Withdrawals and Owner Compensation

Background Information – Economically Disadvantaged
In order to be 8(a) certified the owner of the firm must prove they are economically disadvantaged, as defined by the SBA. This means the individual cannot be in the top 1% of income earners or wealth holder in the United States.

Three Criteria
1. Average income for the applicant cannot exceed $250,000 on average for the past three years.
2. Adjusted Net worth cannot exceed $250,000 excluding (personal residence, retirement accounts, and the applying 8(a) business.)
3. The applicant cannot have more than $4,000,000 in total fair market value of assets regardless of debt.

In this newsletter we are going to cover economically disadvantaged criteria 1 above.

Part 1 – Withdrawals
Withdraws from the business which the business owner did not used to pay taxes associated with the profits earned by the business can create the following issues.
1. Withdraws count towards the owners personal income and effect the calculation of a three year average income that is required to be less than $250,000 to apply.
2. Withdrawals reduce the shareholder equity in the firm. If negative shareholder equity is created by withdrawing too much, the firm may become ineligible to apply for 8(a).
3. Withdrawals lower the working capital in the firm because cash is used to make the payment and that reduces the current asset figure on the balance sheet. If working capital is reduced to a point where it hinders the firm’s ability to perform on 8(a) contracts, the SBA will reject the application.

Part 2 – Applicant Owner Under-Compensation
The SBA pays very close attention to the compensation of the applicant owner reviewing several important considerations
1. Ideally the 8(a) applicant is the highest paid person in the company. This is consistent with the assertion the applicant is making to the SBA that they are the holder of the highest position within the firm. When the applicant is not the highest paid person within the firm a credible justification must be made to the SBA regarding the actual business purpose for the pay structure misalignment. This justification can be that the owner is making a current sacrifice for future growth paying market rates for the higher paid person’s skill sets.

2. When a minority owner of the applicant firm has a higher salary than the qualifying owner it is difficult to create a credible response because one owner is then making a sacrifice for future growth that another owner is not making. Therefore the argument that there is a business purpose for the applicant owner making less money usually fails this SBA test.

3. A dividend provided to owners counts towards overall compensation. So this should not be used as a method for compensating a minority owner more highly than the applicant owner.
If you would like more information regarding these topics or would like for us to determine if you qualify for the SBA 8(a) certification program give us a call at 513-843-4288 or click the link below to be taken to our pre-qualification tool.