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Paycheck Protection Program: Analysis of Forgiveness

Originally Published April 10, 2020; Updated June 16, 2020

The “front end” of the Paycheck Protection Program (“PPP”) was intense for applicants and professional advisors alike. The CARES Act, in many ways was ambiguous, and the clarifying guidance that followed was often sparse on details and filled with confusing language. This created no shortage of anxiety as businesses attempted to participate within a banking system that was entirely unprepared.

We then moved onto forgiveness, wading through an extensive set of rules, again, scant on details or definitions of important terms. After more than 15 Interim “final” Rulings (“IFRs”) and a first draft of a forgiveness application, we had thought we finally got to the finish line with respect to how forgiveness worked. Then came the Paycheck Protection Program Flexibility Act of 2020., which upended many of the rules. If it felt like a roller coaster, that is because it was.

Even with all of these changes, the reality is that “most” of this story has now been told, many of the questions have ultimately been answered and now it is time to look to the future regarding Borrowers’ completion of their Covered Period (“CP”) and application for forgiveness.

This article has been written and re-written as the rules have evolved. This is what we know as of now:

What is forgivable?

The CARES Act lists four general categories of expenses that are forgivable. This means that your PPP loan is forgivable to the extent you spend the loan proceeds on expenses within these four categories, and you maintain the headcount and salaries of employees at the same pre-Covid-19 levels (explained later in this article). Another important requirement is that you actually incur or pay these expenses during the CP, which for most is now defined as the 24-week period immediately after your receipt of the loan proceeds. Amounts spent outside the 24-week period (or eight-week period if elected), or outside one of the four permitted categories of expense, are not forgivable and will need to be repaid. The repayment term is now five years for borrowers who received their loan on or after June 5, and for borrowers who received their loan before that time, they are generally expected to be able to negotiate with their lenders to extend the term from two years to five years.

  1. Payroll costs – What constitutes “payroll costs” was a hot topic as companies were applying for PPP loans. When the dust settled, the SBA clarified that payroll costs include gross salaries and wages of employees (up to a cap of $100,000 per year), employer-paid health insurance, employer-paid 401(k) matching contributions, and employer-paid state and local taxes on payroll (e.g., unemployment insurance), among other things. Payroll costs do not include the employer’s portion of payroll tax expenses such as Social Security and Medicare. Payroll costs for owner-employees, self-employed individuals and general partners have the same definition as above; however, the total costs are capped at $100,000 (prorated) with a maximum forgivable amount of $20,833. This diminishes the benefit borrowers will receive within their forgiveness application for owners and partners. At this point, the prevailing view is the cap on salaries during a 24-week CP is $46,153 (i.e., $100,000 prorated for 24 weeks).
  2. Rent – This includes payments under a leasing agreement in force before February 15, 2020. This generally refers to leases of real and personal property, such as office space.
  3. Utilities – The CARES Act defines utilities narrowly to include: electricity, gas, water, transportation, telephone, or internet service for which service began before February 15, 2020.
  4. Interest – The CARES Act uses a term “covered mortgage obligation,” to describe which interest payments are subject to forgiveness. Interest payments can be for any debt obligation that is a liability of the borrower incurred before February 15, 2020. It does not include prepayments of interest or payments of principal. The CARES Act does require that the underlying debt must be a “mortgage on real or personal property.” This would include debt on real property that is secured by a traditional mortgage lien as well as working capital lines of credit and other indebtedness where a UCC-1 is filed on the borrower’s personal property. This definition does not include unsecured debt.

What expenses are included in the CP?

The CARES Act and subsequent IFRs clarified that expenses which are includible in the borrowers forgiveness application are expenses that are “paid and incurred” during the CP.

