With many businesses forced to shut their doors amid the COVID-19 pandemic, Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act. As part of the Act, the Paycheck Protection Program (PPP) was established to help small businesses cover their everyday expenses. With the Treasury Department announcing this week that they will begin forgiving PPP loans, the questions on the minds of many entrepreneurs are how and if their loans will be forgiven? This post relates to PPP loans issued to sole proprietors, which represent the most common type of business in the United States.
Options for Sole Proprietors
The initial SBA applications for PPP loans were only available to businesses that could provide evidence of their payroll expenses. With 81% of small businesses in the United States having zero employees and 87% of those businesses being sole proprietors, this left thousands of entrepreneurs unable to apply due to not having carefully documented payroll expenses.
In April 2020, the SBA published updated guidance for sole proprietors. The new guidance introduced a program called “Owner Compensation Replacement” (OCR), which allows sole proprietors to receive loans and claim forgiveness without relying on documentation of payroll. If the sole proprietor was in business prior to February 15, 2020, filed a Schedule C with a tax return for 2019, and has a primary place of residence in the United States, the sole proprietor is eligible. Many entrepreneurs applied for and received loans under this program without an understanding of the options available to them.
Before April, the general rule was that businesses could apply for a loan based on an average of 2.5 months of payroll expenses with certain restrictions for seasonal businesses. Under the OCR program, however, the eligible loan amount was calculated by taking an average of 2.5 months of the sole prop’s 2019 net profit. This is calculated by taking 2019 net profit as reported on the Schedule C in the sole proprietor’s tax return, dividing by 12, then multiplying by 2.5. This circumvents the payroll documentation requirement and looks only at a sole proprietor’s 2019 Schedule C.
Requirements for Loan Forgiveness
The Flexibility Act that was signed into law in June 2020 provided that a borrower must spend at least 60% of a PPP loan on payroll expenses to qualify for total forgiveness. If the borrower does not spend at least 60% of a PPP loan on payroll expenses, the forgiveness amount will be reduced. Forgiveness may also be reduced if a borrower reduces the number of his or her full-time employees or his or her employees’ compensation.
The 60% threshold is not an all-or-nothing minimum. If a borrower spends less than 60% of the loan on payroll, the borrower’s forgiveness amount is simply reduced, not eliminated altogether. To illustrate:
A borrower receives a $50,000 PPP loan, and during the covered period spends $27,500 (55%) on payroll expenses. Because the borrower spent less than 60% of the loan on payroll costs, the maximum amount of forgiveness is $45,833 (with the $27,500 spent in payroll costs making up 60% of the forgiveness amount).
For this reason, a borrower should not panic if the borrower falls short of the 60% threshold. The forgiveness amount is simply reduced to ensure that a minimum of 60% of the amount forgiven is spent on paying employees.
Loan Forgiveness Important Dates
A PPP borrower must submit a forgiveness application to his or her lender no later than 10 months from the end of the borrower’s covered period. The covered period, either 8 or 24 weeks, begins on the first day of the first pay period following the loan disbursement, but in no event does it extend beyond December 31, 2020. Borrowers who received their loan prior to June 5, 2020, may elect either an 8 or 24-week covered period. The default covered period for loans disbursed after June 5, 2020, is 24 weeks.
For example, consider a borrower who elected to use the 24-week covered period and received a PPP loan on Friday, July 3. If the first day of the first pay period following this disbursement was Monday, July 6, then the covered period ends 24 weeks from that date, or December 21. The borrower will then have 10 months from this date to apply for loan forgiveness.
Which Forgiveness Application to Use (UPDATED 10/9/2020)
UPDATE: In response to reports that some businesses were spending up to 15 hours on their loan forgiveness applications, the SBA and Treasury Department introduced a new option, Form 3508S, which may be used for all borrowers that received a PPP loan of $50,000 or less. This action streamlines the forgiveness process for small businesses and entrepreneurs who received aforementioned size loans.
In addition to the streamlined application process, borrowers who use SBA Form 3508S are also exempt from any reductions in their loan forgiveness amount based on reductions in full-time equivalent (FTE) employees or reductions in employee salary or wages (section 1106(d) of the CARES Act) that would otherwise apply.
There are three scenarios in which borrowers can use the 3508EZ form to apply for forgiveness:
- You are self-employed AND have no employees; OR
- You did not reduce the salaries or wages of any employees by more than 25% AND did not reduce the number or hours of employees; OR
- You experienced reductions in business activity as a result of health directives related to COVID-19 AND did not reduce the salaries or wages of employees by more than 25%.
If the borrower does not fit into any of these categories, the borrower will need to complete the full forgiveness application.
Unanswered Question about Expenses
One major question that remains unanswered is whether expenses paid for with forgiven PPP loan money will be tax-deductible. Despite the stated intent of Congress to make forgiven loans tax-free, the IRS issued notice 2020-32 on April 30, 2020, stating that expenses paid for with forgiven PPP loans will not be deductible.
Usually, ordinary expenses like payroll, rent, and utilities are deductible from normal taxable income, but the IRS issued this guidance to prevent a “double tax benefit.”
On May 5, 2020, a bipartisan group of senators introduced the “Small Business Expense Protection Act” to address this issue and make sure that these ordinary business expenses are deductible. That bill, however, was referred to the Senate Finance Committee on May 5, 2020, where it has not moved. So, until the Senate acts on this bill, expenses paid for with ultimately forgiven PPP loans may not be tax deductible according to the IRS.
This post was authored by John Nucci, a second-year student at Penn State Law.