We have blogged extensively about the Paycheck Protection Program (PPP) established by the Coronavirus Aid, Relief and Economic Security (CARES) Act. The CARES Act appropriated $349 billion to the PPP to fund government-backed loans to qualifying businesses to cover payroll costs, rent, mortgage interest and utilities. The full amount of principal may be forgiven for borrowers who comply with the PPP’s terms and conditions.
Although the PPP was scheduled to open to self-employed persons and independent contractors on April 10, 2020, the Department of the Treasury (Treasury) did not provide any guidance on this portion of the PPP until last night — the evening of April 14, 2020. The guidance takes the form of a new Interim Final Rule (two such rules were issued previously) entitled “Business Loan Program Temporary Changes; Paycheck Protection Program – Additional Eligibility Criteria and Requirements for Certain Pledges of Loans” (Third Interim Final Rule or Rule).
Unfortunately, the Third Interim Final Rule belatedly provides information that will fundamentally change the way partnerships and limited liability companies complete PPP applications. For thousands of entities that have already received PPP loan proceeds, this means that much-needed money was left on the table.
The Rule also provides guidance as to how sole proprietors and independent contractors will determine their maximum loan amounts, and the types of supporting documentation they must submit with their PPP loan applications and forgiveness requests.
Partners and LLC Members Prohibited from Applying for PPP Loans Despite Being Self-Employed
The Third Interim Final Rule provides that a self-employed person is eligible for a PPP loan if the individual: (i) was in operation on February 15, 2020; (ii) had self-employment income; (iii) had a principal place of residence is in the United States; and (iv) filed or will file a Form 1040 Schedule C for 2019.
Significantly, however, the Third Interim Final Rule clarifies that partners and limited liability company (LLC) members (who elect partnership treatment for tax purposes) who ordinarily pay self-employment taxes may not submit individual PPP loan applications to cover their own compensation. Rather, the self-employment income of general active partners may be reported as a payroll cost, up to $100,000 annualized, on a PPP loan application filed by or on behalf of the partnership or LLC.
According to SBA’s Administrator and the Secretary of the Treasury, it is necessary to limit “a partnership and its partners (and an LLC filing taxes as a partnership) to one PPP loan…to help ensure that as many eligible borrowers as possible obtain PPP loans before the statutory deadline of June 30, 2020.” Moreover, according to the Administrator, “permitting partners to apply as self-employed individuals would create unnecessary confusion regarding which entity, the partner or the partnership, applies for partner and LLC member income, and would generate loan proceeds use coordination and allocation issues. Rent, mortgage interest, utilities, and other debt service are generally incurred at the partnership level, not partner level, so it is most natural to provide the funds for these expenses to the partnership, not individual partners.”
Having waited to issue this clarification until now amounts to a colossal failure by SBA and Treasury. Innumerable partnerships and limited liability companies were previously told by their lenders that they could not include partner income reported on IRS Form K-1 in calculating payroll costs. And, many of their PPP loans have already been approved and disbursed. The end result is that, while these businesses were able to finance their employees’ salaries, actively employed partners and LLC members were deprived of the opportunity to obtain assistance in paying their own compensation.
Since existing regulations permit an entity to take only one PPP loan, it appears there is no obvious recourse for partnerships and LLCs that find themselves in this situation. Whether PPP loans can be modified and extended or otherwise refinanced to address this problem remains to be seen.
Calculating Maximum Loan Amount as a Sole Proprietor or Independent Contractor
For independent contractors and sole proprietors who report their income on IRS Form 1040, Schedule C, the Rule sets out the methods for determining the maximum PPP loan amount. The method to be used depends on whether the applicant has employees.
Self-employed persons who do not have employees should use the following methodology:
- Find the net profit amount on 2019 IRS Form 1040, Schedule C, line 31 (if you have not yet filed a 2019 return, you must fill it out and compute the value). If this amount is over $100,000, reduce it to $100,000.
- Calculate the average monthly net profit amount (divide the amount from Step 1 by 12).
- Multiply the average monthly net profit amount from Step 2 by 2.5.
- Add the outstanding amount of any Economic Injury Disaster Loan (EIDL) made between January 31, 2020 and April 3, 2020 that is required to be refinanced, less the amount of any advance under an EIDL COVID-19 loan (because it does not have to be repaid).
Self-employed persons who have employees should use the following methodology:
- Compute 2019 payroll by adding the following:
a. The net profit amount on the 2019 Form 1040, Schedule C, line 31 (if you have not yet filed a 2019 return, fill it out and compute the value), up to $100,000 annualized. If this amount is over $100,000, reduce it to $100,000.
b. An amount equal to the 2019 gross wages and tips paid to employees, computed using 2019 IRS Form 941 Taxable Medicare wages & tips (line 5c- column 1) from each quarter, less any amounts paid to any individual employee in excess of $100,000 annualized and any amounts paid to any employee whose principal place of residence is outside the United States.
c. 2019 pre-tax employee (but not owner) contributions for health insurance or other fringe benefits excluded from Taxable Medicare wages & tips.
d. 2019 employer health insurance contributions (health insurance component of Form 1040, Schedule C, line 14), retirement contributions (Form 1040, Schedule C, line 19), and state and local taxes assessed on employee (but not owner) compensation (primarily under state laws commonly referred to as the State Unemployment Tax Act or SUTA from state quarterly wage reporting forms).