To further clarify:

  • For payroll, ALL costs paid during the CP will qualify. So if a borrower’s loan was funded on May 1, and on May 2 it paid payroll relating to the pay period of April 15 to April 30, that expense can be included as paid within the CP. In addition, borrowers can include payroll costs “incurred” at the end of the CP even if it was paid after the CP as long as it was paid within the next regularly-scheduled pay run. This allows for more than 24 weeks of payroll to be included in the calculation.
  • For non-payroll costs, a similar result can be achieved and any amounts paid during the CP will be included, and any amounts incurred will also be included as long as they are paid by the “next regular due date.”

What are the tax implications?

The CARES Act states that the forgiveness of debt under the PPP will not be taxable to the borrower. At this time, it is generally accepted that expenses incurred that were funded by the PPP loan will not be deductible. This is important for borrowers who were able to continue to stay open and generate revenue during their CP. If business operations did not substantially diminish, it is possible a borrower could have more taxable income than expected during 2020 if expenses are disallowed.

How do I calculate my maximum loan forgiveness amount?

Once your business has determined the payments eligible for forgiveness, you will need to complete two additional calculations to determine if such amount is ultimately forgivable. Both calculations are based on your payroll: the first is a measurement of your number of full-time equivalents (“FTEs”), and the second is a measurement of actual salary expense. The purpose of these calculations is to ensure that debt forgiveness is directly related to the purpose of the CARES Act – to keep employees working at wages comparable to pre-COVID-19 levels.

Headcount Analysis:
If a business reduces its number of full-time employees during the CP, then the forgiveness amount is reduced by a ratio equal to:

  • The average number of FTEs during the covered period (numerator) divided by the average number of FTEs during the reference period described below (denominator).
  • For the purposes of the calculation, FTEs are calculated as a 40-hour work week and borrowers are permitted to use either of two different methods to calculate the number of FTEs as follows:
    • A. Base method – for each employee, divide the average number of hours paid per week by 40 and round to the nearest tenth, capping any individual employee at 1
      • i. For example, borrower has three employees that work 40, 50 and 10 hours, respectively. There are 2.3 FTEs (40/40 + 50/40 capped at 1 + 10/40 rounded to nearest tenth)
    • B. Simplified method – each employee who works 40 hours or more per week is 1 FTE, and every other employee is assigned 0.5
      • i. Same example as above. There are now 2.5 FTEs (1 + 1 + .5)

Although borrowers have a choice between the two methods, they are required to use the same method consistently throughout the computation.

There are three different options to determine the reference period, and borrowers can select the one most favorable to them:

  • Using 2019 Information –the average number of FTEs per month from February 15, 2019, through June 30, 2019
  • Using 2020 Information –the average number of FTEs per month from January 1, 2020, to February 29, 2020
  • Seasonal Businesses –the average number of FTEs per month from February 15, 2019, through June 30, 2019

Let’s look at an example:
Facts:
Loan amount: $500,000
Average number of FTEs from February 15, 2019 to June 30, 2019: 75
Average FTEs during “covered period” following your first loan disbursement: 55
PPP Calculation: 55/75= 73%
Maximum loan forgiveness: $500,000 * 73% = $365,000
This tells us that the borrower will need to repay $135,000 of the loan.

FTE reduction “safe harbor”: The CARES Act allows for an FTE reduction “cure”.  Many observers thought this safe harbor was a drafting error, but it has been repeated enough times that it is not. So how does it work?

Even if a borrower reduces its headcount during the covered period, it will be deemed to have restored it fully if:

  • (1) the borrower reduced its FTE count in the period beginning February 15, 2020, and ending April 26, 2020;
  • AND (2) the borrower then restored its FTE count by not later than December 31, 2020 to its FTE employee levels in the borrower’s pay period that included February 15, 2020
  • The safe harbor clearly creates a disproportionate benefit to borrowers, allowing them to lower their headcount during the covered period with no limit, as long as, on a single day, they have restored their FTEs when compared to the February 15, 2020 payroll run.

