Ineligible businesses and the SBA passive income rule

Eligibility is a gate, and it is checked before anyone looks at your cash flow. Spending three weeks assembling a package for a business the rules exclude is a common and entirely avoidable waste.

The list of ineligible businesses lives at 13 CFR 120.110, amplified in the SBA's Standard Operating Procedure. Read the current text before relying on any summary, this one included.

The categories that are excluded

Businesses of a prurient sexual nature.

The passive income rule, which is where most people are surprised

The programs finance operating businesses. They do not finance the ownership of income-producing property leased to unrelated tenants.

So: buying an apartment building is out. Buying a strip mall to lease to tenants is out. Buying a building for your own business to occupy is in — that is the owner-occupancy rule, and it is the whole distinction. If you are collecting rent from people who are not you, the deal is heading toward ineligible.

The rule also catches structures that look operational at a glance. A business whose revenue is a share of somebody else's activity, or that subleases most of what it holds, gets examined closely.

The exception that makes real estate deals work

There is a permitted structure. An eligible passive company — typically a holding entity that owns the property — can borrow to acquire real estate and lease it to an operating company that the same principals own. The conditions are set out at 13 CFR 120.111 and in the SOP, and they matter:

• Both entities are on the loan, as borrower and co-borrower or guarantor.
• The lease runs at least as long as the loan term, including options.
• Rent is set within limits so the structure is not used to strip cash out.
• The operating company must itself be an eligible business meeting the occupancy rules.

This is how most owner-occupied SBA real estate is financed, and it is legitimate. Get the entity documents and lease drafted with the lender's SBA department involved, because a lease that does not meet the conditions has to be redone at closing.

Businesses that look passive but are not

Some property-heavy businesses count as operating businesses because the owner sells a service rather than a lease. A hotel is the clearest example: guests are customers, not tenants. Marinas, campgrounds and similar businesses are assessed on the same logic — how much service is being provided, how short the occupancy is, and who controls the space.

Where a specific business sits on that line is a fact question decided under current SBA rules, and it can turn on details of the operation. Ask before you commission an appraisal.

The rent limit inside the permitted structure

The eligible passive company structure works, and it is constrained in a way that surprises owners who expected to set rent at market.

SBA rules generally limit the rent the operating company pays the holding entity to the amount needed to cover the loan payment plus the holding entity's own expenses — property taxes, insurance, maintenance and similar. The structure is not permitted to operate as a mechanism for moving profit into a separate entity.

That matters twice. It changes the operating company's cost base in every projection you build, and it changes what the holding entity looks like as a standalone asset. Confirm the current requirement with the lender's SBA department before the lease is drafted, because the lease has to comply at closing rather than afterwards.

Three questions that place you on the line

1. Who pays you, and for what? If the payment is for occupancy of space over time, you are heading toward passive. If it is for a service delivered while someone occupies space, you are heading toward operating.
2. How long does a typical customer stay, and can you move them? Short stays and operational control point to an operating business.
3. What share of revenue comes from space you have handed over to someone else? Subleasing most of what you hold is examined closely whatever the business calls itself.

Answer all three in writing before the first lender meeting. Those answers are also what the eligibility memo in your file will have to say.

What to do with this

1. Describe your business by what actually generates the revenue, then test it against the list.
2. If any part of the revenue is rent from unrelated parties, raise it in the first conversation with the lender.
3. If you are buying property for your own operations, expect an eligible passive company structure and budget for the entity and lease work.
4. If you are anywhere near the federally-illegal line, get a written answer from the lender's SBA department before spending money.
5. Read 13 CFR 120.110 yourself. It is short, and it is the actual rule.

An eligibility problem found in week one is a redirect. The same problem found at closing is a dead deal and a bill for third-party reports you cannot use.