Paycheck Protection Program Loans: What’s at the End of the Rainbow?

The U.S. Small Business Administration (the “SBA”) began accepting applications for Paycheck Protection Program loans (a “PPP loan”) on April 3, 2020. Even though the SBA and the U.S. Department of Treasury (the “Treasury”) have previously published general guidance in the form of Frequently Asked Questions (“FAQs”) and Interim Final Rules (“IFRs”), a number of important questions remained. However, we now have a detailed roadmap in the form of the Loan Forgiveness Application (the “Forgiveness Application”) (). This article has been updated to include relevant changes resulting from the June 5, 2020 passing of the Paycheck Protection Program Flexibility Act of 2020 (the “Flexibility Act”) and SBA guidance regarding the same.

Should I Return My PPP Loan?

Before turning to loan forgiveness, we should first address the lingering eligibility question. The Coronavirus Aid, Relief, and Economic Security Act (the “Act”) and initial guidance provided businesses and professional advisors with very little information with respect to PPP loan eligibility, other than the general “size-based” requirements found in Section 1102 of the Act. With a rapidly declining economy, apprehension around what would be deemed an “essential business,” and an overall uncertainty surrounding the future, the general consensus among businesses and their professional advisors was to “take it if you can get it.”

Speculation quickly grew that many of the initial PPP loans went to businesses that were not in “need” of liquidity. In response, the SBA added Q&A 31 and Q&A 37 to the FAQs on April 23 and April 28, respectively. The updated FAQs mirror the “certification” requirement found on the PPP loan application that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations” of the business. In making this certification, a business, both public or private, must “[take] into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operation in a manner that is not significantly detrimental to the business.” In conjunction with the FAQs updates, the Treasury announced that the SBA would conduct audits of every PPP loan exceeding $2,000,000, in addition to any other PPP loan as appropriate, to scrutinize whether a business was in need. Unfortunately, this guidance still failed to provide a detailed standard, leaving many businesses in limbo.

On May 13, 2020, the SBA added Q&A 46 to the FAQs. Q&A 46 finally provides businesses with much needed information from which to decide whether to repay a PPP loan. According to this new Q&A, borrowers with PPP loans below $2,000,000 will have very little chance of being audited, based on the acknowledgement by the SBA that it needs to “conserve its finite audit resources and focus its reviews on larger loans…”.

Businesses with PPP loans above the $2,000,000 threshold are not completely out of the woods, but the “new” consequences of an unfavorable audit seem to be much less draconian than originally advertised. Based on Q&A 46, it appears that if the SBA determines that a business “lacked an adequate basis for the required certification” concerning need, the business will be required to repay the entire loan without consideration of any forgiveness. So long as the PPP loan is repaid, the SBA will not pursue any further enforcement of the certification. Thus, it appears the “penalty” is that the business must repay the entire loan at the prescribed interest rate.

Although there is the possibility that additional regulations will be promulgated on this topic, the FAQs are considered to be an appropriate reference source for businesses and can be relied upon by such businesses in making PPP loan decisions.

Another factor that has caused some PPP loan borrowers to return the funds is publicity. Neither the SBA nor the Treasury have publicly released a comprehensive list of businesses receiving PPP loans, but there is a strong push for this to occur. The media and non-government organizations have combed through SEC filings to disclose the public companies that received a PPP loan. Private PPP loan recipients should anticipate that the list of participants and amounts borrowed will be made public. Businesses should consider the effects of such disclosures.

Taxation of PPP Loan Proceeds

Another important issue that arrived prior to the issuance of the Forgiveness Application was the Internal Revenue Service Notice 2020-32 (the “Notice”), which was promulgated by the Internal Revenue Service (the “Service”) on April 30, 2020. This Notice concerns the deductibility of certain business expenses, paid for by using PPP loan proceeds, on a business’s federal income tax return. The plain language of the Act describes the PPP as a tax favorable program for businesses, meaning a business would not incur a negative tax impact from taking a PPP loan and related forgiveness. Generally, a discharge of indebtedness (i.e., loan forgiveness) is includable in “gross income” under Section 61 of the Internal Revenue Code (the “Code”). However, Section 1106 of the Act creates an exception to this general rule by specifically excluding PPP loan forgiveness from gross income. At the same time, Section 1106 is silent on the ability of a PPP loan borrower to take the expenses covered by a PPP loan as a deduction. This intentional “carveout” and “silence” in the drafting of the Act strongly suggests that Congress intended to provide a tax benefit with respect to PPP loans.

In the Notice, the Service takes the position that although PPP loan forgiveness is not included in gross income, such amounts will not be available as business expense deductions for federal tax purposes. In effect, by not allowing an expense deduction, the position of the Notice seems to eliminate the Congressional intent behind the language (and lack thereof) in the Act.

This is an issue that must be resolved sooner rather than later. A bill, titled the Small Business Expenses Protection Act of 2020, was introduced and currently sits with the Senate Finance Committee. The bill is supported by the American Institute of Certified Public Accountants and is expected to have bipartisan support. If passed into law, the bill would override the Service’s position and allow PPP loan borrowers to take a deduction for expenses covered by the PPP loan.