FTE Exemptions:
Since the inception of the CARES Act, there have been several FTE exemptions introduced to Borrowers through IFRs and the PPP Flexibility Act. These exemptions allow you to ignore a reduction in FTEs for specific employees:

  • If the employee is fired for cause, voluntarily resigns or voluntarily requests and receives a reduction in hours during the CP.
  • If an employee rejects a good faith written employment offer from the Borrower to restore the reduced or eliminated hours of an employee during the CP.
  • If the Borrower can document in good faith that it was:
    1. (a) unable to rehire individuals who had been employees as of February 15, 2020, and (b) unable to hire similarly qualified employees for unfilled positions on or before December 31, 2020,
    2. or if the Borrower is unable to resume normal business activity levels due to compliance with HHS, CDC, or OSHA requirements or guidelines in effect between March 1, 2020, and December 31, 2020, related to the maintenance of standards for sanitation, social distancing, or any other worker or customer safety requirement related to the COVID-19 pandemic.

Wage Analysis:
The writers of the CARES Act likely wanted to ensure that borrowers were hiring back employees at a wage rate that was similar to pre-Covid-19 levels. Thus, they introduced a lever that penalizes companies who reduce wages per employee by more than 25% compared to the first quarter of 2020. For purposes of this calculation, however, businesses only need to consider employees who makes $100,000 or less per year. Removing employees that made over $100,000 from this calculation will help employers “manage” higher payroll without being penalized and, at the same time, incentivize them to fully restore the wages of those making $100,000 or less. The statute compares average weekly salaries during the CP to the average weekly salaries of those employees in January through March of 2020.

Let’s look at an example:
Loan issue date: April 1, 2020
Employee’s salary in Q1 2020: $20,000
Employee’s salary during eight-week covered period: $13,000
Amount of forgiveness reduction: ($20,000 – $13,000) – ($20,000 X 25%) = $2,000

How can you “correct” reductions of forgiveness?

Because we are using an eight-week covered period, you have until June 30, 2020, to restore your full-time employment and salary levels for any changes made between February 15, 2020, and April 26, 2020, and thus eliminate the potential reduction in loan forgiveness.

If you have any questions, please contact a member of Withum’s SBA Financial Assistance Services Group.

60/40 rule:
The PPP Flexibility Act. changed the 75%/25% rule to a 60%/40% rule, allowing borrowers to realize a greater benefit from the non-payroll costs they incurred during their covered period.  However, the law seemed to introduce a “cliff” effect whereby a borrower would not obtain ANY loan forgiveness if it did not spend at least 60% of its forgivable expenses on payroll.  As noted below in an excerpt from a joint statement from the Treasury and SBA, it appears the intent is for the mechanics of this ratio to work in a similar way to the previous rule, meaning that non-payroll costs cannot exceed 40% of the total amount of forgiven costs, thus there is not a scenario where there will be no forgiveness on amounts spent if you do not reach a certain spend on payroll.  Borrowers just need to understand that increasing spend on payroll increases the non-payroll costs that will be eligible for forgiveness.  This is obviously a welcome clarification for borrowers.

“Lower the requirements that 75 percent of a borrower’s loan proceeds must be used for payroll costs and that 75 percent of the loan forgiveness amount must have been spent on payroll costs during the 24-week loan forgiveness covered period to 60 percent for each of these requirements. If a borrower uses less than 60 percent of the loan amount for payroll costs during the forgiveness covered period, the borrower will continue to be eligible for partial loan forgiveness, subject to at least 60 percent of the loan forgiveness amount having been used for payroll costs.”

Over the course of the last few months, there has been a multitude of changes to the forgiveness calculation. While confusing, almost every change has been borrower-friendly, demonstrating the underlying motivation of the Treasury and SBA to ensure that businesses pay back as little as possible. With most borrowers enjoying an extended 24 week covered period, we expect that will be the case. Stay tuned for more changes and clarifications as we are sure there will be many!

SBA Financial Assistance Services

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