Wednesday, May 13, 2020

On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). This package was a $2.3 trillion relief package, and it included a number of provisions designed to stimulate the economy and keep Americans employed. The most important and highly debated provision of this Act is the loans under the Paycheck Protection Program (PPP), which put forth $349 billion into a Small Business Administration (SBA) loan program for small businesses to obtain and to be administered by the banks. Those funds have since been depleted. However, on April 24, 2020, the President signed into law the Paycheck Protection Program and Health Care Enhancement Act which provides $484 billion of additional relief. This measure includes an additional $310 billion in funding for the PPP.

A key facet of the PPP is the possibility of the PPP loans being forgiven on a tax-free basis. The purpose of this article is to discuss this aspect of the bill. There are still many unanswered questions existing about the loan forgiveness calculation. More guidance is desperately needed by businesses and the banks as they will eventually be tasked with determining how much of the loans to forgive. However, because businesses are beginning to receive funds from the program, we have no choice but to interpret the rules that we do have to figure out what to do with the funds. This article represents a Q&A of the most frequent questions we are hearing about loan forgiveness.

Q: I have received my PPP loan. What can I spend the money on that is eligible to be forgiven?

A: During the “covered period” of the loan, the sum of the below costs are eligible to be forgiven:

  • Payroll costs,
  • Any payment of interest on any mortgage obligation that was incurred before 2/15/2020,
  • Any payment of rent under a leasing agreement in force before 2/15/2020, and
  • Any utility payment, including electricity, gas, water, transportation, telephone, or internet for which service began before 2/15/2020.

Q: You said “covered period.” What is that?

A: The covered period begins on the date that the business receives and has full access to the loan from the PPP and ends 8 weeks from that date. This is the window of time that your spending of the PPP funds will be analyzed by the banks and/or SBA to determine what portion of your loan will be forgiven. For example, let’s say the bank deposited your PPP loan into your account on Monday, April 20. Any spending of eligible costs through Sunday, June 14 would be the costs used in the loan forgiveness calculation.

Q: Can you provide a little bit more clarity on what is included when you say “payroll costs”?

A: Payroll costs include the sum of:

  • Salaries, wages, commissions, or similar compensation for employees capped at $100,000 per employee on an annualized basis. For partnerships, partner guaranteed payments and share of income subject to self-employment tax are included in payroll with the same $100,000 cap per partner on an annualized basis,
  • Payment of cash tip or equivalent,
  • Payment for vacation, parental, family, medical or sick leave,
  • Allowance for dismissal or severance pay,
  • Payments for group health care benefits, including health insurance premiums,
  • Payments of retirement benefits, and
  • Payments of state or local tax assessed on compensation.

Payroll costs do not include:

  • Compensation to any individual employee/partner/owner in excess of $100,000 on an annualized basis. To simplify this, wages to an employee/partner/owner in excess of $15,384.62 during the 8 weeks covered period will be excluded from the forgiveness computation (calculated as $100,000, times 8 weeks in covered period, divided by 52 weeks in the year).
  • Compensation paid to any independent contractors (1099 workers).
  • Taxes imposed or withheld under chapters 21, 22, or 24 of the IRC. More guidance will be required to understand exactly what is meant by this, but I’m interpreting this rule to mean that payroll taxes (FICA & employee withholdings) are not added to the employees’ gross payroll in the calculation. Also, it is not subtracted from gross payroll; instead, it is left out of the calculation altogether.
  • Compensation to an employee whose principal residence is outside of the United States.
  • Qualified family or sick leave wages for which a credit is allowed under sections 7001 or 7003 of the Families First Coronavirus Response Act.

What we still do not know:

  • Is qualifying payroll that which is earned or accrued in the covered period, or is it payroll that is paid in the covered period, even if that was earned before the covered period began? Does that question depend on whether the taxpayer is on the cash or accrual method of accounting?

Q: What is the 75/25 rule that was on some of the banks’ applications?

