Business owners and advisors are still waiting for additional guidance surrounding the Paycheck Protection Program (PPP) loan debt forgiveness. As a result, businesses have been forced to develop alternatives and track multiple scenarios in order to estimate their PPP debt forgiveness. In the absence of SBA guidance, the concern continues to grow that lenders will be forced to come up with their own terms, required documentation, and computational formulas for the purpose of determining forgiveness which could be significantly different based on the financial institution. However, the SBA and IRS continue to provide guidance surrounding PPP loans, and the most recent guidance over the last 10 days continues to have PPP borrowers evaluate their funding for eligibility and the potential tax implications of debt forgiveness.
Tax Deductions for Expenses Paid with PPP Debt Forgiven Funding
On April 30, the IRS sent borrowers of the PPP loan who are expecting debt forgiveness into a frenzy when they issued Notice 2020-32. Under the CARES Act, Section 1106(i), it was made clear that PPP borrowers would not have to include debt forgiveness in gross income when calculating taxable income. However, Notice 2020-32 stated the IRS position that because the income is not taxable, any expenses paid with PPP funding that is eventually forgiven, will also not be allowable tax deductions when calculating taxable income.
For example, let’s assume that ABC Company received PPP funding of $800,000. After tracking their allowable expenses in the 8-weeks after loan origination, and submitting the documentation to the bank, the bank determined that $500,000 of the PPP funding would be forgiven. Of the $500,000 being forgiven, $400,000 was related to payroll costs, and $100,000 was related to covered rent and utilities. The CARES Act was clear that the $500,000 would not be includible in 2020 taxable income. However, the IRS Notice provided clarification that, based on current law, it cannot allow the payroll deduction of $400,000 and the deduction related to rent and utilities for $100,000 to be subtracted when calculating taxable income. This could effectively cause businesses to be assessed with a federal tax on the amount of debt forgiveness, up to 21% for C Corporations, or up to 37% for flow-through entities. In our example, this would result in a tax liability of $105,000 (500,000 x 21%) and $185,000 (500,000 x 37%) respectively.
While many were disappointed with the position taken in the IRS Notice, there is a glimmer of hope that the Notice was necessary to force Congress to enact a legislative fix that will enable the IRS to go along with the Congressional intent.
Senate Finance Committee Chairman Chuck Grassley (R-Iowa) did express disappointment with the IRS guidance, believing this issue was discussed during the development of the program. He was quoted as stating, “The intent was to maximize small businesses’ ability to maintain liquidity, retain their employees, and recover from this health crisis as quickly as possible. This notice is contrary to the intent.” The spokesperson for House Ways and Means Committee Chairman Richard Neal (D-Mass) stated they were planning to fix this issue in the next piece of response legislation.
While the IRS notice is not binding SBA guidance, it may have been provided some insight regarding whether costs have to be paid and incurred during the 8-week period after the loan origination date in order to be forgiven. The literal reading that costs must be both incurred and paid in the 8-week period is troublesome to many businesses. The IRS Notice stated, “a recipient of a covered loan can receive forgiveness of indebtedness on the loan (covered loan forgiveness) in an amount equal to the sum of payments made for the following expenses during the 8-week covered the period beginning on the covered loan’s origination date.” There is no reference to the fact that the expenses must be incurred in the covered period. We will continue to monitor legislation and SBA guidance for updates.
Full-Time Equivalent Employee Definition
While PPP borrowers are aware that full-time employee equivalents for designated time periods could decrease their debt forgiveness, there is still confusion surrounding how to measure a full-time equivalent and whether a full-time employee is an individual who works an average of at least 30 or 40 hours per week.
While no further guidance has been offered regarding the hour definition, the SBA did clarify that an employer will not be penalized in the FTE calculation when determining debt forgiveness for employees that were laid off, that the business offered to rehire, but the employee declined the offer. However, the SBA did note that the interim final rule will specify that, to qualify for this exception, the borrower must have made a good faith written offer of rehire, and the employee’s rejection of that offer must be documented by the borrower. Therefore, we are encouraging all employers to make sure that the rehire offer is in writing, and the employee’s rejection is properly documented.
