SBA Looking Closely at 8(a) Owners’ Finances By Nan Kargahi and Jon Williams The SBA appears to be taking a harder line on 8(a) owners’ compliance with the financial restrictions that govern continued eligibility for the agency’s business development programs. This is not altogether surprising because as congressional scrutiny increases, it follows that the SBA will step up enforcement actions to meet this heightened scrutiny. Recently, such actions have involved regulations the SBA has historically not strictly enforced. 8(a) owners should be aware that even if the SBA allowed certain conduct in the past, it may not continue to permit it, especially if the conduct violates any of the SBA’s program requirements. There are four personal financial rules that program participants must follow to avoid being the target of an enforcement action. First, owners cannot receive average annual compensation (over the most recent two-year period) in the top 1% of all U.S. taxpayers. This equates to roughly $200,000 per year, and includes both salary and other sources of income. Second, the owner’s personal net worth cannot exceed $750,000. Personal net worth is calculated as the sum of the owner’s assets minus liabilities, and excludes the value of the personal residence and interest in the 8(a) firm. Third, the SBA’s so-called “excessive withdrawal rule” provides that an owner cannot withdraw more than $300,000 from the firm on an annual basis, and may only withdraw that amount if the entity generated more than $2 million in sales (the withdrawal threshold is lower if the company’s sales are less than $2 million). Several years ago, the SBA indicated that, rather than strictly enforcing the rule, it would use its discretion and apply a sliding scale to determine the annual withdrawal threshold. Under this approach, if the company’s annual revenue was $4 million, the owner could withdraw $600,000 (i.e., 15% of $4 million) or if the annual revenue was $6 million, the owner could withdraw $900,000, and so on. Finally, under the “total asset rule,” the SBA may evaluate an owner’s total assets in determining whether he or she remains economically disadvantaged. Unlike the personal net worth rule, the calculation of total assets includes the owner’s personal residence and interest in the 8(a) firm. This means the SBA may conclude that an owner is no longer economically disadvantaged solely because the value of the business is several million dollars (the threshold is not definitive, but is likely between $2 million and $4.5 million). In such circumstances, it would be irrelevant that the owner’s personal net worth is far less than $750,000 or that the owner’s annual compensation is less than the top 1% of all U.S. taxpayers. Indeed, the SBA need only “rationally” relate the owner’s total assets to a finding that the owner is not economically disadvantaged in order to justify a conclusion that the owner’s total assets are excessive. Recently, program participants have encountered surprising enforcement actions under these rules. For example, the SBA proposed a participant for early graduation because of allegedly excessive withdrawals of approximately $900,000, far less than 15% of the company’s $19 million annual revenue. The owner was able to maintain her eligibility only after agreeing to reinvest a significant portion of the withdrawals back into her company. Another program participant was recently confronted with a proposed termination based upon her allegedly excessive total assets. In calculating total assets, the SBA simply included a snapshot of the firm’s book value, which vastly inflated the figure. In light of these actions, we recommend compliance with the plain regulatory language rather than relying on SBA discretion. This means withdrawing no more than $300,000 from the firm on an annual basis (excluding withdrawals for business income tax payments), ensuring that the disadvantaged owner’s annual compensation does not exceed the top 1% of all U.S. taxpayers, and maintaining an accurate valuation of the company. As to the latter, if the company’s value becomes too great, owners can consider divesting themselves of 100% ownership because the calculation of total assets includes only the owner’s stake in the company. It is important for program participants to be mindful of the SBA’s personal financial requirements as they grow in the program. Please contact us if you would like more information regarding the rules and how they are being enforced. (Nan Kargahi is a partner with PilieroMazza PLLC. Her practice is concentrated on representing companies in a variety of corporate matters, including mergers, acquisitions, divestitures and joint ventures as well as corporate formation and governance. Jonathan Williams is an associate with PilieroMazza PLLC, where he practices in the areas of government contracts, general corporate matters, and telecommunications law. Mr. Williams also has an emphasis on federal procurement programs, such as the 8(a), small disadvantaged and HUBZone programs.)