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Losing PPP Loan Forgiveness

PPP loan forgiveness not at much grace as you hopeA disturbing possibility: Surely many small business owners risk losing PPP loan forgiveness.

Hopefully, most firms will only lose a bit. Some will lose a lot. Unfortunately, a few may lose out completely.

Let me therefore point out the risk areas you need to stay alert to. Hopefully the fog surrounding PPP forgiveness clears up. The Treasury and Small Business Administration will provide more and detailed guidance. But gosh, you need to stay on top of this.

A Quick Paycheck Protection Program Refresher

So first, just to bring everyone up to speed, a quick refresher.

If your small business was slammed by the Covid 19 crisis, you theoretically could obtain a “paycheck protection program” loan—a PPP loan—equal to 2.5 times your monthly payroll.

If your monthly payroll runs $40,000, for example, your PPP loan amount might be $100,000.

Payroll by the way included not just wages but employee benefits, state payroll taxes, and the business owner “compensation replacement.”

And the other part of this: If you spend the loan proceeds on payroll, rent, interest and utilities over the eight weeks that followed you receiving the loan? Bingo. The Small Business Administration forgives the loan. Free money, in other words. Maybe…

But some gotchas exist. And these gotchas may limit or eliminate forgiveness.

Gotcha #1: Headcount Reduction

The PPP loan forgiveness formula makes a small business eligible for total forgiveness. You just need to spend the loan proceeds on payroll costs, interest, rent and utilities over the eight weeks that follow you receiving the money.

However, the Section 1106 statute makes two adjustments to the initial “eligible for forgiveness” amount.

The first adjustment appears in Section 1106(d)(2)(A). It says that if you reduce the headcount of full-time equivalent employees, that percentage reduction reduces the initial “eligible for forgiveness” amount.

This adjustment works pretty simply. Say you employed five full time employees and ten half-time employees last year. Converted to full-time equivalent employees, the formula says you employed 10 workers.

But say that you terminate a couple of full-time employees. Those terminations drop your full-time equivalent employees count from 10 to 8 workers.

Dropping from 10 employees to 8 employees represents a 20% cut in headcount.

That would reduce the initial “eligible for forgiveness” loan amount by 20%.

For example, say your firm had spent a total of $100,000 on payroll, interest, rent and utilities. But say you had reduced your headcount by 20 percent. In this scenario  the “adjusted for headcount reduction” loan amount drops by 20 percent to $80,000.

One other thing to note: The headcount adjustment lets a business choose which period of employment it looks back at to calculate a reduction in workers. A firm can compare its current employment to employment from February 15, 2019 through June 30, 2019 or to employment from January 1, 2020 through February 29, 2020.

Gotcha #2: Pay Rate Reductions

The PPP loan forgiveness formula includes another adjustment, too, from Section 1106(d)(3)(A).

After the formula adjusts the initial “eligible for forgiveness” amount for any reductions in headcount, it looks for any reductions in employee pay rates in excess of 25%.

Note that the formula ignores pay rate reductions for employees who earned more than $100,000 (on an annualized basis) in 2019.

But for everyone else, a pay rate reduction in excess of 25% further reduces the amount actually available for forgiveness.

Suppose a firm reduces the pay rate for one employee from $8,000 to $2,000. Perhaps this employee earns a sales commission, for example. And the bad economy just destroys sales for a few months.

That 75% decrease in payroll (from $8,000 to $2,000) equals $6,000. A 25% decrease in payroll equals $2,000. So, the reduction in pay rate in excess of 25% equals $4,000.

That $4,000 further reduces the loan forgiveness.

If a small business started out with an initial “eligible for forgiveness” amount equal to $100,000, a 20% reduction in headcount might reduce that $100,000 to $80,000.

And then a pay rate reduction like that described in these paragraphs would decrease the loan forgiveness amount by another $4,000 to $76,000.

Gotcha #3: Missing the Rehire Window of Opportunity

The Section 1106 statute includes a couple of mulligans.

The first mulligan? Per Section 1106(d)(5)(A) and 1106(d)(5)( (B), if a firm rehires employees it laid off sometime after February 15, 2020 and before April 27, 2020 and then it rehires them by June 30? Yeah, that’s good enough.

Rehiring workers lets you avoid a reduction in the initial “eligible for forgiveness” amount due to an earlier reduction in your headcount.

Note, though, that if a firm finds itself in this situation, the firm surely calculates a smaller initial “eligible for forgiveness” amount.

