We are certainly not the first to tell you, nor will we likely be the last. The secret is out! The CARES Act has been signed into law. While you have no doubt been inundated with news and other communications outlining all of the various provisions contained in the Act, you may not yet have had the time to understand the specifics. The purpose of this communication is to analyze in greater detail some of the key provisions of the Act that relate to small businesses so that you may gain a greater understanding of how they may impact you and your business interests.
There are four major provisions that are likely to have an immediate economic impact on small business. The CARES Act aims to afford small businesses with welcomed cash flow assistance in four primary ways:
- The Paycheck Protection Program (“PPP”) as part of the Small Business Administration (“SBA”) loan program,
- Emergency EIDL grants as part of the existing SBA loan program,
- Delay of payment of employer payroll taxes, and
- Employee Retention Credit for employers subject to closure due to COVID-19
In this communication we will cover the first two items in detail. Items three and four will be covered in a subsequent communication.
Paycheck Protection Program (PPP)
The PPP is a loan program administered by the Small Business Administration (SBA). The U.S. Senate Committee on Small Business & Entrepreneurship describes the program in this way:
The program would provide cash-flow assistance through 100 percent federally guaranteed loans to employers who maintain their payroll during this emergency. If employers maintain their payroll, the loans would be forgiven, which would help workers remain employed, as well as help affected small businesses and our economy snap-back quicker after the crisis. PPP has a host of attractive features, such as forgiveness of up to 8 weeks of payroll based on employee retention and salary levels, no SBA fees, and at least six months of deferral with maximum deferrals of up to a year. This program would be retroactive to February 15, 2020, in order to help bring workers who may have already been laid off back onto payrolls. Loans are available through June 30, 2020.
The loan program will be made available through banks that are authorized as SBA 7(a) lenders. Congress also added to the Act a provision that gives the Treasury the ability to expand the base of authorized lenders to meet what is expected to be significantly increased demand for loans. The SBA has signaled that lenders may begin processing PPP loan applications April 3, 2020.
Who is eligible?
Historically, only small-business concerns were eligible for SBA assistance. The definition of small-business concern is not statutorily defined rather 15 USC 632 gives authority to the SBA to define that which is a small-business concern. The SBA has published guidance in its Table of Small Business Size Standards. The size standards are the largest that a concern can be and still qualify as a small business for Federal Government programs.
The CARES Act expands the group of business concerns eligible for SBA assistance during the covered period (February 15, 2020 to June 30, 2020) to include any business concern, nonprofit organization, veterans organization or Tribal business concern that have fewer than 500 employees¹. For this purpose, employees are defined as including individuals employed on a full-time, part-time or other basis. The employee threshold is not a full time equivalent threshold, but rather a pure head count.
Eligible recipients also include sole proprietors, independent contractors and self-employed individuals. Any self-employed individual, independent contractor or sole proprietor seeking a loan under this program must submit documentation establishing their eligibility, including payroll tax filings reported to the IRS, Form 1099-MISC, and income and expenses of the sole proprietorship.
Notably, business concerns in the accommodation and food services sector (e.g. hotels and restaurants) with no more than 500 employees per location are also eligible recipients. In order to open up this group for eligibility, the CARES Act waives the affiliation rules during the covered period for these businesses. Importantly, the CARES Act explicitly affirms that the provisions applicable to affiliations shall apply with respect to a nonprofit organization and a veterans organization in the same manner as with respect to a small business concern. This means that two commonly-controlled business concerns that each have 300 employees would not be considered a small business concern. The affiliation rules would require both groups to be aggregated together resulting in 600 employees; a number that exceeds the maximum threshold. The affiliation rules can be quite complex. A link to the SBA overview on affiliation is included here for your reference.
