer eligibility upon multiple 8(a) firms, which may participate in the 8(a) Program concurrently (subject to certain limitations on the primary industries in which they operate), or at different times.

Contracting and Related Assistance for 8(a) Participants

Federal agencies "set aside" certain contracts for 8(a) firms by conducting procurements in which only 8(a) firms may compete. They can also award contracts to 8(a) firms on a sole-source basis, sometimes in circumstances in which they could not otherwise make sole-source awards. Federal agencies reportedly spent $16.3 billion on competitive or sole-source contracts with 8(a) participants in FY2014. However, 8(a) participants are not assured of receiving federal contracts, and only 44% of 8(a) firms not owned by Alaska Native Corporations reportedly received contracts in one recent fiscal year.

8(a) firms are also eligible for (1) direct and guaranteed loans from the SBA; (2) transfer of technology and surplus property owned by the United States; and (3) management and technical assistance, including training in financing, management, accounting, bookkeeping, marketing, the operation of small businesses, and the identification and development of new business opportunities. Additionally, the SBA sponsors a mentor-protégé program for eligible 8(a) participants. Mentors are established firms that provide their 8(a) protégés with technical or management assistance; financial assistance in the form of equity investments or loans; subcontracts; and assistance in performing prime contracts through joint venture arrangements. In particular, mentors and protégés may form joint ventures that could qualify as "small" for purposes of government procurements, including sole-source awards under Section 8(a).

Small Disadvantaged Businesses

"Small disadvantaged businesses" (SDBs) include 8(a) participants and other small businesses that are at least 51% unconditionally owned and controlled by socially or economically disadvantaged individuals or groups. SDBs that are not 8(a) firms need not demonstrate potential for success, and individuals owning and controlling non-8(a) SDBs may have net worth of up to $750,000 (excluding ownership interests in the SDB firm and equity in their primary personal residence). Otherwise, however, SDBs must generally satisfy the same eligibility requirements as 8(a) firms, although they do not apply to the SBA to be designated SDBs in the same way that 8(a) firms do.

Certification of SDBs

At one time, SDBs had to be certified by the SBA, or a private certifying entity acting in compliance with SBA regulations, to qualify for certain federal programs as prime contractors. However, most federal programs for SDB prime contractors have been discontinued, with only the government-wide and agency-specific goals for the percentage of federal contract and/or subcontract dollars awarded to SDBs each year remaining. Because of the discontinuance of these programs, the SBA ceased certifying SDBs in October 2008, and no longer issues regulations for private certifiers. In the few cases where SDB certification is currently required, 8(a) participants are deemed to be certified, and other firms may be certified by the agency conducting the procurement, private certifying entities, or state and local governments. Firms not relying on their 8(a) status that have submitted applications for SDB certification to a procuring agency are treated as if they are certified so long as the agency has not rejected their application. Certification generally lasts for three years, and the same firm could apparently be certified as an SDB repeatedly, so long as it meets the requirements for certification.

Firms do not need to be certified SDBs to qualify for federal programs for subcontractors. Rather,

[a] firm may represent that it qualifies as an SDB for any Federal subcontracting program if it believes in good faith that it is owned and controlled by one or more socially and economically disadvantaged individuals.

Prime contractors "acting in good faith" may rely on subcontractors' written representation of their status as an SDB. However, the SBA retains the authority to review the status of uncertified firms that represent themselves as SDBs for purposes of federal subcontracts when it receives "credible information" that they are not disadvantaged. The SBA, agency contracting officers, and other "interested parties" (such as business competitors) may also protest firms' SDB status.

Contracting Programs for SDBs

The government promotes contracting and subcontracting with SDBs by setting government-wide and agency-specific goals for the percentage of federal contract and subcontract dollars awarded to SDBs each fiscal year. The government-wide goal is that "not less than 5 percent of the total value of all prime contract and subcontract awards" be made to SDBs, a goal that was met in FY2014, when $34.7 billion was awarded to SDBs. Agency specific goals are generally also set at 5% of the total value of prime contracts and subcontracts awarded each fiscal year, although agency achievements range from 2.3% (Department of Energy) to 47.8% (SBA). In the past, agencies also had authority to "us[e] less than full and open competitive procedures and partial set-asides," including a 10% price evaluation adjustment, when evaluating bids or offers involving SDB contractors or subcontractors. However, such authorities have either expired or been subject to statutory conditions or judicial decisions precluding their use.