For example, say a firm averages $40,000 a month in payroll during 2019. As a result, it receives a $100,000 loan. Assume, however, that the firm has to lay off its entire workforce before receiving the PPP loan and can’t rehire them until June 30.

Because the firm rehires employees by June 30, it avoids the headcount reduction adjustment. But without employees on the payroll during April, May and June, it lacks payroll costs to plug into the initial “eligible for forgiveness” amount.

Gotcha #4: Missing the Pay Cut Reversal Window of Opportunity

The statute includes another similar mulligan for pay rate cuts.

If a firm reverses a reduction in salaries or wages by June 30, that reversal eliminates the requirement to reduce the initial “eligible for forgiveness” loan amount for pay rate cuts in April, May and June.

Again, though, note that the pay rate cuts themselves should reduce the payroll costs that plug into the formula.

For example, suppose a firm with ten employees making $1,000 a week cuts people’s wages to $500 a week. If the employer reverses the wage cuts by June 30, the wage cut adjustment doesn’t need to be calculated. The firm doesn’t need to calculate that a $500 per worker reduction is $250 more than a 25% decrease, for example. And then it doesn’t need to tally up these excess wage reductions and subtract the total from the initial “eligible for forgiveness” amount.

But the 50 percent cut in wages means the firm pays 50 percent less payroll.

Gotcha #5: Bad Documentation

Tax accountants will tell you that taxpayers often lose audits only because they lack good documentation.

Something similar, surely, will happen with the PPP loans. The statute requires a borrower to provide rich, detailed, high quality documentation. Here’s the actual list from the law:

…payroll tax filings reported to the Internal Revenue Service; state income, payroll, and unemployment insurance filings; documentation, including cancelled checks, payment receipts, transcripts of accounts, or other documents verifying payments on covered mortgage obligations, payments on covered lease obligations, and covered utility payments… and any other documentation the Administrator determines is necessary.

I added the boldfacing to that last little bit.

But mark my words, many small business owners won’t be able to provide this detail. And in that case? The statute says they lose forgiveness. To quote the actual text of the law,  “no recipient shall receive forgiveness without submitting the documentation required.”

One other thing to consider about documentation, too. The Section 1102 statute–the main law that creates the paycheck protection program–requires you to use the PPP funds for the approved purposes. Very possibly some small businesses will spend enough money on the appropriate expenses (payroll, rent, interest and utilities). But then lack the ability to prove the PPP loan funds provided the money that got spent.

I would worry about a situation, for example, where a borrower deposits the PPP loan funds into a savings account–and then spends money from a checking account on payroll, rent, interest and utilities.

Note: I have another blog post that talks about how to not goof up the bookkeeping: PPP Loan Accounting Tips.

Gotcha #6: The 25% Non-Payroll-Costs Rule

The statutes passed by Congress say you can receive forgiveness if you spend the money on payroll, rent, interest and utilities.

The Treasury and the Small Business Administration refined this however and say in the Interim Final Rule that non-payroll costs can’t represent more than 25% of the loan forgiveness amount.

You can read this requirement two ways. But the friendly way to read this rule goes like this…

You received a $100,000 loan. Due to state mandated closures, you could only spend $60,000 on payroll during the eight weeks the PPP loan forgiveness formula considers.

You also spent $40,000 on rent, interest and utilities. You might think you’re okay in this situation.

But you won’t get forgiveness for the entire $100,000. Even though your spending all counts as valid use of the PPP loan funds.

Rather, you will get limited to only forgiveness for half of the $40,000 you spent on rent, interest and utilities. Why? Because then, with $80,000 of forgiveness, only 25% or $20,000 of the forgiven amount goes to rent, interest and utilities.

Gotcha #7: Failing to Spend at Least 75% on Payroll-Costs Rule

Scattered through the Interim Final Rule just referenced, you also see (repeatedly) the phrase, “at least 75 percent of the PPP loan proceeds shall be used for payroll costs.”

What this means isn’t clear to me. For example, is this the same thing as what I describe in Gotcha #6?

Or does this mean something different? For example, does it mean that if you borrow $100,000 but then for whatever only spend $60,000 on payroll costs, you lose forgiveness?

I flip-flop in my assessment of this. But you probably want to consider the possibility you lose forgiveness in this situation.

If you read through the Interim Final Rule, the language seems clear,

… the Administrator believes that the finite appropriations and the structure of the Act warrant a requirement that the borrowers use a substantial portion of the loan proceeds for payroll costs, consistent with Congress’ overarching goal of keeping workers paid and employed.”