The certification requirements to be made in good faith by the borrower are that (a) the uncertainty of current economic conditions makes necessary the loan request to support the ongoing operations of the eligible recipient, (b) the funds will be used to retain workers and maintain payroll or make mortgage payments, lease payments, and utility payments, (c) the eligible recipient does not have an application pending for another PPP loan for the same purpose and (d) that during the period beginning on February 15, 2020 and ending on December 31, 2020 the eligible recipient has not received loaned funds that are to be used for the same purposes.
How much may be borrowed and what can I use it for?
The amount of the loan an eligible recipient may borrow is equal to 250 percent of their average monthly payroll costs incurred during the 1-year period before the date the PPP loan is made. The reference period is adjusted to January 1, 2020 to February 29, 2020 if the recipient was not in business from February 15, 2019 to June 30, 2019. The loan cannot exceed $10 million. Of note is that these loans are made available on an entity-by-entity basis and are traced to the EIN of the entity.
Given average monthly payroll is the basis for the borrowing determination, the Act further defines what costs can be considered in that calculation. Compensation (salary, wage, commission, payment of cash tip or equivalent), vacation and sick pay, health care benefits, retirement benefits and state and local tax assessed on compensation are all included in the total payroll cost. Payroll taxes, qualified sick and family leave pay pursuant to the Families First Coronavirus Response Act and any compensation paid to an employee whose principal place of residence is outside the United States are excluded from the computation. When aggregating this data, it is important to do so on an employee by employee basis. To the extent any employees total payroll cost exceeds $100,000, the excess cost is not considered in this calculation. For example, if the salary, health benefits and retirement payments of an employee total $105,000, the amount included in the computation of average monthly payroll is limited to $100,000 with the excess of $5,000 excluded.
Borrowed funds can be used to cover payroll costs, cost of continuing health care benefits, payments of interest (but not principal) on any mortgage obligation, rent or lease payments, utilities and interest on any other debt obligations incurred prior to the beginning of the covered period. As part of the borrowing process, the borrower must certify in good faith that the funds will be used to retain workers and maintain payroll or make mortgage payments, lease payments, and utility payments. It is interesting to note that the statute contains an internal inconsistency between this self-certification and the allowed uses of funds. The certification indicates use for mortgage payments, but the limitation on uses in the statute clearly limits the use to only interest (not principal) thereon.
Loan forgiveness provisions
Any loan made pursuant to the PPP is a covered loan that is eligible to be forgiven under the terms of the statute. The amount that may be forgiven is the sum of the following costs incurred and payments made during the 8-week period that begins on the origination date of the covered loan (the “Covered Period”): payroll costs, payment of interest on any covered mortgage obligation, any payment on any covered rent obligation, and any covered utility payment. The introduction of the term “covered” is first found in this section on loan forgiveness.
Heretofore, the statute had omitted the additional qualifier. The forgiveness section provides further definition of those terms. A covered mortgage obligation mean any mortgage on real property incurred prior to February 15, 2020. A covered rent obligation means rent obligated under a leasing agreement in force before February 15, 2020. A coveredutility payment mean payment for a service for the distribution of electricity, gas, water, transportation, telephone, or internet access for which service began before February 15, 2020. The amount which may be forgiven on a covered loan is the sum of payroll costs, plus these explicitly defined costs.
The statute contains some internal anomalies. We are uncertain at this point if these represent drafting errors or intentional differences. For example, the statute omits from the sum eligible for forgiveness interest on any other debt obligations incurred prior to the covered period, even though that interest is specifically enumerated as an acceptable use of the borrowed funds. The definitions used in the forgiveness provisions are potentially more restrictive than those used in the allowed uses of funds section. An allowed use is specifically enumerated as payments of interest on any mortgage obligation, whereas the amount eligible for forgiveness is interest on a mortgage on real property incurred prior to February 15, 2020. Did the drafters really intend that the loan proceeds could be used for costs with respect to which forgiveness wasn’t available? For those borrowers who do not wish to test this, we recommend those borrowers restrict their use of funds to only that which is clearly eligible to be forgiven.
