Redpath Insights

Preparing for PPP Loan Forgiveness

by Gloria McDonnell, CPA

UPDATED: May 1, 2020 - 11:44 a.m.

On April 30, 2020, the IRS issued Notice 2020-32 which provides guidance regarding the deductibility of expenses related to tax-free loan forgiveness from the Paycheck Protection Program (PPP). The Notice explains that expenses attributable to the loan forgiveness portion are not deductible for tax purposes. Any expenses related to the portion of loans not forgiven will be tax-deductible.

This determination by the IRS is unfortunate, but not entirely unexpected. IRC 265(a)(1) generally disallows deductions that are related to gross income which is wholly exempt from taxes. The purpose of IRC 265 is to prevent a double tax benefit related to tax-exempt income.    

The Notice calls into question why the CARES Act included the provision to exclude PPP loan forgiveness from gross income. If the gross income exception wasnโ€™t included in the CARES Act, the loan forgiveness would generally be taxable and the expenses would be tax deductible (effectively putting taxpayers in the same position). If the legislators intended to allow tax deductions related to PPP loan forgiveness, it appears an exception to IRC 265(a)(1) will need to be included in future legislation.      

Download our free PPP loan forgiveness presentation.

ORIGINAL POST - April 17, 2020 - 11:25 a.m.

One of the most significant benefits of the Paycheck Protection Program (PPP) loan is the loan forgiveness feature. Most businesses obtained the loans to provide financial relief during the COVID-19 pandemic with the intent of having allโ€”or mostโ€”of the loan proceeds available for tax-free loan forgiveness.

It is imperative that taxpayers take proper steps to understand how the funds are permitted to be used and which expenditures are eligible costs for forgiveness. However, much guidance is still needed from the Small Business Administration (SBA) and United States Treasury regarding the calculation of the loan forgiveness. Updates to this article will be included as information becomes available, but there are some key points you should consider now as we await further guidance.

PLEASE NOTE

The rules surrounding the Paycheck Protection Program are complex and the guidance is ever-changing. This memo summarizes interpretations based on guidance that is currently available as of April 14, 2020 and does not serve as formal guidance regarding the calculation of PPP loan forgiveness. We recommend clients consult with their SBA banker and attorney for specific guidance relating to their PPP loan.

 

Tracking the Use of Funds

Tracking the use of PPP loan proceeds is paramount to preparing for loan forgiveness.  Some steps you may want to consider taking include:

  • Retaining documentation to support all payments made with PPP funds.
  • Setting up separate account codes within your general ledger to track expenses paid with PPP funds.
  • Setting up a separate bank account (many attorneys are recommending that businesses set up a separate bank account for the PPP funds to help track expenditures).

How PPP Funds May Be Used

Not all use of funds listed below qualify for debt forgiveness, but they represent acceptable uses of PPP loan proceeds. 

  • Payroll costs
    • Salary, wage, commission or similar compensation paid to employees (subject to the $100,000 annualized cap per employee).
    • Payroll costs do not include compensation of an employee whose principal place of residence is outside of the United States.
    • SE income of partners up to $100,000 annualized.
    • Cash tips or the equivalent.
    • Payments for vacation, parental, family, medical or sick leave.
    • Payments for separation or dismissal.
    • Payments for group health care including insurance premiums and retirement benefits.
    • Payment of employer portion of state and local taxes assessed on employees.
    • Payroll costs do not include the employer portion of FICA, Medicare, and FUTA.
    • Payroll costs do not include wages for which a credit is allowed under the emergency paid sick leave or the emergency family medical leave provisions of the Families First Coronavirus Response Act.
  • Mortgage interest payments (regardless of when mortgage was acquired).
  • Rent payments (for real property or equipment leases - regardless of when lease was entered into).
  • Utility payments โ€“ gas, electricity, water, transportation, telephone or internet (regardless of when service agreement was entered into).
  • Interest payments on debt incurred before February 15, 2020.
  • Refinancing an SBA Economic Injury Disaster Loan made between January 31, 2020 and April 3, 2020.
OBSERVATION
  • PPP funds may be used to pay any mortgage interest, rent or utility expense incurred during the covered period, however, only amounts paid for covered mortgage, rent and utility payments are eligible for loan forgiveness (defined below). Entering into a new lease arrangement or a new mortgage obligation will not provide benefit related to loan forgiveness.
  • Guidance issued on April 14, 2020 implies that rent expense includes payments for equipment rental.