Preliminary Review of the Loan Forgiveness Application and Paycheck Protection Program Flexibility Act

The 60/40% Spending Rules for Forgiveness

The Act itself does not discuss PPP loan spending restrictions other than the requirements that PPP loans be used on payroll costs and other eligible expenses (i.e., rent expense, mortgage interest expense, etc.). Initial legislation and guidance established that in order to receive the maximum amount of PPP loan forgiveness, no more than 25% of the loan could be used for non-payroll costs (the “75/25” Rule”). The Flexibility Act significantly changes the 75/25 Rule and states that forgiveness is available so long as no more than 40% of the loan is used for non-payroll costs (the “60/40 Rule”). Although the Flexibility Act reads as though the new 60/40 Rule operates on all or nothing with respect to forgiveness, subsequent guidance provided that there will be some forgiveness in instances where non-payroll costs exceed the 40% threshold.

Impact of Previous Employees That Refuse to Return to Work

Section 1106 of the Act states that a reduction in the (i) total number of “full-time equivalent” employees or (ii) total salary and wages may result in a reduction to the forgivable PPP loan amount. Employers are concerned that a laid-off or furloughed employee who chooses not to return to work could negatively impact PPP loan forgiveness. Q&A 40 addresses this issue and states that such a decision will not impact PPP loan forgiveness provided the employer makes a good faith, written offer of rehire, and the employee’s rejection of that offer is documented by the borrower. Q&A 40 also states that employers and employees should be aware that an employee’s rejection of such offer could forfeit the employee’s eligibility for unemployment. The Forgiveness Application clarifies this even further by stating that a PPP loan borrower’s forgiveness amount will not be reduced when an employee refuses to return to work, is fired for cause, voluntarily resigned or voluntarily requested a reduction in hours, provided proper documentation is maintained.

c. Timing of Expenses Eligible for Forgiveness

Under the Flexibility Act, forgiveness of a PPP loan is available for expenses paid for payroll costs, mortgage interest, rent, and utilities during the period, starting on the disbursement of PPP loan funds and ending the earlier of (i) 24 weeks or (ii) December 31, 2020 (the “PPP Period”).

One area that remains somewhat “gray,” even after publication of the Forgiveness Application, is the timing of certain eligible nonpayroll expenses. The Forgiveness Application is clear that the prepayment of mortgage principal and interest is not allowable for forgiveness purposes, but this diktat is missing when the Forgiveness Application speaks of rent or utility expenses. With respect to these items, the relevant language states that a nonpayroll cost “must be paid during” the PPP Period or “incurred during [the PPP Period]… and paid on or before the next regular billing date…”. Based on this language, the Forgiveness Application does not appear to prohibit the prepayment of these items. Nonetheless, it is difficult to believe that the SBA intended loan forgiveness to apply to prepaid rent and utilities, so caution is advised. Additionally, the 60/40 Rule will impact the benefit of including prepaid items (even assuming such inclusion is allowable). The Flexibility Act alleviates the concern for most businesses since it is expected that businesses will not have issues using the entire PPP loan amount during the newly extended PPP Period.

d. Documentation

The Forgiveness Application also provides additional guidance on the documentation that must be submitted with the Forgiveness Application. As it relates to payroll, a borrower must submit documentation “verifying the eligible case compensation and non-cash benefit payments” during the PPP Period. Acceptable documentation must consist of: bank account statements or payroll service provider reports; payroll tax filings reported to the Service or state income, payroll, or underemployment insurance filings; and payment receipts, cancelled checks, or other account statements. Documentation confirming the number of full-time equivalent employees during the PPP Period and the historical employment period most favorable to the business must be submitted. This employment data can be documented using payroll tax filings reported to the Service or state income, payroll, or underemployment insurance filings. For non-payroll expenses, PPP loan borrowers must provide documentation as follows: for mortgage interest, copies of lender amortization schedules or account statements confirming the amount and payment of mortgage interest; for rent or lease payments, copies of current lease agreements (along with receipts or cancelled checks) or bank account statements verifying payment; and for utility payments, copies of invoices and receipts, canceled checks, or bank account statements verifying payment.

For all non-payroll expenses, borrowers must also provide such documentation verifying the existence of the obligations prior to February 15, 2020.

Borrowers also are required to maintain, but not submit, the PPP Schedule A Worksheet (included in the Forgiveness Application) and documentation of the information required to complete such worksheet, as well as any information regarding “any employee job offers and refusals, firings for cause, voluntary resignations, and written requests… for reductions in work schedules” and documentation supporting the “FTE Reduction Safe Harbor” included in the worksheet.

Submitting the Application

Since the Forgiveness Application will be the primary method of flagging ineligibility and abuse issues, submitting a complete and accurate application will be critical. It is important that PPP loan borrowers work with their accountants and attorneys to ensure that their first submission is their only submission. We at Isaac Wiles stand ready to help.