The amount of the loan that may ultimately be forgiven could be reduced if the borrower either has a reduction in the number of employees or a reduction of greater than 25 percent of wages paid to employees. The forgivable amount is the payroll cost during the Covered Period multiplied by the ratio of the number of full-time equivalent employees per month during the 8-week Covered Period (see definition above) to the average number of full-time equivalent employees during the borrowers choice of either the period from February 15, 2019 to June 30, 2019 or January 1, 2020 to February 29, 2020. This choice gives the borrower the opportunity to select the denominator for the ratio that results in the highest percentage of payroll cost being forgiven. This ratio is in place to incentivize borrowers to retain their employees. The greater the retention relative to the choice of previous periods, the greater the amount of loan forgiveness.
There is also a reduction in the forgiveness amount to the extent any employee with annualized wages below $100,000 has reduced wages in excess of 25 percent. For example, if an employee made $70,000 annualized salary, but the borrower reduced the employees wage to $50,000, the amount of payroll cost eligible for forgiveness would be reduced by $2,500. This amount is calculated as follows: $70,000 * 0.25 = $17,500; $20,000 salary reduction is greater than 25 percent of the salary $17,500; excess of $20,000 – $17,500 = $2,500 reduction of the payroll cost.
Page 3 of the Small Business Guide and Checklist prepared by the U.S. Chamber of Commerce presents these calculations graphically. Not included on the checklist is another possible reduction to the forgiveness amount described above. If a business has received an Economic Injury Disaster Loan Grant (described in the next section), the amount of the grant received will reduce the amount to be forgiven from the formulae described above.
While these formulae are intended to incent businesses to retain employees, Congress did recognize there may be circumstances in which businesses have already furloughed employees or must do so in the near term. For those businesses who have either furloughed employees or reduced salaries in excess of 25 percent between February 15, 2020 and April 26, 2020 (30 days after the enactment of the CARES Act), Congress has provided an opportunity to circumvent the reduction provisions above. As long as the business re-hires employees and/or restores salaries before June 30, 2020. The statute does not require that the business re-hire the same employees, only the same number of employees. If the business meets this requirement, the reduction provisions above do not apply to the amount of the loan that may be forgiven.
The statute indicates that the amount forgiven may not exceed the principal balance made available under the applicable covered loan. Although the statute is silent about the interest that accrues on the forgiven balance during the 8-week Covered Period, the Paycheck Protection Program FAQs for Small Businesses published by the U.S. Senate Committee on Small Business & Entrepreneurship indicates that the borrower will not be responsible for the interest accrued on the principal balance that is forgiven.
To obtain forgiveness on the loan, a borrower must apply through their lender. The application must include documentation verifying the number of employees on payroll and pay rates, including IRS payroll tax filings and State income, payroll and unemployment insurance filings; documentation verifying payments on covered mortgage obligations, lease obligations, and utilities; and certification from a representative of the business or organization that is authorized to certify that the documentation provided is true and that the amount that is being forgiven was used in accordance with the program’s guidelines for use.
Under many circumstances, debt that is forgiven is considered gross income to the borrower unless it can otherwise be excluded pursuant to the provisions of IRC Section 108. Amounts that are excluded from gross income typically reduce a taxpayer’s tax attributes including net operating losses, other loss carryforwards and ultimately basis of property. The CARES Act specifically provides that for purposes of the Internal Revenue Code, any amount which would be includible in gross income of the eligible recipient by reason of forgiveness described in [the Act] shall be excluded from gross income. As such, the borrower need not meet the requirements of IRC Section 108 for the forgiveness to be excluded from income. The CARES Act does not directly address whether the amount excluded from gross income will reduce the taxpayer’s tax attributes under the established provisions of the IRC and Regulations. We must wait for the Regulatory guidance to be issued to determine whether this point will be directly addressed.
What about the remaining balance?
