UPDATE AS OF MAY 1, 2020
UNDERSTANDING PAYCHECK PROTECTION PROGRAM (PPP) LOAN FORGIVENESS
RESOLUTION TO Open Item #2 (see details at end of article) – Are expense payments made with forgiven PPP loan funds going to be tax deductible even though the borrower did not bear the economic cost of the expenses?
Yesterday the IRS issued Notice 2020-32 which answers our question above. The answer is, “NO”. Under Notice 2020-32 the IRS clarifies that no income tax deduction will be allowed for an expense that results in forgiveness under section 1106(b) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) and the Paycheck Protection Program. In other words, this tax treatment prevents a double tax benefit. No taxable income attributable to the loan forgiveness and no corresponding income tax deduction attributable to the forgiven loan proceeds. To deny the income tax deductions, the IRS invoked IRC Section 265 of the tax code, which says that deductions can’t be taken if they are tied to a specific class of tax-exempt income.
Congress could override the IRS notice by passing a law that specifically allows the deductions.
By now, many Paycheck Protection Program (PPP) applicants have received loan proceeds or expect to receive them soon. While these funds are intended to provide immediate assistance to employers to minimize economic disruptions from the COVID-19 outbreak, improper use or misunderstanding on how the proceeds can be used may bring negative results. Here are key facts to ensure your loan forgiveness.
HOW TO QUALIFY FOR LOAN FORGIVENESS
The CARES Act loan forgiveness is undoubtedly a primary benefit of the PPP loan program. Your loan proceeds are eligible for forgiveness of up to the full principal amount of qualifying loans guaranteed under the program plus accrued interest.
To qualify, your PPP loan funds must be used for “Covered Costs” during your “Covered Period” which is eight weeks from the date the lender makes the first disbursement of the PPP loan to you.
Any funds that are unused during this period or spent for unauthorized purposes will not be forgiven and must be repaid over a two-year period at 1% interest (six-month deferral of first repayment is available).
Covered Costs – The potential amount of loan forgiveness will depend on the total amount of costs incurred and payments made for:
75% – At least 75% of the PPP loan proceeds must be used for payroll costs – regardless of whether a borrower ultimately seeks loan forgiveness.
Payroll costs include:
- Employee’s gross salary, wages, commissions or similar compensation equal to or less than $100,000
- For a partnership, recent guidance from the SBA explains that payroll costs include not only guaranteed payments to a partner, but also any partner’s share of income of the partnership subject to self-employment income. These amounts are subject to a per-partner cap of $100,000
- For a sole proprietor or independent contractor who is a self-employed taxpayer, recent guidance defines payroll costs in a purely mechanical fashion as the net self-employment income reported on line 31 from his/her 2019 Form 1040, Schedule C, “Profit or Loss From Business.” This line item is subject to the $100,000 cap
- Payment of cash tips or equivalent
- Payment for vacation, parental, family, medical and sick leave
- Payment for allowance for dismissal or separation
- Payment required for provisions of group health benefits, including insurance premiums
- Payment of any retirement benefits
- Payment of State or local employment taxes (e.g. SUTA) assessed on the compensation of employees
A recent Small Business Administration (SBA) FAQ clarified several points of confusion surrounding the items that are excluded from payroll costs, and this clarification should apply equally when determining the costs eligible for forgiveness. First, the $100,000 per-employee limit applies only to cash compensation, salary, or wages. Additional payroll costs allocable to the employee, including employer contributions to defined-benefit or defined-contribution retirement plans, payment for the provision of employee benefits consisting of group health care coverage, including insurance premiums, and payment of state and local taxes assessed on compensation of the employee may be added to the $100,000 of maximum salary in computing payroll costs.
As PPP borrowers learned the hard way during the application process, the critical term “payroll costs” is poorly defined. Unfortunately, it’s a term we have to contend with again when determining forgiveness, so let’s remind ourselves what is and is not considered a “payroll cost.”
Payroll costs do NOT include:
- Compensation of an individual employee in excess of $100,000 on an annualized basis and prorated for the Covered Period
- The aggregate of guaranteed payments plus self-employment income of a partner in a partnership in excess of $100,000 on an annualized basis and prorated for the Covered Period
- The net earnings for a self-employed individual in excess of $100,000 on an annualized basis and prorated for the Covered Period
- Any compensation of an employee whose principal place of residence is outside of the United States
- Employer portion of FICA, FUTA and Railroad Retirement Act taxes (Chapters 21, 22 or 24 of the Internal Revenue Code) during the Covered Period
- Qualified sick leave wages for which a credit is allowed under section 7001 of the Families First Coronavirus Response Act
- Qualified family leave wages for which a credit is allowed under section 7003 of the Families First Coronavirus Response Act
- Payments to independent contractors
25% – Not more than 25% of the PPP loan proceeds may be used for non-payroll costs:
- Rent payments (for real property or equipment leases) that are obligated to be paid under a leasing agreement in force before February 15, 2020
- Utility payments for gas, electricity, water, transportation, telephone or internet access for which service agreement began prior to February 15, 2020
- Interest payments on a mortgage incurred before February 15, 2020 that is a liability of the borrower and secured by real or personal property. Also, allowed are interest payments on any other debt obligations incurred before February 15, 2020. Caution: Payments or prepayments of principal do not count
- Refinancing an existing SBA EIDL loan made between January 31, 2020 and April 3, 2020
MINIMIZING THE REDUCTIONS IN LOAN FORGIVENESS
There are two provisions that may reduce the amount of loan forgiveness:
- Number of Employees- Your loan forgiveness will be proportionately reduced if the average number of full-time equivalent (FTE) employees that you employed during your eight-week Covered Period is lower than the average number of FTE employees that you had during (at your election) from either:
- February 15, 2019 to June 30, 2019 or
- January 1, 2020 to February 29, 2020
For seasonal employers, you will be tested for the period between February 15, 2019 and June 30, 2019.
