An Update on PPP Forgiveness

August 29, 2020 | Kristine A. Tidgren

The period for making Paycheck Protection Program loans through the CARES Act ended August 8. The program enabled 5.2 million loans, with $525 billion in proceeds disbursed to U.S. small businesses. When all was said and done, nearly $137 billion was left on the table. Although Congress could authorize a PPP round two under potential Phase IV stimulus relief, attention for borrowers under PPP round one has turned to forgiveness. A new interim final rule was issued on August 24, which answers a few outstanding questions. Even as developing guidance is digested, borrowers are attempting to determine their best next steps.

Patience is Still Advisable

The key feature of a PPP loan is that if the proceeds are spent in accordance with guidelines, the loan will be forgiven, with no repayment required. To receive this “gift,” however, the rules must be followed and the proper forms submitted. Throughout the PPP season, the rules have evolved as new guidance has trickled out. Clients and their advisors have been working with a moving target. And the target continues to shift. Although many clients are anxious to submit the forgiveness application and put this program behind them, there are several good reasons for many to be patient.

The Deadline is Not Immediate

The program now allows a 24-week covered period. This is the period during which the proceeds can be spent. Borrowers may submit a loan forgiveness application any time on or before the maturity date, including before the end of the covered period, if all of the proceeds have been spent. If a borrower does not submit the application for forgiveness within 10 months after the end of the covered period, payments on the loan will be due. In other words, there is time to wait and, in many cases, good reason to do so.

Possible Simplification of the Forgiveness Process

The forgiveness process may be simplified for small borrowers. One legislative proposal, for example, would allow borrowers of a loan under $150,000 to receive forgiveness after affirming that the rules had been followed. 

Deductibility of Expenses Paid with PPP Proceeds

Current Treasury rules disallow deductions for expenses paid with forgiven PPP loan proceeds. Although Congress excluded forgiven PPP proceeds from a taxpayer's gross income, Treasury stepped in with Notice 2020-32 to say that expenses paid with forgiven proceeds (such as payroll costs) will not be deductible. IRC § 265(a)(1), the notice explained, prevents a double tax benefit in such a case. Proposed legislation in the HEROES Act and the Small Business Expense Protection Act would overrule this result, with proponents of the proposals arguing that Congress intended the double benefit.

What to Do with Expenses?

The expense deductibility question presents a quandary for those filing fiscal year returns. The deductibility restriction applies to the extent of loan forgiveness. If a loan hasn’t yet been forgiven, the expense remains deductible. The PPP proceeds, at that time, are loan proceeds. It is not until after the loan is forgiven and the loan amount is excluded from gross income that the double tax benefit problem arises.

If Congress does not change the rules, the stroke of the forgiveness pen would trigger the recovery of the so-called tax benefit. This rule requires that when a taxpayer deducts an item from gross income but later recovers its value, the amount recovered is income and must be recognized to the extent of the previous tax benefit. This would mean a tax bill in the year of forgiveness. But Treasury has yet to provide rules for fiscal year-end filers. In the meantime, taxpayers who deduct expenses while waiting for forgiveness must consider potential future tax liability. Congress could remove the burden of this rule by passing a legislative fix. Treasury could remove some uncertainty by providing more guidance.We continue to monitor this important issue.

Schedule C/F Filers with No Employees

Self-employed borrowers with no employees and no deductible expenses should not be impacted by Notice 2020-32. A Schedule F farmer who received a $20,833 loan, for example, should be allowed $20,833 of forgiveness under the new 24-week covered period. This amount, which is designated as “owner compensation replacement,” is not impacted by the tax benefit rule. An owner “draw,” which is what this amount  represents, is not deductible. As such, this amount should be excluded from gross income, with no risk of future tax benefit recapture. In the absence of further guidance, owners should write themselves a check or transfer the funds to a personal account during the covered period to ensure the distribution is recognized as owner compensation replacement.

Some Program Rules Still Unclear

Questions remain with respect to the application of some rules, such as the mechanics of the FTE reduction if the employer applies for forgiveness before the 24 weeks has expired.  Borrowers facing uncertainty should wait to file for forgiveness until their questions are resolved. Borrowers can use this time to gather documentation and ensure that they are keeping good records of their expense payments.