A: This rule states that at least 75% of your loan must be used for payroll costs over the 8-week covered period to be eligible for full forgiveness. If less than 75% is used for wages, the forgivable portion of the loan will be reduced. A simple example of this would involve a business that receives a $100,000 PPP loan, spends $70,000 on payroll costs and $30,000 on rent and utilities. In this example, $93,333 would be eligible for forgiveness ($70,000 for payroll and $23,333 for rent/utilities). This example is determined by using the below calculation:

$70,000Total Payroll
/     75%75% Rule
$93,333Eligible for forgiveness. Cannot be greater than the total loan amount

In this example, the balance of $6,667 must be repaid under the loan terms. A company that projects that they will be in this situation should consult with us about other possible actions.

Q: What happens to my loan forgiveness amount if I was forced to furlough or lay-off employees due to the pandemic?

A: If you experienced either of the above, you will likely find this calculation to be the most complicated part about calculating your loan forgiveness amount. To determine your loan forgiveness if you reduced staff, you’ll need to follow the below steps:

  1. Determine the average number of full-time equivalent employees per month during the covered period.
  2. Determine the average number of full-time equivalent employees per month during the period between 2/15/19 – 6/30/2019.
  3. Determine the average number of full-time equivalent employees per month during the period between 1/1/2020 – 2/29/2020.
  4. Divide the number of employees in Step 1 by the lesser of Step 2 and 3. This ratio is the amount of the loan that is potentially forgivable due to the reduction in headcount.

However, there is hope. If your reduction in full-time equivalent employees (FTEs) that took place between 2/15/2020 – 4/27/2020 is FULLY restored by 6/30/2020, your business is still eligible for full forgiveness of the loan (assuming all other requirements are still met). Where it will get complicated is if some FTEs are restored by 6/30/2020 but not all of them. Not enough guidance has been provided to advise on what happens in this scenario. Nevertheless, it is assumed that the restoration of FTEs will improve your loan forgiveness calculation by increasing the forgivable ratio calculated in Step 4.

For example, let’s say a company receives a $500,000 PPP loan. During the next 8 weeks, they have an average of 10 FTEs. During the period of 2/15/19 – 6/30/19 they averaged 13 FTEs and during 1/1/20 – 2/29/20 they averaged 15 FTEs. They spend their PPP loan in the following manner: $375,000 on payroll and $125,000 on rent. The forgiveness calculation is determined using the following calculation:

              10Average FTEs during the covered period
/             13Lesser of average FTEs 2/15/19 – 6/30/19 and average FTEs 1/1/20 – 2/29/20
     .769231Forgivable ratio
X $500,000PPP loan
    $384,615Forgivable PPP loan

 

However, if the three employees that were furloughed or laid off were done so during the 2/15/2020 – 4/27/2020 window and they are rehired by 6/30/2020 the loan forgiveness will not be reduced.

Q: How do I calculate FTEs for this computation?

A: At this point, no guidance has been provided on how to determine FTEs for the PPP loan forgiveness. However, the CARES Act has previously referenced IRC Section 4980H in other portions of the bill.

Section 4980H states that a “full-time employee means, with respect to any month, an employee who is employed on average at least 30 hours of service per week.” IRC Section 4980(c)(2)(E) goes on to state that to determine FTEs for employees who are not full-time employees, take the aggregate number of hours that were worked by the non-full-time employees in a given month and divide it by 120.

Q: What if instead of furloughing or laying off employees my business instead just reduces compensation?

A: There is a reduction in loan forgiveness if wages are reduced for any one employee by greater than 25%. In order to determine if this happened, you will follow the below steps:

  • Identify all FTE employees who are employed during the covered period that earned less than $100,000 annualized in the 2019 calendar year. These are your applicable employees. Any employee who earned greater than $100,000 in the previous calendar year is excluded from this calculation.
  • For each applicable employee, take the employee’s wages/salary rate during the 8-week period and compare it to that employee’s wages/salary rate for the first quarter of 2020.
  • If the covered period wages have not dropped for any single employee by more than 25%, then no further calculation is required.
  • If it has dropped by more than 25% for any single employee, then the dollar amount of wage/salary decrease in excess of 25% for each employee should be gathered and totaled up.
  • The aggregate dollar amount totaled up reduces the amount of loan that should be forgivable.
  • This calculation excludes any current employee who in 2019 had a variable pay arrangement (overhead, commissions,etc.).