If you restore your FTE headcount level to pre-February 15, 2020 by June 30, 2020, the reduction in forgiveness will be eliminated.
- Compensation Level- Your loan forgiveness will be also reduced to the extent that you decreased the wages of any one or more employees by more than 25% when compared to the most recent full quarter during which the employee was employed (salaries with more than $100k per year are excluded). The Act implies that this will be an employee-by-employee analysis. (We expect further guidance as a full quarter may be eight weeks vs nine weeks.)
If you restore salary and wage levels to pre-February 15, 2020 by June 30, 2020, the reduction in forgiveness will be eliminated.
WHAT TO EXPECT WHEN APPLYING FOR LOAN FORGIVENESS
After your eight-week “Covered Period,” you will be asked to provide following information:
- Documentation verifying the number of full-time equivalent (FTE) employees on payroll and pay rates for the applicable periods, including payroll tax filings reported to the IRS, and state income, payroll, and unemployment insurance filings
- Documentation including cancelled checks, payment receipts, transcripts of accounts, or other documents verifying payments on covered rent, utility and interest payments
- A certification (from a representative authorized to make the same) that the documentation is true and correct and that the amount for which forgiveness was requested was used to retain employees or to make payments on a covered rent, utility and interest payments
- Any other documentation the SBA determines necessary to verify Covered Costs
The Act makes it clear that no forgiveness will be given if the necessary documentation is not provided. Your lender will make a decision on your loan forgiveness application no later than 60 days from the date of application.
Additionally, be advised that proceeds from any advance up to $10,000 on the Economic Injury Disaster Loan (EIDL) will be deducted from the loan forgiveness amount on the PPP loan.
TAX TREATMENT OF AMOUNT FORGIVEN
The CARES Act is clear that PPP loan amounts forgiven will not be included in gross income of the borrower for income tax purposes.
Current guidance is still unclear on the determination of eligibility and calculation for the loan forgiveness process. We expect further guidance to clarify many questions, but borrowers should act proactively to ensure they manage the use of the funds to stay in compliance and maximize loan forgiveness. Our suggested best practices are:
- Prevent “co-mingling” or misuse whether intentional or accidental with other accounts by setting up a separate bank account
- Accurate record-keeping of the use of your PPP loan funds by establishing separate accounting code(s) within your general ledger
- Start organizing your documentation to support information discussed above and prepare your loan forgiveness application in advance
- Keep close contact and communicate with your lender for their most up-to-date information and guidance
- Pay attention to your FTE and compensation numbers to maintain good standing
WHAT WE DO NOT KNOW
Open Item #1 – Covered Costs must be “incurred and paid” during the Covered Period. What the heck does that mean? This goes to the issue of back payments and forward payments (prepayments) – to what extent are they forgivable? Is there a difference between incurred and accrued? The statute is unclear. There is often a timing difference between when an expense is incurred and paid. If the interpretation is to include only expenses incurred and paid, then borrowers should plan to make final expense payments on the last day of the eight-week period or they will suffer a reduction in forgiveness and have to repay parts of the loan for which forgiveness was expected. If the interpretation is to include expenses incurred or paid during the eight-week period, then we expect there might be some exceptions for previously-accrued or prepaid items. We expect further guidance to clarify whether the expenses must be both incurred AND paid during the covered period.
Open Item #2 – Are expense payments made with forgiven PPP loan funds going to be tax deductible even though the borrower did not bear the economic cost of the expenses? Traditionally, under IRC §265 no deduction shall be allowed for expenses attributable to tax-exempt income. Congress is aware of this issue and is considering a legislative fix. If no deduction is allowed, then the borrower receives no tax benefit – it has no income from the forgiveness and no deduction for the expenses. This seems contrary to the intent of the statute.
Open Item #3 – It appears Congress will allow a borrower to use the funds to pay interest on a non-mortgage debt during the covered period, but will not allow a borrower to have that amount forgiven. We expect further guidance to clarify Congress’ intent.
Open Item #4 – Can self-employed taxpayers who file a 2019 Form 1040, Schedule C, “Profit or Loss From Business” have rent or utilities or interest forgiven, or can’t they? Under the present calculation, every self-employed taxpayer without employees is eligible for a PPP loan up to the $100,000 wage cap, but no other expenses can increase the maximum loan amount. Thus, their maximum loan amount is determined on a monthly basis, and is $20,833 ($100,000/12 x 2.5). The maximum forgiveness amount for owner compensation is determined on a weekly basis and must be based on the taxpayer’s 2019 Form 1040, Schedule C, line 31, “Net profit or (loss)”. The maximum amount of loan forgiveness is $15,385 ($100,000 x 8/52). Can the taxpayer spend the remainder of the loan amount on forgivable overhead expenses, and apply the 25% overhead (non-payroll) limitation to the maximum forgiveness amount? More broadly, the SBA’s formula effectively precludes an self-employed taxpayer from ever reaching 100% loan forgiveness and some amount of the loan will always need to be repaid. We expect further guidance to clarify Congress’ intent.