August 24, 2020, Interim Final Rule

As noted above, the August 24 Interim Final Rule provided a bit more clarity to the forgiveness process.

Definition of Owners

Under previous guidance, forgiveness attributable to owner cash compensation is capped at $20,833 for a 24-week covered period. Forgiveness for cash compensation paid to non-owners is capped at $46,154 for the same period. The August 24 IFR answers a key question regarding what percentage of ownership is required to trigger the “owner” limitation.

Are any individuals with an ownership stake in a PPP borrower exempt from application of the PPP owner-employee compensation rule when determining the amount of their compensation that is eligible for loan forgiveness? 

Yes, owner-employees with less than a 5 percent ownership stake in a C- or S-Corporation are not subject to the owner-employee compensation rule.  The First Loan Forgiveness Rule, as revised by the Revisions to Loan Forgiveness and Loan Review Procedures Interim Final Rules, 85 FR 38304, 38307 (June 26, 2020), caps the amount of loan forgiveness for payroll compensation attributable to an owner-employee.  There is no exception in the rule based on the owner-employee’s percentage of ownership.  The Administrator, in consultation with the Secretary, has now determined that an owner-employee in a C- or S-Corporation who has less than a 5 percent ownership stake will not be subject to the owner-employee compensation rule.  This exemption is intended to cover owner-employees who have no meaningful ability to influence decisions over how loan proceeds are allocated.

The rule appears to create a “safe harbor” ownership threshold for owner-employees of a C corporation or an S corporation. Compensation to those employees with less than a five percent ownership share are not subject to the owner cash compensation cap. August 4 FAQs clarified that this cap applies to all compensation paid to the self-employed Schedule C or F filer and to all compensation paid to the partner. It does not apply to health care and retirement benefits paid on behalf of the C corporation owner-employee and it does not apply to retirement benefits paid for S corporation owner-employees (the cap does apply to health care benefits paid on the behalf of S Corporation owner-employees).. Forgiveness for retirement benefits paid on behalf of C corporation and S corporation owner-employees is limited to 2.5/12 of 2019 contributions. The new IFR does not discuss attribution rules and whether they apply to the new five percent threshold.

The Eligibility of Certain Nonpayroll Costs for Forgiveness

A second Q & A addresses the eligibility of several specific nonpayroll expenses for forgiveness.

Are amounts attributable to the business operation of a tenant or sub-tenant of the PPP borrower or, in the context of home-based businesses, household expenses, eligible for forgiveness?

No, the amount of loan forgiveness requested for nonpayroll costs may not include any amount attributable to the business operation of a tenant or sub-tenant of the PPP borrower or, for home-based businesses, household expenses.   

The IFR explains this rule further. If, for example, a borrower rents an office building for $10,000 per month and subleases a portion of the space to another business for $2,500, only $7,500 in rental expenses would be eligible for loan forgiveness. In terms of the home office expenses, the IFR clarifies through an example that covered expenses arising from the home office that were deductible on the borrower’s 2019 return are eligible for forgiveness.

Self-Rentals and Forgiveness

The last Q & A in the IFR addresses whether rent payments made to a related party are eligible for forgiveness. The rule states that any ownership in common between the business and the property owner is a related party for these purposes. The rule seeks to limit the forgiveness of a rental payment in this situation to the portion of the rent attributed to mortgage interest on the property. This approach, the guidance explains, seeks to put a business with a self-rental in the same position as a business that does not separate ownership of the real property from the ownership of the business operation.

Are rent payments to a related party eligible for loan forgiveness?

Yes, as long as (1) the amount of loan forgiveness requested for rent or lease payments to a related party is no more than the amount of mortgage interest owed on the property during the Covered Period that is attributable to the space being rented by the business, and (2) the lease and the mortgage were entered into prior to February 15, 2020.

The guidance states that a borrower must provide its lender with mortgage interest documentation to substantiate these payments. The IFR goes on to state, “PPP loans are intended to help businesses cover certain non-payroll obligations that are owed to third parties, not payments to a business’s owner that occur because of how the business is structured. This will maintain equitable treatment between a business owner that holds property in a separate entity and one that holds the property in the same entity as its business operation.”

We continue to watch for updates on this every-evolving program and see what happens when Congress returns from the Labor Day recess.