SBA Passive Business Ineligibility Under 13 CFR 120.111

An Eligible Passive Company is the narrow exception that lets a business holding real estate or equipment qualify for SBA 7(a) or 504 financing even though passive businesses are otherwise ineligible. Under 13 CFR 120.111, the SBA Eligible Passive Company rules allow this only when the passive entity leases the financed property to a related Operating Company that meets a defined set of conditions on size, eligibility, lease terms, rent, and loan liability.¹

The starting point is 13 CFR 120.110(c), which makes businesses that don’t actively use or occupy the property bought with loan proceeds ineligible. The rule targets “businesses owned by developers and landlords that do not actively use or occupy the assets acquired or improved with the loan proceeds.”² Section 120.111 carves out the EPC as the way around it.

What an EPC Is Allowed to Do With Loan Proceeds

An EPC can use SBA loan proceeds only to buy, lease, improve, or renovate real or personal property that it then leases to one or more Operating Companies for the OC’s business use.¹ The EPC can also use proceeds to finance a change of ownership between its existing owners, which matters for partner buyouts and succession.

The proposed use of proceeds has to be something that would qualify if the Operating Company were borrowing directly. If the OC couldn’t finance it, routing the money through an EPC doesn’t fix the problem.

Size and Eligibility on Both Sides

Both the EPC and the Operating Company must independently qualify as small under the SBA’s size standards in 13 CFR Part 121. The Operating Company must be in an eligible industry. There is one carve-out: if the EPC is structured as a trust, the trust itself does not need to meet size standards.¹

The Operating Company’s Role on the Loan

The Operating Company must be either a guarantor or a co-borrower on the loan.¹ The choice is not cosmetic. For a 7(a) loan that includes working capital or the purchase of other assets, including intangible assets like goodwill or intellectual property, the OC must be a co-borrower, not merely a guarantor.

Co-borrower status is what unlocks the broader use of proceeds. When the OC signs as a co-borrower, the loan can fund the OC’s working capital needs and purchases of intangible assets for the OC’s use alongside the EPC’s real estate purchase.¹ Without that structure, the EPC loan is limited to real property and equipment.

Lease Requirements Between the EPC and the OC

The lease between the two entities carries specific requirements that are easy to miss during structuring. It must be in writing. It must be subordinate to the SBA’s mortgage or security interest on the property. The EPC must assign all rents from the lease as collateral for the loan, which lets the lender collect rent directly if the EPC defaults.¹

The lease term, including any renewal options the Operating Company alone can exercise, must be at least as long as the loan term. SBA real estate loans can run 25 years, and the lease has to match. If the lease expires first, the OC loses the right to occupy the property securing the debt and the structure falls apart.

Rent Is Capped

The EPC cannot charge the Operating Company more than the amount needed to make the loan payment to the lender, plus direct expenses of holding the property such as maintenance, insurance, and property taxes.¹ The EPC is not permitted to profit from the lease. It functions as a pass-through that holds the asset while the Operating Company does the earning.

Occupancy Percentages the OC Has to Hit

Section 120.131 sets occupancy thresholds for any SBA-financed building, and in an EPC deal the Operating Company has to meet them. The EPC leases 100 percent of the building to the OC, and the OC then subleases any excess space to third parties within the following limits.

For an existing building, the OC must permanently occupy and use at least 51 percent of the rentable property. Up to 49 percent can be leased to outside tenants.³

New construction is tighter. The OC must occupy at least 60 percent of the rentable property at the outset. Up to 20 percent can be permanently leased to third parties. The remaining 20 percent can be temporarily leased, but the borrower must plan to occupy some of that space within three years and all of it within ten years.³ A new building financed with SBA funds must eventually reach 80 percent owner-occupancy. Occupancy is measured on rentable property, so common areas and exterior spaces don’t count.

Trusts as Eligible Passive Companies

A trust can serve as an EPC, but the analysis shifts. The SBA looks at the trustor’s eligibility rather than the trust’s own characteristics, and all donors to the trust are treated as trustors for this purpose. The trust itself is exempt from size standards.

The trustee must certify in writing that the trust has authority to borrow funds, pledge trust assets, and lease property to the Operating Company. The trustee must also confirm that the trust will not be revoked or substantially amended during the loan term without the SBA’s prior written consent. The trustor must guarantee the loan, and any beneficiary who exercises control over the trust’s actions must also guarantee it.

One boundary: if an Employee Stock Ownership Plan trust agreement prohibits the trust from acting as a guarantor or co-borrower, the ESOP trust cannot use the EPC structure. That is not negotiable.

Using an EPC to Finance a Change of Ownership

An EPC loan can be used to finance a change of ownership among the existing owners of the EPC itself, which is how a partner buyout inside the real estate entity gets funded.¹

For 504 loans there is an added restriction. If the EPC owns assets beyond the financed real estate or long-term fixed assets, the loan can’t be used for a change of ownership unless those extra assets are directly related to the real estate, are minor in value, and are excluded from the project financing. The rule keeps 504 funds from being used to buy out an owner’s interest in a diversified holding entity that happens to own the building.

False Statements Carry Federal Criminal Exposure

Because an EPC transaction involves two related entities, a lease with specific required terms, capped rent, and occupancy certifications the lender monitors over the life of the loan, the compliance surface is wide. Knowingly falsifying a material fact, making a fraudulent statement, or submitting a document containing false information in an SBA loan matter is a federal crime under 18 U.S.C. 1001.⁴

The penalty is up to five years in prison, and fines for individuals can reach $250,000 under the general federal sentencing statute. Organizations face fines up to $500,000.⁵ Overstating projected occupancy, fabricating the terms of an inter-company lease, or misrepresenting the relationship between the EPC and the Operating Company are the kinds of material misstatements the statute targets, and discrepancies that surface years into the loan can trigger both civil default and criminal referral.

1
eCFR. 13 CFR 120.111 – What Conditions Must an Eligible Passive Company Satisfy?
2
eCFR. 13 CFR 120.110 – What Businesses Are Ineligible for SBA Business Loans?
3
eCFR. 13 CFR 120.131 – Leasing Part of New Construction or Existing Building to Another Business
4
Office of the Law Revision Counsel. 18 USC 1001 – Statements or Entries Generally
5
Office of the Law Revision Counsel. 18 USC 3571 – Sentence of Fine