The remaining balance of the loan not forgiven pursuant to the provisions above would carry forward for a period not to exceed 10 years and would accrue interest at a rate not to exceed 4 percent. The principal and interest would continue to be deferred for a total of 6 months to a year after the disbursement of the loan.
Please note that the guarantee provisions ordinarily applicable to SBA loan programs have been waived for PPP loans.
Economic Injury Disaster Loan (“EIDL”) Program and EIDL Grants
The SBA has an existing disaster loan program for small business concerns that make available lower interest loans of up to $2 million, with discretionary principal and interest deferment that are available to pay for expenses that could have been met had the disaster not occurred, including payroll and other operating expenses. Any small business concern that can demonstrate a substantial economic injury is eligible for a loan. Substantial economic injury is defined under the SBA provisions as an economic harm to a business concern that results in the inability of the business concern to (a) meet its obligations as they mature, (b) pay its ordinary and necessary operating expenses, or (c) market, produce, or provide a product or service ordinarily marketed, produced, or provided by the business concern.
The CARES Act expanded the eligibility requirements to include the same additional business concerns as the PPP. The Act did not modify the additional requirement to demonstrate a substantial economic injury. As such, the qualifications to apply for an EIDL are slightly more restrictive than the PPP. Any business concern that cannot, in good faith, demonstrate a substantial economic injury would not be eligible for the EIDL program or an EIDL grant.
The CARES Act creates, as part of the EIDL program, an EIDL grant. This is a grant of up to $10,000 that every business which is eligible for an EIDL may receive. The amount is available within 3 days of applying for an EIDL. The grant need not be repaid, even if the business concern ultimately does not receive an EIDL.
A business concern may apply for both an EIDL and a PPP. As previously mentioned, any EIDL grant received by a business concern would reduce the amount of that business concerns PPP loan that may ultimately be forgiven. Care must be taken to demonstrate that the proceeds from a PPP loan and the proceeds from the EIDL loan are not reportedly used for the same purpose.
Why might a business apply for an EIDL or EIDL grant?
First, the EIDL program is an existing program with respect to which the application process is currently available through the SBA.gov website. The application process for the PPP through SBA lenders has not yet been established and may take more time for loan proceeds to ultimately become available.
The CARES Act waives the personal guarantee requirement on advances and loans of not more than $200,000 during the Covered Period. The requirement that an applicant be in business for at least 1-year is also waived, although the applicant must have been in business prior to January 31, 2020. The requirement that an applicant was unable to obtain financing elsewhere has also been waived. The CARES Act also streamlined the application process allowing an applicant to obtain approval based solely on the credit score of the applicant without having to submit a tax return or tax return transcript.
An application for an EIDL loan provides a business with the opportunity to apply for an EIDL grant within 3 days and likely have those funds available prior to the loan disbursement date. Amounts advanced under the EIDL program may be used by the recipient to provide paid sick leave to employees unable to work due to the direct effect of COVID-19, maintain payroll to retain employees during business disruptions, meet increased costs to obtain materials unavailable from the applicant’s original source, making rent or mortgage payments, and repaying obligations that cannot be met due to revenue losses.
The guidelines also allow an EIDL to be refinanced into a PPP loan. However, the current guidance is unclear whether amounts expended with respect to an EIDL can be counted toward expenses incurred during the covered period for a PPP. Per the PPP provisions, only those expenditures during the covered period qualify for the forgiveness provisions under the PPP. It is important to note that EIDLs are not eligible for loan forgiveness.
Additionally, the EIDL is administered directly by the SBA. As such, applicant information is subject to the Freedom of Information Act (“FOIA”) and could become a matter of public record. The PPP is administered by SBA lenders and applicant information would not be subject to the FOIA.
Given the novelty and complexity of these provisions, it is likely that this summary may have generated more questions than answers. If you have any questions about this or any other topic, please call any member of your TFO Phoenix engagement team.
Director of Tax Strategy
TFO Phoenix, Inc.