Other federal programs focus specifically on promoting SDBs as subcontractors on federal prime contracts. Agencies must negotiate "subcontracting plans" with the apparently successful bidder or offeror on eligible prime contracts prior to awarding the contract. Subcontracting plans set goals for the percentage of subcontract dollars to be awarded to SDBs, among others, and describe efforts that will be made to ensure that SDBs "have an equitable opportunity to compete for subcontracts." Failure to make a good faith effort to comply with the subcontracting plan constitutes a material breach of the contract, potentially allowing the agency to terminate the contract for default and subjecting the contractor to liquidated damages. Federal agencies may also consider the extent of subcontracting with SDBs in determining to whom to award a contract, or give contractors "monetary incentives" to subcontract with SDBs. Such incentives reward prime contractors by paying them up to 10% of the amount by which their actual performance in subcontracting with SDBs exceeds their proposed performance.

Disadvantaged Business Enterprises

Like 8(a) participants and SDBs, "disadvantaged business enterprises" (DBEs) are small businesses at least 51% unconditionally owned and controlled by socially and economically disadvantaged individuals. However, DBEs differ from 8(a) participants and SDBs in that members of the following groups—which include women—are presumed to be both socially and economically disadvantaged:

(i) "Black Americans," which includes persons having origins in any of the Black racial groups of Africa;

(ii) "Hispanic Americans," which includes persons of Mexican, Puerto Rican, Cuban, Dominican, Central or South American, or other Spanish or Portuguese culture or origin, regardless of race;

(iii) "Native Americans," which includes persons who are enrolled members of a federally or State recognized Indian tribe, Alaska Natives, or Native Hawaiians;

(iv) "Asian-Pacific Americans," which includes persons whose origins are from Japan, China, Taiwan, Korea, Burma (Myanmar), Vietnam, Laos, Cambodia (Kampuchea), Thailand, Malaysia, Indonesia, the Philippines, Brunei, Samoa, Guam, the U.S. Trust Territories of the Pacific Islands (Republic of Palau), Republic of the Northern Marianas Islands, Samoa, Macao, Fiji, Tonga, Kirbati, Tuvalu, Nauru, Federated States of Micronesia, or Hong Kong;

(v) "Subcontinent Asian Americans," which includes persons whose origins are from India, Pakistan, Bangladesh, Bhutan, the Maldives Islands, Nepal or Sri Lanka;

(vi) [w]omen;

(vii) [a]ny additional groups whose members are designated as socially and economically disadvantaged by the SBA, at such time as the SBA designation becomes effective.

Members of these groups must submit a signed, notarized statement regarding their group membership, as well as certain information concerning their economic condition. Additionally, their net worth cannot exceed $1.32 million, excluding their ownership interest in the DBE firm and equity in their primary residence. Individuals who are not members of designated groups must demonstrate by a preponderance of the evidence that they are socially and economically disadvantaged.

Certification of DBEs

DBEs are certified by Department of Transportation (DOT) funding recipients, who must determine DBEs' eligibility based upon (1) an on-site visit with the firm, including interviews with its principal officers; (2) an on-site visit to any job sites operated by the firm; (3) an analysis of the legal structure, ownership, and control of the firm, as well as its bonding and financial capacity; (4) the firm's work history, including the contracts it has received and the work it has completed; (5) a statement from the firm indicating its preferred type(s) of work and work locations; (6) a list of equipment and licenses owned by or available to the firm, as well as its key personnel to perform the work it seeks to do as part of the DBE program; (7) federal income tax returns for the past three years; and (8) a completed application form. All certifications must be final before the due date for bids or offers for any contract on which a firm seeks to participate as a DBE. Once certified, DBEs must provide written notices of any changes in circumstances affecting their eligibility as these changes occur. They must also produce a sworn affidavit affirming that there have been no changes in circumstances affecting the firm's eligibility each year on the anniversary of their date of certification.

Firms that have been certified as DBEs generally remain certified "until and unless" the funding recipient removes their certification, in whole or in part, using procedures spelled out in federal regulation. Assuming firms must be recertified, there is no apparent limit on the number of times they may be recertified. Certifications are state-specific, although states may recognize one another's certifications.

Contracting Programs for DBEs

DBEs are eligible for various contracting programs, most of which are operated by state governments and other entities that receive certain federal highway or transit funds, or airport funds. The federal government has as a goal that 10% of such funds be awarded to DBEs. However, this is "an aspirational goal at the national level" and "does not authorize or require [funding] recipients to set overall or contract goals at the 10 percent level, or any other particular level, or to take any special administrative steps if their goals are above or below 10 percent."

