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Featured Article: Do Your Clients Recognize the Risks of SBA Set Aside Programs?

 DHG views February 2018

Is The Compliance Risk Worth The Reward? A Closer Look Into the Compliance Risks Encountered in SBA Set Aside Programs

The benefits to participating in a Small Business Administration (SBA) set aside program can be extensive. With a federal contracting goal of almost $100 billion of the fiscal year 2017 budget designated for SBA set aside programs, contracting officers and large prime contractors are actively looking for ways to meet this contracting goal. SBA established multiple set aside programs to help small businesses participate in the procurement process.

These programs include socio-economic disadvantage programs such as 8(a) Business Development, HUB Zone, Service Disabled Veteran Owned (SDVO), or Women Owned Small Business (WOSB). In addition, SBA has its general small business designation. Having one of these designations enables a business to win procurements without the need to compete in full and open competition with large prime contractors. These set aside program designations are very valuable to a small business.

However, these set aside programs have compliance requirements that must be met. Being aware of the risks is the first step to compliance! Each program brings with it a variety of compliance requirements, which, if violated, can cause the business to lose their valuable SBA designation.

Economically Disadvantaged Programs and Associated Compliance Requirements


Economically disadvantaged programs like 8(a) Business Development or Economically Disadvantaged Woman Owned Small Business (EDWOSB) have strict social and financial requirements for obtaining entry to and maintaining participation in the program. The SBA’s goal for graduates of these programs is to produce businesses which can thrive in a competitive environment by using the experience and knowledge gained from participation. To ensure the business 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. Managing the limits over adjusted gross income (AGI), net worth, total assets and revenue size can be challenging, but by far, the excessive withdrawals limit is the most difficult.

Compliance Requirements for Excessive Withdrawals and Managing AGI Limits
Depending on the small business’ revenue levels, the owner is limited to $250,000
- $400,000 in withdrawals from the business. These withdrawals include loans to related parties, rent paid to related parties, distributions in excess of amounts needed to pay taxes. It could also include owner’s salary in excess of what is deemed to be reasonable compensation. Not only will withdrawals of cash from the business (other than for reasonable owner’s salary or tax distributions) count against the excessive withdrawal limit, but they will also 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 are only $100,000 in this year, they now have withdrawals in excess of  amounts  required  to  pay tax of $200,000. This excess would be included in the AGI calculation and result in 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 may also 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 primary NAICS Code (North American Industry Classification System) of the contractor dictates the average receipts over a three year period the contractor can have. 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 can also result in early graduation.

Managing the Net Worth and Total Asset Risk
Managing the net worth test and total assets test for 8(a) compliance also presents issues. Net worth of the business owner is required to remain below $750,000 throughout the nine year 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 less than $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 and obtaining a qualified business valuation showing a lower FMV 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. 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 over the previous two years. If transfers are detected by the SBA, they 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 (meaning service disabled veteran, socially disadvantaged, or economically and socially disadvantaged 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: do they hold the highest officers’ position of the company, are they active in the day to day operations and long term decisions of the business, are they the highest paid employee of the business, do they work at the business full time, etc. 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 is another significant concern for small businesses who are trying to manage their revenue limits under their primary NAICS code. 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 annual receipts of the entities 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 (WOSB/SDVOSB/VOSB). 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 which require the prime 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.

With all these opportunities, and the related risks, the right advisor can help ensure you successfully navigate this changing environment and reap the rewards of the SBA set aside programs. DHG is a professional service CPA firm with experienced professionals dedicated to the government contracting industry who are available and willing to help.

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About The Authors

Rob Oden, Partner, DHG Assurance
Phone: 757-316-3223    |    Email: rob.oden@dhgllp.com

Rob has more than 15 years of experience in the field of public accounting (all with DHG), concentrating his efforts in the construction, government contracting, and manufacturing and distribution industries. During that time, he has managed the assurance and tax preparation services for a number of clients in the Hampton Roads area, including several large internationally owned manufacturing and distribution companies, and construction and government contractors.

This wide range of audit and tax experience across many industries and accounting services has allowed Rob to develop the skills required to provide his clients with industry knowledge, timely tax advice, and the high level of knowledge and experience they should expect from their CPA.

Josh Brinkman, Senior Manager, DHG Assurance
Phone: 757-316-3246     |    Email: josh.brinkman@dhgllp.com

I certainly did not have career aspirations of becoming a Certified Public Accountant when I was a young boy. I was your typical 8 year old who saw himself playing baseball for his favorite team. Striking out the last batter of the World Series was a scenario every young baseball player plays in their mind. This continued until my sophomore year of college. My lovely girlfriend (who is now my wife) had a “come to Jesus meeting” with me. She gave me the blunt truth for which I am extremely grateful. She said, “Josh, you have to find a job…a REAL job.” So from that point, I spoke with various professors from different departments at Christopher Newport University. Each of them suggested their own department and how it was greater than any other study that CNU had to offer. But I took a more important step by examining myself. What kind of things did I enjoy that would lead to a successful career? I still had the same love for math that began when I was just a young kid. I loved learning but above all, I loved helping people. I could not think of a more fulfilling career than becoming a Certified Public Accountant.

CPAs do more than just taxes or audits. They sincerely and genuinely help people do things they would not be able to do on their own. When you think of meeting a CPA, you may picture a short guy, with a receding hairline and a growing belly. He may be wearing a short sleeve collared shirt with an outdated and stained tie. But I can speak on behalf of those CPAs and others when I say, we want to help…we want to make a difference.


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