The below article has been updated to reflect threshold adjustments SBA announced in December 2022 to Personal Income, Net Asset and Total Asset limitations.
Our smaller government contracting clients often ask: “How can I manage operations in order to remain under the financial limitations set by the Small Business Administration’s (SBA) 8(a) program?” This discussion usually also begs the question: “How does income tax planning for my 8(a) business correspond with efforts to stay within the 8(a) program’s limitations?” After summarizing the limitations 8(a) companies and their owners face, this article will attempt to briefly address these questions.
What are the financial limitations under the 8(a) program?
They can be summarized as four tests:
1. Personal Income: the business owner personally must maintain an adjusted gross income (AGI) of less than $400,000. This calculation excludes pass-through income from the LLC, partnership or S-Corp as long as earnings and profits are being reinvested in the business. An exclusion is also allowed for withdrawals made to pay taxes on pass-through income, but withdrawals for personal use are not excluded.
2. Net Worth: The net worth of an 8(a) owner must remain below $850,000 each year. Exclusions are allowed for:
- The individual’s primary residence,
- The value of the owner’s interest in the 8(a) company, and
- The value of qualified retirement accounts.
3. Total Asset: the value of all the individual’s assets must remain less than $6.5 million. The only exclusions allowed for this test are qualified retirement accounts. To date, no official guidance has been released by the SBA regarding how an owner’s interest in the 8(a) company should be valued.
4. Excessive Withdrawals: for 8(a) companies with sales in excess of $2 million, an owner cannot withdraw more than $400,000 from the company. Lower thresholds apply for companies with less than $2 million in sales. A withdrawal includes retirement contributions, rent paid to affiliate companies, and withdrawals for personal use (as opposed to withdrawals needed to pay income taxes on pass-through income, which are exempt). Even loans to related parties and distributions to non-employee family members can be included. Owner’s salaries are generally not considered withdrawals unless the SBA believes the company is using owner salaries to circumvent the excessive withdrawal limitations.
Operating under these limitations for as long as possible or needed, can be challenging for a rapidly growing 8(a) company, and some common tax planning strategies either may not be applicable or may be detrimental to company goals in the long run.
How can I manage operations in order to remain under the financial limitations set by the SBA’s 8(a) program?
Of the four tests summarized above, planning to remain within the personal income and excessive withdrawal tests can be the most straight-forward. The owner’s personal income for the past two years must be accurately tracked in order to determine the upper threshold of the owner’s salary for the current year. For many start-up companies, the first few years may be leaner, allowing the owner to receive income in excess of $400,000 in the 3rd year and still maintain a three-year average below $400,000. A chart projecting income for future years can be constructed to help the owner plan out and maximize income as the company becomes more profitable.
Since withdrawals are limited to $400,000 per year, planning can be done at year end to maximize the withdrawal for each year, taking care to include all forms of withdrawals, not just cash distributions (i.e., retirement contributions). If the owner is getting close to the limitations applied by the net worth or total asset tests, withdrawals could be utilized to make larger contributions to retirement plans. These withdrawals would then not impact those tests, while still maximizing the withdrawals under this limitation.
The net worth test is usually not a limiting factor for many 8(a) owners since it does not include the value of the owner’s interest in the 8(a) company. However, if the owner has any rapidly appreciating assets outside of the 8(a) company ownership interests, they may need to be sold or transferred in order to preserve 8(a) eligibility.
Generally, the total asset test is the most difficult for an owner of a growing 8(a) company to control because it includes the value of the ownership interest. Often when an 8(a) company is forced to graduate early from the program, it is a result of the total asset test limitation being violated due to the value of the ownership in the 8(a). Not many strategies exist to help in this scenario, other than taking valuation discounts for lack of control and lack of marketability in order to reduce the value of the ownership interest. As the company approaches this limitation, it is generally advisable to plan for transition out of the 8(a) program.
How does income tax planning for my 8(a) business correspond with efforts to stay within the 8(a) program’s limitations?
8(a) companies on cash basis can still utilize various tried and true tax planning techniques, such as delaying income collection and paying or pre-paying expenses towards year end and taking advantage of bonus and 179 depreciation rules. Recent experience has shown that many 8(a) companies incorrectly report and calculate the qualified business income (QBI) deduction, which can be a very large deduction and will not impact the 8(a) limitations. Various business credits available at the federal and state levels may also be available, and do not affect the 8(a) limitations.
Some activities that may otherwise be harmless or recommended for other companies could cause an 8(a) company to be disqualified. For example, if an 8(a) owner wants to start another company doing related work and decides to create a separate entity outside of the 8(a) company, this may normally be advisable. However, as the new company grows, the ownership interest presumably would not be excluded from the net worth and total asset tests, and thus may cause the 8(a) company to be prematurely terminated from the program. A more advisable structure may be to make the new company a subsidiary of the 8(a) company, shielding its value at least from the net worth test’s much lower threshold. Other potential pitfalls include taking out large retirement plan distributions and accidently taking excessive withdrawals through loans to related parties, personal withdrawals and large retirement plan contributions.
In Summary
The 8(a) program offers tremendous opportunities for smaller government contracting companies, which it protects by enforcing the above limitations. With proper planning, 8(a) companies can manage their income tax liability and remain compliant with the limitations for as long as possible, before making a planned, orchestrated transition out of the 8(a) program.