Additional Criteria for PPP Loan Eligibility
Prior to SBA clarification, PPP loan applicants needed to certify that current economic uncertainty made the PPP loan request necessary to support ongoing operations. Two important questions were added to the SBA FAQ List for businesses who have received or are going to accept PPP funding, expanding the eligibility requirements to include two highly subjective tests.
Under the additional guidance, borrowers must consider their current business activity and their ability to access other sources of liquidity that would not be significantly determinantal to the business. The problem is that there is no definition or guidance surrounding current activity or what would be considered significantly detrimental to the business. This lack of definition is problematic for many PPP borrowers.
Question 31 (added on April 23, 2020): Do businesses owned by large companies with adequate sources of liquidity to support the business’s ongoing operations qualify for a PPP loan?
Answer: In addition to reviewing applicable affiliation rules to determine eligibility, all borrowers must assess their economic need for a PPP loan under the standard established by the CARES Act and the PPP regulations at the time of the loan application. Although the CARES Act suspends the ordinary requirement that borrowers must be unable to obtain credit elsewhere (as defined in section 3(h) of the Small Business Act), borrowers still must certify in good faith that their PPP loan request is necessary. Specifically, before submitting a PPP application, all borrowers should review carefully the required certification that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” Borrowers must make this certification in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business.
For example, it is unlikely that a public company with substantial market value and access to capital markets will be able to make the required certification in good faith, and such a company should be prepared to demonstrate to SBA, upon request, the basis for its certification. Lenders may rely on a borrower’s certification regarding the necessity of the loan request. Any borrower that applied for a PPP loan prior to the issuance of this guidance and repays the loan in full by May 7, 2020 will be deemed by SBA to have made the required certification in good faith.
Question 37, added on April 29, 2020, clarified that private companies with adequate liquidity to support the business's ongoing operations would also be required to follow the guidance provided in Question 31.
The additional criteria sent many businesses scrambling to understand the criteria, and either document accordingly or repay the loan in full by May 7 in order to be deemed as making the certification in good faith. On May 5, the SBA FAQ list extended the repayment date for this safe harbor to May 14, 2020.
However, what makes these new requirements, issued on April 23 and April 29, even more, confusing is the guidance that was provided in the SBA FAQ list question 17 on April 6. The SBA stated that borrowers do not need to take any action based on the updated guidance in the FAQ’s if they already filed and received approval on PPP loan based on the PPP Interim Final rule published on April 2, 2020. The SBA stated that borrowers and lenders may rely on the laws, rules, and guidance available at the time of the relevant application. As the additional criteria regarding the need to account for their current business activity and assess other sources of liquidity sufficient to support ongoing operations were not added until April 23, 2020, do borrowers who already filed and received their PPP loan by April 23, 2020, have to re-evaluate under this new criteria? It would appear not but remains unclear.
The new requirements of Question 37 and the timing of when the applicant applied and received PPP funding, continues to be part of our discussion with clients when encouraging internal documentation to be developed regarding the SBA guidance, and relevant support, that was available at the time they submitted their application versus guidance that was issued subsequent to that date. It is important to recognize that such internal documentation should document considerations that were contemporaneous with the PPP loan application, separately from consideration of additional facts that occurred after the original funding date.
The SBA and IRS guidance surrounding PPP loans continues to evolve and is only getting more complicated and cumbersome as additional information is provided. We strongly encourage you to work with your advisors to monitor the changing guidance, review contemporaneous documentation surrounding the businesses PPP eligibility, run alternative testing scenarios for debt forgiveness calculations, and assist in gathering proper documentation. If you need help regarding your PPP loan, please do not hesitate to reach out.
The information and advice we are providing for this matter relates to COVID-19 legislative relief measures. Because legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that could modify some of the advice and information provided to you, after the conclusion of our engagement. We, therefore, make no warranties, expressed or implied, on the services provided hereunder.