With almost $100 billion in the fiscal year 2017 budget designated for Small Business Administration (SBA) set-aside programs, contracting officers and large prime contractors are actively looking for ways to meet this contracting goal.
The SBA’s multiple set-aside programs include socio-economic disadvantage programs such as 8(a) Business Development, HUB Zone, Service Disabled Veteran Owned (SDVO), and Women Owned Small Business (WOSB). Each program carries a variety of compliance requirements, which, if violated, can cause a business to lose its SBA designation.
Economically disadvantaged programs have strict financial requirements for obtaining entry to and maintaining participation in the program. To ensure the company is financially stable upon exit of one of these programs, the SBA has placed restrictive requirements on the owner’s ability to withdraw money from the business.
Excessive Withdrawals
Managing the limits over adjusted gross income (AGI), net worth, total assets and revenue size can be challenging, but the excessive withdrawals limit is by far the most difficult. Depending on the company’s revenue level, the owner is limited to $250,000 to $400,000 in withdrawals from the business. These withdrawals include loans and rent paid to related parties and distributions in excess of amounts needed to pay taxes. It also could include the owner’s salary in excess of what is deemed to be reasonable compensation.
Not only will withdrawals of cash from the business count against the excessive withdrawal limit, but they also will count in the owner’s AGI calculation. The AGI calculation normally excludes income passed through to the shareholder on a K-1 from a partnership or S corporation as long as the profits are left in the business.
For example, an owner of an 8(a) business concern takes W-2 wages of $200,000 and also takes shareholder distributions from the S corporation of $300,000 in the same year. Depending on the use of the shareholder distributions, this could be allowed.
The wages are below the AGI limit of $350,000 and the withdrawals are under the top limit of $400,000. But if the owner’s tax liability on the profits of the business is only $100,000 in this year, it now has withdrawals in excess of amounts required to pay the $200,000 tax. This excess would be included in the AGI calculation and result in an AGI of $400,000, which is over the limit.
This is sometimes done inadvertently and can be cured by either putting the excessive withdrawals back into the business in the same year or by making the election to apply the overpayment of taxes to the following year’s tax liability. Leaving the excess tax payments on deposit with the IRS also may satisfy the SBA.
Managing the Size Risk
Avoiding early graduation from the 8(a) program also requires planning of revenue levels and sources of revenue. The contractor’s primary NAICS Code dictates the average receipts the contractor can have over a three-year period. Exceeding this three-year average limit for two consecutive periods will result in an early exit from the program. Not properly transitioning revenue sources away from set-aside contracts at the proper pace during the last five years of the program also can result in early graduation.
Managing the Net Worth and Total Asset Risk
Net worth of the business owner is required to remain below $750,000 throughout the nine-year 8(a) program. For a successful business, this may be difficult to avoid. Fortunately, the value of the owner’s personal residence, qualified retirement accounts and value of the business are excluded from the calculation. On the other hand, the total assets test, which must remain below $6 million, does include the owner’s personal residence and value of the business. Qualified retirement accounts remain excluded.
Typically, the value of the business is measured at “book value,” but in some circumstances, the fair market value may be less. Obtaining a qualified business valuation showing a lower fair market value may prevent early graduation.
Also, for a WOSB to qualify as economically disadvantaged, net worth upon entry to the program must be below $250,000. A spouse’s income and wealth are normally excluded from this calculation, but the SBA will be on the lookout for transfers from the woman to her spouse or trust controlled by the woman during the previous two years. If the SBA detects transfers, it may include these assets in the applicant’s net worth calculation to determine eligibility for entry into the program.
Control Requirements
For all these set-aside programs, majority ownership and control of the business is required to reside with the qualifying individual). The SBA has made it very clear that control is not determined by the company’s ownership percentage.
The SBA will look at a variety of information to determine if the majority owner actually controls the business, including:
- Does he/she hold the highest officers’ position in the company?
- Is he/she active in the company’s day-to-day operations and long-term decisions?
- Is he/she the company’s highest paid employee?
- Does he/she work at the business full time?
A situation where a qualifying individual may own 51 percent of the company but does not meet the control requirement is grounds for dismissal from the program and may be considered fraud in some cases.
Risk of Affiliation
Affiliation between entities typically follows control and may be evidenced by stock ownership, family relationship between owners, common management, and merger, stock option or buy-sell agreements. If the SBA determines two entities are affiliated after evaluating the totality of the circumstances, it may aggregate average their annual receipts in determining whether they continue to qualify as a small business under the applicable NAICS code.
Recent rules by the SBA have expanded small businesses’ ability to work together and avoid affiliation. The 8(a) Mentor Protégé program has been around for many years, but in July 2016 the SBA expanded this program to all other set-aside programs. This allows a large business to enter into a joint venture with a small business under a formal arrangement approved by the SBA for designated small business procurements and avoid affiliation.
Further, in May 2016, the SBA issued its rule that clarified limitations on subcontracting and introduced the idea of “similarly situated entities.” This rule also expands small business contractors’ ability to work together and avoid affiliation. Normal subcontract limits that require the prime contractor to perform a minimum percentage of the contract can be ignored if the entities are considered to be “similarly situated” under the same set-aside program, and allows both entities to be considered “small” for the NAICS code assigned to the subcontract.
