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Paycheck Protection Loan Formula Explained and Illustrated

The paycheck protection loan formula is complicated.People are confused about how the paycheck protection loan formula works. And no wonder.

Simple on the surface, the formula gets complicated once you collect the inputs and try do the math.

Further complicating the effort? As practical matter, you can’t get help from either your accountant or banker. Neither has time for a personalized consultation. And for the record, your accountant probably can’t provide this service for a fee (per the rules).

Like I said, people are confused.

To try to help you, your accountant and your banker a bit, then, this blog post explains the paycheck protection formula. And it provides a bunch of examples to illustrate how the formula works.

Before We Start

But before we start, let me say something.

One can’t responsibly write a blog post like this without citing the relevant bits of the statutes and the other guidance from the Treasury and the Small Business Administration.

However, the usual way of doing that won’t in my opinion work very well. I can’t imagine it’s very effective, for example, if I point you to Section 1102(a)(1)(A)(viii)(I)(aa)(AA).

Accordingly, I point you to page numbers of the CAREs Act PDF document available here from the Congress.gov website.

What you want to do is print pages 6 to 21. (This range includes both the Section 1102 statute that sets up the paycheck protection loan program and the Section 1106 statute that defines how you ask for forgiveness.)

You can then refer to the appropriate page if you want to see the bit of the law I’m discussing.

And now we start.

The Basic Paycheck Protection Loan Formula

The way to understand the formula: It provides money to pay employees and then a small business’s owners for eight weeks. Plus a little extra to keep the doors open and the lights on.

For example, suppose a small business pays employees $60,000 in W-2 wages. Further suppose the firm generates self-employment income for the two owners equal to $40,000. In addition, the firm provides employee healthcare insurance that costs $20,000.

This firm’s payroll costs total $120,000: $60,000 of wages + $40,000 of self-employment earnings plus $20,000 of health insurance.

That annual payroll cost equates to a $10,000 average monthly cost. (You divide the $120,000 by twelve months.)

That $10,000 monthly payroll cost determines the paycheck protection loan. The loan equals 2.5 times the monthly payroll costs. With $10,000 in monthly payroll costs, for example, the loan amount equals $25,000.

So, it sounds simple, right? We only wish. The formula gets complicated in real life. Small business owners (and their accountants and bankers) ask dozens of questions. Accordingly, in the paragraphs I share the best answers I’ve heard from others or find in the statute or agency guidance.

W-2 Wages Paid Employees

The statute obviously looks at employee W-2 wages. So, you need to determine that value.

My suggestion? Use the Box 1 amount shown on the W-3 but add to that amount the retirement account elective deferrals listed in Box 12.

A W-3, in case you don’t know, summarizes the information on the W-2s an employer gives employees.

Example: The W-3 shows $120,000 in Box 1, $150,000 in Boxes 3 and 5, and $40,000 in Box 12 for employee 401(k) elective deferrals. In this situation, you might be tempted to just grab the total wages subject to Medicare shown in Box 5. That amount equals $150,000. But don’t. If you do that, you may miss the part of the wages that represents the owner’s self-employed health insurance.

A caution: The error some of the payroll services and maybe the banks made initially with regard to wages? They wanted to deduct the federal payroll taxes shown in Boxes 2, 4 and 6. That approach? Clearly wrong. (The error these folks make is to use the paycheck protection loan forgiveness formula rather than the paycheck protection loan amount formula.)

Wages More than $100,000 Don’t Count

The statute specifically limits its funding to only the first $100,000 of salaries an employee or owner earns. (See page 7 if you printed the PDF pages of the statutes.)

Further, the statute converts the $100,000 annual figure, in effect, into a monthly amount of $8,333. (If you divide $100,000 by 12, you get $8333.)

Example: A firm has two employees: One earns $5,000 a month. One earns $10,000 a month. The paycheck protection formula in effect counts $5,000 as the payroll cost for the first employee. The formula counts $8,333 as the payroll cost for the second employee.

Tip: To calculate the “excess” wages, the small business can look at each employee’s W-2. You want to look at Box 1 but add back the elective deferrals for things like a 401(k) shown in Box 12.

Partial Year Wages

The loan formula also doesn’t let you average wages over the year. The statute requires pro rata calculations. (Page 7.)

Example: Say a business starts operations halfway through the year and hires a single employee at an annual rate of $200,000. Because the employee works only half the year, she earns $100,000. For purposes of the paycheck protection loan, however, the payroll cost equals $50,000. Only the first $8,333 of payroll paid each month counts.

Independent Contractors Receiving a 1099-MISC

Some of the banks suggest you include in payroll costs the amounts paid to independent contractors to whom you send 1099-MISC forms at the year-end.

I see little risk in following the bank’s suggestion to include these amounts when you apply. If the bank suggests you include. But as the interim final rule from the Small Business Administration states, payroll costs don’t include 1099-MISC contractors.

Your 1099-MISC contractors should get their own paycheck protection program loans (PPP loans.)

Note: If your bank funds your PPP loan to include amounts you pay to 1099 independent contractors, you may want to hire these contractors as W-2 employees. Talk with your accountant about this. He or she will know the rules in effect then. But probably the PPP loan forgiveness formula, something I’m not talking about in this blog post, reduces the PPP loan for employee W-2 wages but not for 1099-MISC contractor payments.