This discussion then goes on and makes the statement that the Secretary of the Treasury and the Small Business Administrator have decided that “75 percent is the appropriate percentage.” Further, the discussion notes that this limitation on the use of funds “will help ensure that the finite appropriations available for these loans are directed toward payroll protection.”

And something else.  Within this rule, two statements appear in close proximity.

As explained above, not more than 25 percent of the loan proceeds may be used for non-payroll costs.

As explained above, not more than 25 percent of the forgiven amount may be for non-payroll costs.

I don’t believe that these two statements are equivalent. (I boldface and italicize the difference.) Accordingly, I will not be surprised if spending less than 75 percent on payroll eliminates the forgiveness.  Sorry.

A Tip Related to a Harsh Reading of the 75 Percent Rule

If you inadvertently received a PPP loan much larger than you should have, stay especially alert to this Gotcha #7.

Say, for example, that your PPP loan application erroneously treated amounts paid to 1099 independent contractors as wages. People understandably made this mistake. Early guidance lacked clarity.

In this case, however, you received a far larger loan than you should have. And you may find it impossible to spend 75 percent or more on payroll.

I’m not sure what you do about this. Maybe you want to think about hiring your contractors? Or maybe you want to return the loan? Or maybe you just want to plan to repay the loan?

What a mess, right? Unbelievable…

A Sidebar: Can You Round 74 Percent to 75 Percent?

A tangential comment related to the 75 Percent.  The PPP loan formula provides you with 2.5 months of payroll. Per the Interim Final Rule, you must spend 75 percent of this on payroll–or essentially 1.875 months. (I’m calculating this as .75 times 2.5.)

The problem some people good at math point out? 1.875 months is slightly more than 8 weeks. 8 weeks, it turns out, equals 1.84 months. This potential “bug” in the statute flows from the Section 1102’s use of “months” and Section 1106’s use of “weeks.” But in the Interim Final Rule, the Treasury and Small Business Administration say, “oh, yeah, you round up in this case.” Just so you know.

Gotcha #8: Self-Employed Folks Counting on Full Forgiveness

One last gotcha to mention. A self-employed Schedule C business without employees always receives only partial forgiveness of a PPP loan.

Here’s the complete language from the Additional Eligibility Criteria Interim Final Rule:

For individuals with self-employment income who file a Schedule C, the Administrator, in consultation with the Secretary, has determined that it is appropriate to limit loan forgiveness to a proportionate eight-week share of 2019 net profit, as reflected in the individual’s 2019 Form 1040 Schedule C. This is because many self-employed individuals have few of the overhead expenses that qualify for forgiveness under the Act. For example, many such individuals operate out of either their homes, vehicles, or sheds and thus do not incur qualifying mortgage interest, rent, or utility payments. As a result, most of their receipts will constitute net income. Allowing such a self-employed individual to treat the full amount of a PPP loan as net income would result in a windfall. The entire amount of the PPP loan (a maximum of 2.5 times monthly payroll costs) would be forgiven even though Congress designed this program to limit forgiveness to certain eligible expenses incurred in an eight-week covered period. Limiting forgiveness to eight weeks of net profit from the owner’s 2019 Form 1040 Schedule C is consistent with the structure of the Act, which provides for loan forgiveness based on eight weeks of expenditures.

To illustrate this, if your 2019 Schedule C shows exactly $52,000 of profit, you earned $4,333 a month and $1,000 a week.

Your loan equaled 2.5 times $4,333, or $10,833. But forgiveness equals 8 times $1,000, or $8,000.

A Closing Comment

I want to end with a comment about how I think you process this “losing forgiveness” risk. To my way of thinking, you want to unbundle the PPP loan thing from the forgiveness formula thing.

Think about the loan as a loan, pure and simple. And if you need a loan, the PPP loan works great. Well, except for the goat rodeo element to applying. But other than that, the PPP loan may provide inexpensive flexible financing that helps you get through an almost unimaginably rough patch.

The forgiveness thing? Consider that icing on the cake. If you get some or a bunch of forgiveness? Great. Count yourself fortunate. But don’t bank on forgiveness.

Ready for a Break from the Covid 19 Topic?

Let me point you to a couple of lighter, uplifting blog posts…

In Defending Millionaire Next Door: What Thomas Stanley’s Critics Got Wrong, I describe why small business ownership makes sense. Maybe the post will make you feel a little less bummed out. Maybe the post will help you rekindle enthusiasm regarding small business ownership.

In Lifetime Earnings of the Top One Percent, I explain why I think you’re doing way, way better than you imagine.

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