Funding recipients also generally set goals for DBE participation overall and on individual contracts that have the possibility of subcontracting. However, they are barred from using "quotas," or requiring that certain percentages of their contract dollars go to DBEs, and they can "set aside" contracts for DBEs only "in limited and extreme circumstances … when no other method could be reasonably expected to redress egregious instances of discrimination." Instead, they must use race-neutral means to meet "the maximum feasible portion" of these goals. Such means include

arranging solicitations, times for the presentation of bids, quantities, specifications, and delivery schedules so as to facilitate DBE participation; providing assistance in overcoming limitations that DBEs may encounter in obtaining bonding or financing; providing technical assistance and other services; publicizing contract opportunities and providing information about contracting procedures; assisting DBEs in developing and improving their business management, record keeping, and financial and accounting capabilities; providing services to help DBEs develop, participate in various kinds of work, and achieve self-sufficiency; assisting new start-up firms, particularly in fields where DBE participation has historically been low; distributing DBE directories to potential prime contractors; and assisting DBEs to develop their capability to utilize emerging technology and conduct business through electronic media.

Funding recipients cannot be penalized for failure to meet their goals unless they did not administer their DBE program in good faith.

Recipients may also establish development and mentor-protégé programs for DBEs, although participants in any mentor-protégé programs do not enjoy the same exemption from the SBA size standards when they form joint ventures as 8(a) firms participating in the SBA mentor-protégé program do.

Tabular Comparison of the Various Types of Disadvantaged Small Businesses

Table 2 provides a comparison of the various types of disadvantaged small businesses for purposes of federal and federally funded contracting programs.

Constitutionality of Federal Programs for Disadvantaged Small Businesses

All federal programs for disadvantaged small businesses currently define "disadvantage," in part, based on the presumption that racial and ethnic minorities, or women, are disadvantaged. Presumptions based on race have been found to constitute "explicit racial classifications," subjecting programs that incorporate them to "strict scrutiny" if they are challenged on the grounds that they violate the constitutional guarantee of equal protection. For a challenged program to survive strict scrutiny, the government must show that the program is necessary to meet a compelling government interest. Presumptions based on gender are similarly subject to heightened scrutiny, with the Supreme Court in United States v. Virginia having required the state of Virginia to provide an "exceedingly persuasive justification" for its policy of maintaining an all-male military academy. In contrast, classifications that are not based on race, gender, or another suspect classification, and that do not involve the exercise of a fundamental right, will generally be upheld so long as they are rationally related to a legitimate government interest.

The ability of programs to withstand strict or other heightened scrutiny may depend, in part, upon how the program is structured. In a recent decision, the U.S. District Court for the District of Columbia found that the 8(a) Program is not unconstitutional on its face, although it is unconstitutional as-applied in the military simulation and training industry. Particularly in its rejection of the facial challenge to the 8(a) Program, the court emphasized certain aspects of the program's history and requirements when finding that "breaking down barriers to minority business development created by discrimination" constituted a compelling government interest, and the government had a strong basis in evidence for concluding that race-based action was necessary to further this interest. For example, the court rejected the plaintiff's assertion that the 8(a) Program was "not truly remedial," but rather favored "virtually all minority groups … over the larger pool of citizens," because non-minority individuals may qualify for the program, and all 8(a) applicants must demonstrate economic disadvantage. Similarly, in finding that the program was narrowly tailored to meet the government's interests, the court noted (1) that goals for contracting with small disadvantaged businesses are purely aspirational, and there are no penalties for failing to meet them; (2) the nine-year limits on program participation for individual owners and firms; and (3) that SBA may not accept a requirement for the 8(a) Program if it determines that doing so will have an adverse effect on another small business or group of small businesses. The court emphasized that the last two factors, in particular, helped ensure that race-conscious remedies do not "last longer than the discriminatory effects [they are] designed to eliminate," and "work the least harm possible to other innocent persons competing for the benefit."

On the other hand, in 2008, the U.S. Court of Appeals for the Federal Circuit focused less on the details of the program than on the evidence of discrimination before Congress when Congress reauthorized the program when striking down a Department of Defense (DOD) program for SDBs. Specifically, the Federal Circuit found that the DOD program—which allowed DOD to take 10% off the price of bids or offers submitted by SDBs when determining which bid or offer had the lowest price or represented the best value for the government—was unconstitutional on its face because Congress lacked a strong basis in evidence for concluding that race-conscious contracting was necessary to remedy discrimination in the defense industry when it reauthorized the program in 2006. The district court, which had upheld the constitutionality of the challenged SDB program, had found that six state and local disparity studies, along with other statistical and anecdotal evidence, constituted a strong basis in evidence for the re-enactment. However, the Federal Circuit disagreed. It found that the six state and local disparity studies—which had been the "primary focus of the district court's compelling interest analysis and of the parties' arguments on appeal" —did not constitute a strong basis in evidence because they did not provide the "substantially probative and broad-based statistical foundation ... that must be the predicate for nationwide, race-conscious action." A similar lack of evidence of discrimination also played a part in the U.S. District Court for the District of Columbia finding that the 8(a) Program is unconstitutional as applied in the military training and simulation industry. However, in this case, DOD conceded that it had "no evidence of discrimination, either in the public or private sector, in the simulation and training industry."