To qualify for the 8(a) program, a disadvantaged individual must fall below certain personal net worth thresholds. Loans can reduce net worth–but not all loans are treated the same.

According to the SBA Office of Hearings and Appeals, if a disadvantaged individual intends to rely on a loan to reduce net worth, the loan better be bona fide.

In a recent decision, OHA held that it is the unconditional obligation to repay that is critical to determining whether a loan will reduce the net worth of an 8(a) applicant.

The 8(a) program has a net worth threshold of $250,000, which the socially and economically disadvantaged individual(s) must be below to initially qualify for the program. Once a company is admitted to the 8(a) program, the net worth threshold for ongoing participation rises to $750,000.  Various assets are exempted from these thresholds, including equity in the 8(a) applicant/participant and equity in the disadvantaged individual’s primary residence.  (A second “catch all” net worth threshold–$4 million for applicants and $6 million for participants– eliminates most of these exemptions.)

Net worth, of course, ordinarily means assets minus liabilities.  Due to their status as liabilities, loans can offset an applicant’s net worth. But to do so, they must be bona fide, or legitimate liabilities, according to a recent OHA case.

OHA’s decision in ORB Solutions Inc., SBA No. BDPE-559 (2017) is a tale of two loans: one deemed bona fide, the other not.

In 2011, ORB Solutions Inc. loaned its owner, Ms. Seema Gupta, $132,858.  At the time the loan was made, there were no “common indicia of a typical loan arrangement including a promissory note, repayment schedule, or provision for interest.” After Ms. Gupta used a portion of the loan for corporate investments, she kept the remainder in her personal bank account instead of returning it to the company.

In August 2015, ORB Solutions applied to the 8(a) program. In evaluating ORB Solutions’ application, the SBA determined that the 2011 loan was not bona fide; therefore, it was not a liability that would offset her net worth. As a consequence, Ms. Gupta’s net worth exceeded the $250,000 threshold. In May 2016, the SBA denied ORB Solutions’ initial application.

Around the same time, the situation reversed itself: Ms. Gupta loaned $27,226 to ORB Solutions. The 2016 loan, however, had a much different flavor. It had all of the hallmarks of a typical loan, including a repayment schedule and a promissory note.

In June 2016, ORB Solutions and Ms. Gupta executed a promissory note for the 2011 loan. In July 2016, ORB Solutions requested reconsideration of the SBA’s decision.

Although Ms. Gupta had now provided a promissory note for the 2011 loan, that promissory note had been executed “five years after the transfer of funds,” and the SBA found that there was “nothing else in the record” to establish that the loan was bona fide. The SBA determined, again, that the 2011 loan was not a liability that offset Ms. Gupta’s net worth. On the other hand, the 2016 loan was counted as an asset. The SBA denied ORB Solutions’ application for a second time.

ORB Solutions appealed to OHA. There, it argued the SBA had erred on its treatment of both loans.

With respect to the 2011 loan, ORB Solutions contended the loan was a true bona fide liability that Ms. Gupta was obligated to repay to ORB Solutions; therefore, it should offset some of Ms. Gupta’s net worth. OHA was not convinced.

As OHA explained, “[i]t was reasonable for the SBA to conclude that the $132,858 transfer advance [from ORB to Ms. Gupta] was not a true, bona fide liability to Ms. Gupta but was, in effect, an asset that Ms. Gupta likely would not enforce against herself or her spouse.” OHA noted that the record was “void of any common indicia of a typical loan arrangement, including a promissory note, repayment schedule, or provision for interest.” The “obligation to pay was conditional rather than unconditional.” As a result, “such conditional liability should not be considered as a factor to reduce Ms. Gupta’s net worth because it was uncertain whether the loan would in fact be repaid.”

Stated differently, OHA found the loan was not bona fide because there was nothing to guarantee the company would be paid back as the loan’s debtor and enforcer are one and the same. Consequently, the SBA was correct to find that the 2011 loan was not a liability that reduced Ms. Gupta’s net worth.

Separately, ORB Solutions also argued the 2016 loan from Ms. Gupta to ORB Solutions should not count as an asset because it involved the same parties as the first loan, which was found not to be a bona fide loan. OHA was again not convinced.

Comparing the two loans, OHA explained “the set of circumstances surrounding the [second] loan poses a different scenario because the SBA made its asset determination based on a record that clearly demonstrated the existence of a loan arrangement that proves the clear intent to execute a repayment schedule for that loan and the intent that the loan continues to accrue interest payable to Ms. Gupta.” As such, ORB Solutions was unconditionally obligated to repay Ms. Gupta. Because Ms. Gupta was entitled to full repayment of her loan, OHA found it was properly counted as an asset.

As OHA explained, ORB Solution’s loans told two very different stories. The first loan from ORB Solutions to Ms. Gupta did not include an unconditional obligation to repay (at least not until five years later), whereas the second loan did include legally-binding repayment obligations from the outset. As a result, the first loan was not a liability and did not reduce Ms. Gupta’s net worth, while the second loan was an asset that counted toward Ms. Gupta’s net worth.

A situation like that seen in ORB Solutions is one that other 8(a) applicants can unintentionally find themselves facing. Oftentimes, small business owners receive loans from non-traditional sources, and these loans don’t always include the sort of binding requirements that SBA will look for to determine if the loan is bona fide. As ORB Solutions painfully discovered, for those businesses looking at the 8(a) program participation in the future, managing loans can be an important component of acceptance into the program.