S Corporation Shareholder Payroll Costs

An S corporation owner’s compensation–including appropriately accounted for self-employed health insurance–counts as payroll cost. The amount to include then? What the W-2 shows in box 1 (as adjusted for any elective deferrals to things like a 401(k).

Example: An S corporation shareholder-employee earns $48,000 in her business and this amount shows on her W-2 in Box 3 and Box 5. Box 1 shows $60,000 because her compensation includes $12,000 of health insurance, and the IRS says the S corporation counts this amount as wages. Use the box 1 value, or $60,000.

Example: An S corporation shareholder takes no wages from his corporation. But his K-1 shows $60,000 of income and distributions. The S corporation counts his payroll costs as zero.

Sole proprietors

The statute and the agency guidelines only vaguely describe how to calculate the payroll cost for a sole proprietor. But guidance available references the business owner’s “self-employment earnings.” (See page 7.)

My conclusion? You look at the Schedule SE form’s “self-employment earnings” amount. (The Schedule SE tax form appears inside a sole proprietor’s or working partner’s 1040 tax return.)

Example: A sole proprietor’s Schedule C form inside her 1040 return calculates $100,000 of business profit. Her Schedule SE reduces this amount for the “employer” share of the Social Security and Medicare taxes and calculates $92,350 of self-employment earnings. The $92,350 counts as the business owner’s PPP loan amount payroll costs for purposes of the PPP loan amount formula.

Partners in an Active Trade or Business

As for sole proprietors, the statute and agency guidelines give few details about how partners in an active trade or business calculate their payroll costs. But as for sole proprietors, self-employment earnings make sense as the payroll costs.

Example: A working partner in an active trade or business receives a K-1 that reports $50,000 in Box 1 of the K-1 and another $50,000 in Box 4a of the K-1. Box 1 shows the partner’s share of the partnership’s profits. Box 4a reports on the partner’s guaranteed payments received for working in the business. On the partner’s 1040 return, his Schedule SE will report $92,350 of self-employment earnings. Use that amount for the payroll costs for that partner.

Health Insurance

The statute says that group health insurance counts as a payroll. But two questions pop up regarding health insurance and the PPP loan amount formula:

  • First, whether health insurance counts toward that $100,000 limit.
  • Second, whether self-employed health insurance counts.

Accountants and bankers disagree on the answers to these questions. But here are my thoughts and the reasons for those thoughts.

With regards to whether health insurance counts toward the $100,000 limit? I think it does for two reasons.

A first quick reason? Both the statutes (Section 1102 which appears on pages 6-14 of that PDF and then Section 1106 which appears on pages 17-20) seem to lump together health insurance costs with other payroll costs like wages and salary.

A second reason? This approach means that health insurance counts for employees the same way it does for S corporation shareholder-employees, sole proprietors and partners working an active trade or business.

How so? In all these “business ownership” situations, the self-employed health insurance gets baked into another “number” that explicitly counts as a payroll cost.

Example: For an S corporation shareholder-employee, self-employed health insurance gets included in the W-2 wages and so is included in payroll costs because it’s part of the wages.

Example: For a sole proprietorship, the self-employment health insurance deduction doesn’t reduce the Schedule SE calculation of “self-employment earnings.” Rather, those “self-employment earnings” provide the money that gets used to pay for health insurance.

Example: For a partner working in an active trade or business, self-employed health insurance counts as a guaranteed payment. That means it counts as self-employment income. And of course self-employment income counts as a payroll cost.

Retirement Benefits

I initially read the statute to say it counted retirement benefits paid to retired employees as payroll costs. (So if I used to work for you but now I’m retired yet you still pay me some sort of benefit, that cost.)

The banks running the paycheck protection program loans, however, seem to consistently be treating employer contributions to employee pensions as a payroll cost.

Because that accounting mirrors the approach used for health insurance—and because I figure the banks have had teams of attorneys look at the laws—I think you include employer matching amounts as payroll costs.

These costs will, however, be limited by the $100,000 ceiling.

Example: A small business has two employees. One makes $50,000. The other makes $100,000. The company operates a SEP-IRA plan which means 25% contributions to employee’s IRA accounts. That means a $12,500 contribution for the first employee and a $25,000 contribution for the second employee. Because the second employee makes $100,000 before the SEP-IRA contribution, however, that retirement benefit doesn’t count as a payroll cost.

Three Quick Comments to Close

Sorry, this is another long post. But three quick comments before I close.

First, if the bank suggests something about what to include and not to include? Yeah, I think you go with their suggestion. Surely, they’ve had their “best people” try to puzzle out this statute. Also I see little risk in you following some big bank’s suggestion as to how the loan formula works.

Second, I would not make “perfect” the enemy of “good” here. If you have an easy way to calculate and then document you’re entitled to $50,000 of paycheck protection loan money, don’t waste time trying to legitimately nudge that amount up a bit.

Third, understand that the loan forgiveness formula works differently than the loan amount formula. I’ll try to write about that when good details come out. (You may want to subscribe to our email newsletter to make sure you get that information. There’s a sign-up form just below the blog post.)

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