To calculate a company’s size under a receipts-based NAICS code, the SBA will add the company’s total income to its costs of goods sold, as those amounts are reported on its tax returns. In fact, the SBA’s regulations are clear that it must use these reported amounts to determine a company’s size status.
What happens, then, when a company’s taxes show “income” that might not really reflect money in the company’s accounts? The SBA’s Office of Hearings and Appeals recently considered this question, and affirmed a company’s ineligibility based on the income reported in its tax returns.
In Kingfisher Systems, Inc., SBA No. SIZ-6003 (2019), Kingfisher appealed a determination that found it to be an ineligible large business under NAICS code 541512’s $27.5 million size standard. In response to the size protest, Kingfisher argued that its average annual receipts fell below the size standard, based on the “total revenue” that it independently calculated.
Finding Kingfisher to be an ineligible large business, the SBA Area Office noted that Kingfisher’s revenue calculation was incorrect. Rather than adding its total income and costs of goods sold (as reported on its tax returns), Kingfisher instead listed only its gross receipts or sales (IRS Form 1120 line 1a). Under the correct calculation, however, Kingfisher’s receipts exceeded the applicable size standard.
Kingfisher appealed the Area Office’s determination, arguing that “the Area Office had good reason to believe the general rule that receipts is total income may not apply in this specific case.” Kingfisher believed this to be the case because, for one of the years in question, it reported a reduction in purchase price of certain assets, and an associated depreciation reversal, as revenue. Because this was less an actual receipt and more a tax reporting correction, Kingfisher argued that these amounts should have been excluded from the calculation of its receipts.
The OHA rejected this argument. Doing so, it drew an analogy to the regulations’ defined exclusions from the receipts calculation. In an instance where a company seeks to exclude, say, an inter-affiliate transaction from the receipts calculation, the OHA noted that the company is responsible for demonstrating the exclusion applies—“it is unrealistic and unduly burdensome,” the OHA noted, “to expect the Area Office, on its own initiative,” to apply the exclusion.
Kingfisher’s initial response to the SBA did not argue that any of the reported amounts on its tax returns should be excluded from the receipts calculation. Instead, it simply provided its own calculation, without explanation. Absent any such argument or explanation, the OHA concluded that the Area Office correctly applied the receipts calculation as defined in the regulations. The OHA thus denied Kingfisher’s appeal.
Kingfisher is an important reminder of how the SBA will calculate a firm’s average annual receipts. So what’s a company to do if it believes its tax returns include amounts that should be excluded from the calculation?
First, before any size protest or challenge, a company should explain to its accountant the importance of its small business designation and how the SBA calculates size. The company’s accountant can then determine whether there’s any way to legally and accurately report amounts as other than total income or costs of goods sold.
Second, a response to a size protest should include all arguments explaining why the company is a small business. This can be tricky, given the often-complicated issues involved and the short response deadline. But as the OHA made clear in Kingfisher, an Area Office won’t be faulted for not considering arguments that weren’t raised by a protester.