For example, let say your business has five full-time equivalent employees. Each employee earned an average annualized wage of $80,000 in quarter 1 of 2020. Four of the five employees earned an average annualized compensation over the covered period of $70,000 (87.5% of quarter 1 of 2020). One of the five employees earned $55,000 (68.75% of quarter 1 of 2020). To determine the reduction in loan forgiveness we would perform the below calculation.

                      1The number of employees where wages were reduced by more than 25%.
          $80,000Employee’s quarter 1 of 2020 annualized wages
 X            75%75% reduction limit
          $60,00075% of employee’s quarter 1 of 2020 annualized wages
 –        $55,000Actual annualized wages for the covered period
            $5,000Reduction in loan forgiveness amount

Similar to the rule related to rehiring employees by 6/30/2020, if wages are restored for employees who had a decrease in wages greater than 25% to at least the level existing on 2/15/2020, the reduction in forgiveness attributable to the wage/salary decline will be excused.

Q: As a business owner, how can I maximize the amount of loan forgiveness that I receive?

A: A business that is interested in spending all of the PPP loan funds on qualified expenses to receive full loan forgiveness should consider the below strategies:

  1. Create a budget of all qualified expenses expected to be paid over the 8 week covered period.
  2. Increase payroll by paying annual bonuses during the 8-week covered period. Remember that wages are still capped at $15,384.62 per employee.
  3. Increase payroll by paying annual profit sharing or other retirement contributions during the covered period.
  4. Increase payroll by making sure that the wages incurred before the end of the 8 week covered period are paid out by that date, even if it means doing a short period payroll run.

Q: What are the tax implications of receiving and ultimately having forgiven the PPP loan?

A: Section 1106(i) of the CARES Act specifically states that PPP loan amounts that are forgiven will not be included in gross income for federal income tax purposes. This was good news for all businesses receiving the PPP loan. However, on April 30, the IRS released Notice 2020-32 stating that the expenses covered by the forgiven loans represent expenses related to tax-exempt income under IRC Section 265(a) and therefore are not deductible. This effectively removes the benefit of having the forgiven loans be excluded from gross income. This decision from the IRS has received a lot of pushback from members of Congress who argue that this was not congressional intent when drafting the CARES Act. I suspect that we haven’t seen the last of this debate and that there could even be future legislation that overrides the IRS’s decision.

Q: What will I need to provide my bank with when I apply for loan forgiveness?

A: Bank requirements are still unknown and will vary from bank to bank. They are the key holders for loan forgiveness, so be prepared to provide them with all documents that they request. Businesses should, at the very least, be prepared to provide banks with:

  • Documents verifying the number of full-time equivalent employees that you had on the payroll at all key dates provided above, including their pay rate.
  • Payroll reports from your payroll provider.
  • Payroll tax filings from all 2019 periods through 6/30/2020.
  • Income, payroll, and unemployment insurance filings to your state.
  • Documents verifying the businesses group health care benefits and health insurance premiums paid on behalf of employees during the covered period.
  • Documents verifying the retirement plan contributions made by the business during the covered period.
  • Documents verifying your eligible mortgage interest, rent, and utility payments made during the covered period.

There is a lot of information to digest here and likely more guidance to come related to the PPP loan forgiveness. One thing is for sure, you are not alone and we are here to help. If you have any questions or if we can be of assistance in calculating your forgivable PPP loan amount please let us know.

Jeff Marko, CPA
Jeff Marko, CPA

Jeff is a Senior Tax Manager in DMJ’s Durham, North Carolina office with experience in large multi-state C-Corporations, closely held S-Corporations and Partnerships, Sole Proprietorships, and high net-worth individuals. In addition, Jeff provides a variety of services including international and domestic tax consulting and compliance, business entity structure and planning, individual income tax planning, ASC 740 tax provision services, FIN 48 documentation and analysis, state tax nexus studies, and IRS correspondence.

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