Material Considerations that Should be Evaluated by All Borrowers under the Paycheck Protection Program
Summary: This week is a very important week for borrowers ("borrower(s)") under the Paycheck Protection Program ("PPP") as the May 14 deadline to return PPP Loan proceeds is quickly approaching and there are still many questions left unanswered. While we expect to receive more guidance on certain of the following subjects this coming week (before May 14), we wanted to share with you what we believe to be the three most material considerations that each borrower under the PPP should be evaluating: (1) potential new rules regarding qualification for a PPP Loan; (2) the IRS guidance to disallow deductions for expenses paid with PPP funds; and (3) the IRS guidance to disallow the Employee Retention Credit to companies that receive PPP loans.
These considerations are not mutually exclusive, and must be weighed together to determine their net effect. While the decision to apply for (or return) a PPP Loan is primarily a business decision, we welcome you to contact us to better understand the interplay of varying provisions of the CARES Act and resulting guidance.
1. Certification Regarding Need for a PPP Loan
All companies that applied for PPP Loans were required to certify that the "[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant." On April 23 (weeks after many companies had already filed applications for PPP loans), the SBA issued FAQ 31 to advise that businesses that certify "[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant," as required by the CARES Act, "must make [or have made] 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." While many thought this guidance was intended only for public companies, the SBA clarified that it extends to privately-held companies as well in FAQ 37. The SBA, in consultation with the Treasury, intends to review loans files as appropriate to ensure eligibility, including all loans in excess of $2 million. The review will take place upon submission of the necessary materials for loan forgiveness. Borrowers now have until May 14 to return their PPP funds without penalty if they believe that, in light of this new guidance, their original certification is inaccurate.
Recall that the CARES Act expressly waives the normal requirement that an applicant for an SBA loan be unable to obtain credit elsewhere. FAQ 31 arguably contradicts the waived "credit elsewhere" requirement as the use of the term "liquidity" is perhaps broad enough to encompass credit and other forms of liquidity, such as a capital call. To date, there is no telling how the SBA will interpret or enforce its new guidance, but borrowers should consider whether they have truly exhausted all other sources of liquidity including reasonable sources of credit. The SBA could deny forgiveness to any borrower the SBA believes to have made this certification inaccurately, though more severe repercussions are possible.
The SBA, which has been inundated with questions regarding FAQ 31 ever since it was issued, intends to deliver additional guidance on this issue before May 14.
2. IRS Disallowing Deductions for Expenses paid with PPP
Under Section 1106(i) of the CARES Act, "any amount which (but for this subsection) would be includible in gross income of the eligible recipient by reason of forgiveness...shall be excluded from gross income." On April 30, the IRS released Notice 2020-32 which states "that no deduction is allowed under the Internal Revenue Code for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b)." The IRS intent was to eliminate the double tax benefit borrowers under the PPP would receive from both receiving a forgivable loan with no tax impact and deducting the expenses paid with that loan. While not expressly contradictory to the plain language of the CARES Act, the IRS' position is certainly contradictory to the intent of the CARES Act. In fact, Charles Grassley, Senator from Iowa and Chairman of Senate Finance Committee (drafters of the CARES Act), wrote a letter to Treasury Secretary Mnuchin on May 5 urging him and the IRS to revise Notice 2020-32 disallowing deductibility of PPP expenses. Grassley's letter explains that the effect of Notice 2020-32 is that "whatever income a small business is able to produce will be taxed on a gross basis to the extent of the loan forgiveness, leaving substantially less after-tax capital for the swift economic recovery we hope is on the horizon." While it seems likely the IRS guidance will be challenged in court based on Senator Grassley's comments, borrowers should consider that existing IRS guidance reduces the net benefit of a PPP Loan. Borrowers should expect that the IRS will scrutinize 2020 tax filings in light of this guidance. Loss of the deductibility of expenses paid for with PPP proceeds will "cost" a PPP borrower approximately 30% to 40% (dependent on its tax bracket) of the value of the PPP Loan. The net effect is to make the value of a PPP Loan that is fully forgiven only about 66% of its face value.
3. Employee Retention Credit Cannot be Used by Companies that
Receive PPP Loans.
Section 2301 of the CARES Act introduced the Employee Retention Credit for Employers Subject to Closure Due to COVID, which offers a fully refundable tax credit for employers equal to 50% of qualified wages (including allocable qualified health plan expenses) that Eligible Employers pay their employees. As its name implies, the purpose of the Credit is to encourage employers to keep employees on their payroll. The Credit applies to qualified wages paid after March 12, 2020 and before January 1, 2021. The maximum amount of qualified wages taken into account with respect to each employee for all calendar quarters is $10,000, so that the maximum credit for an Eligible Employer for qualified wages paid to any employee is $5,000.
Eligible Employers are for-profit and not-for-profit entities carrying on a trade or business in 2020 that either:
a. Fully or partially suspend operation during any calendar quarter in 2020 due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19; or
b. Experience a "significant decline" in gross receipts during the calendar quarter.
Significant decline" has been interpreted by the IRS to begin with the first calendar quarter in 2020 in which gross receipts are less than 50% of gross receipts compared to the same quarter from the prior year.
IRS guidance advised that an "employer may not receive the Employee Retention Credit if the employer receives a PPP loan that is authorized under the CARES Act." Subsequently, the SBA advised under FAQ 45 that "[a]n employer that applied for a PPP loan, received payment, and repays the loan by the safe harbor deadline (May 14, 2020) will be treated as though the employer had not received a covered loan under the PPP for purposes of the Employee Retention Credit." As such, borrowers should consult with their tax advisors as to whether the benefit of the Employee Retention Credit is greater than the benefit offered by a PPP Loan. Of course, this analysis will need to include (a) due consideration to the overall benefit of a PPP Loan in light of existing IRS guidance to disallow deduction of PPP expenses; and (b) whether the business could survive without a PPP Loan to be in existence at the time it could claim the Employee Retention Credit. Borrowers should keep in mind they could miss out on both the benefit of forgiveness of a PPP Loan and the benefit of the Employee Retention Credit if the borrower takes a PPP Loan, but forgiveness is later denied for any reason (including by reason of an invalid certification as discussed in paragraph 1 of this message).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.