Misuse of Funds

Use of funds for purposes other than those listed above may incur additional financial liabilities and criminal penalties  including, but not necessarily limited to:
    • The taxpayer will be required to repay misused funds.
    • If funds are knowingly used for unauthorized purposes, the borrower could be subject to additional liability such as fraud charges. The SBA will have recourse against a shareholder, member, or partner who knowingly uses funds for unauthorized purposes.

Determining the Amount of Loan Forgiveness

Only PPP funds used to pay qualified expenses within the 8-week period beginning on the date the first loan proceeds are received (covered period) are eligible for loan forgiveness. In addition: 
  • Only 25% of the amount forgiven can relate to non-payroll costs.
  • Qualified expenses used in calculating loan forgiveness amount:
    • Payroll costs.
    • Interest payments on mortgage obligations incurred prior to 2/15/20.
    • Rent payments (for real property or equipment leases) on leases dated prior to 2/15/20.
    • Utility payments under service agreements dated prior to 2/15/20.
    • Additional guidance is needed to clarify whether the expenses must be both paid and incurred, during the covered period to be treated as a qualified expense.
  • There are two provisions which may limit the amount of loan that can be forgiven:
    • 1) Reduction in the number of Full Time Employees (FTE) during the covered period.
    • 2) Reduction in employee salary/wage during the covered period.
      • There are corrective actions that may be taken in either situation to maximize the amount of loan forgiveness.
    • Additional guidance is needed regarding the calculation of the reductions in FTE or salary/wage as well how to successfully take corrective action.

Special Rules for Self-Employed (Schedule C) Taxpayers

In addition to the permitted use of PPP funds outlined above, a sole proprietor may use PPP funds for owner compensation replacement per the following guidelines below:

  • Owner compensation replacement for a sole proprietor is defined as:
    • 2019 Schedule C net profit (limited to $100,000).
  • The loan forgiveness amount includes the amounts listed above plus:
    • Sole proprietor owner compensation replacement determined as follows:
      • (1) 2019 Sch C net profit (up to $100,000).
      • (2) Multiply amount calculated in step 1 by 8/52 to represent 8 weeks of profit.
      • (3) Reduce amount calculated in step 2 by any qualified sick or family leave amount for which a credit was claimed under the Families First Coronavirus Response Act.
    • Additional guidance from the SBA will be provided for self-employed individuals who were in business on 2/15/20 but were not in business in 2019.

How to Request Loan Forgiveness

Initial guidance in the legislation indicates that a borrower should submit to the lender an application to request loan forgiveness and supply the lender with the following documentation relating to the covered period:
  • Documentation verifying the number of FTE and pay rates.
  • Payroll tax filings reported to the IRS.
  • State income tax, payroll and unemployment insurance filings.
  • Documentation, including cancelled checks, payment receipts, transcript of accounts or other documents verifying payments of covered mortgage interest, rent and utility payments.
  • Certification from a representative of the business that:
    • The documentation presented in true and correct.
    • The loan amount for which forgiveness is requested was used to retain employees and to make payments on covered mortgages, lease or utility obligations.
  • The lender must issue a decision regarding the loan forgiveness within 60 days of the application being filed.
  • The amount forgiven is excluded from gross income.

Remember, understanding what qualifies for loan forgiveness is the critical first step to taking a proactive approach to documenting the use of the PPP loan proceeds. The action you take now could make the loan forgiveness process less cumbersome, but there is a lot that remains unknown.  We expect further guidance from the SBA regarding the procedure for requesting loan forgiveness and recommend you consult with your SBA banker and attorney as you complete the loan forgiveness application.

COVID-19 CARES Act

Gloria McDonnell, CPA

Gloria McDonnell, CPA

Gloria McDonnell is the tax operations director and serves on the leadership team at Redpath and Company. She specializes in corporate and individual tax planning and compliance, multi-state taxation, international tax, and tax research. Gloria works with closely-held businesses in a variety of industries, and has provided business tax accounting services since 1989, and has been at Redpath and Company since 1996.