2. Calculate the average monthly amount (divide the amount from Step 1 by 12).
3. Multiply the average monthly amount from Step 2 by 2.5.
4. Add the outstanding amount of any EIDL made between January 31, 2020 and April 3, 2020 that is required to be refinanced, less the amount of any advance under an EIDL COVID-19 loan (because it does not have to be repaid).
Self-employed persons applying for a PPP loan must provide a 2019 IRS Form 1040, Schedule C with their PPP loan application. This is true even if the individual has not yet filed a tax return with the IRS. Additionally, a 2019 IRS Form 1099-MISC detailing non-employee compensation must be provided where applicable, along with an invoice, bank statement, or book of record that proves that the business was in operation on or around February 15, 2020.
Additionally, those who have employees must provide Form 941 (or other tax forms or equivalent payroll processor records containing similar information) and state quarterly wage unemployment insurance tax reporting forms from each quarter in 2019 or equivalent payroll processor records, along with evidence of any retirement and health insurance contributions, if applicable. A payroll statement or similar documentation from the pay period that covered February 15, 2020 must also be provided to establish that the business was in operation on February 15, 2020.
Use of PPP Loan Proceeds by Self-Employed Persons
According to the Third Interim Final Rule, when paid to someone who is self-employed, PPP loan proceeds can be used for the following expenditures:
- “Owner compensation replacement” — according to the Rule, this will be 8/52 of the amount of net profit received in 2019 according to IRS Form 1040, Schedule C.
- Employee payroll costs (as defined in the First Interim Final Rule) for employees whose principal place of residence is in the United States, if any.
- Interest payments on debt obligations that were incurred prior to February 15, 2020.
- Refinancing an EIDL loan taken between January 1, 2020 and April 3, 2020.
- The following expenditures, but only if the individual claimed or would be entitled to claim a deduction on his/her 2019 IRS Form 1040, Schedule C:
a. Mortgage interest payments on any business mortgage obligation on real property (e.g., a warehouse in which to store supplies) or personal property (e.g., a car utilized by the business).
b. Business rent payments, which includes vehicle lease payments.
c. Business utility payments, which may include the cost of gasoline for business travel.
To the extent that a self-employed individual utilizes PPP loan proceeds to pay the following expenses during the eight weeks after the loan originates, the entire amount of principal and accrued interest is eligible for forgiveness.
- Payroll costs including salary, wages, and tips, up to $100,000 of annualized pay per employee (for eight weeks, a maximum of $15,385 per individual), as well as covered benefits for employees (but not owners), including health care expenses, retirement contributions, and state taxes imposed on employee payroll paid by the employer (such as unemployment insurance premiums).
- Owner compensation replacement limited to an amount that is equal to 8/52 of 2019 net profit as set forth in the 2019 IRS Form 1040, Schedule C, but excluding any amount of paid sick or family leave for which a refundable payroll tax credit is claimed under the Families First Coronavirus Response Act.
- Payments of mortgage interest on mortgages that were in force before February 15, 2020 on real or personal property so long as they are deductible on Form 1040 Schedule C.
- Rent payments on lease agreements in force before February 15, 2020, to the extent they are deductible on Form 1040 Schedule C.
- Utility payments under service agreements dated before February 15, 2020 to the extent they are deductible on Form 1040 Schedule C.
As in the case of other businesses, self-employed individuals must use at least 75% of PPP loan proceeds on payroll costs, including owner compensation replacement, in order to qualify for forgiveness.
In order to apply for forgiveness, self-employed individuals will be required to submit:
- A borrower certification.
- Evidence of business rent, business mortgage interest payments on real or personal property, or business utility payments during the covered period, if applicable.
- The 2019 Form 1040, Schedule C that was provided at the time of the PPP loan application, in order to determine the amount of net profit allocated to the owner for the eight-week covered period.
- Form 941 and state quarterly wage unemployment insurance tax reporting forms or equivalent payroll processor records that best correspond to the covered period (with evidence of any retirement and health insurance contributions), if the business has employees.
The Third Interim Final Rule also clarifies the eligibility of certain businesses to obtain PPP loans. Specifically, eligible businesses owned (in whole or part) by an individual who is a director of a PPP lender, or who owns an interest of less than 30 percent in a PPP lender, may obtain a loan from that PPP lender. Such eligible businesses must, however, follow the same processes as any similarly situated customer, and the PPP lender may not give those businesses’ applications any type of priority. The PPP lender also must comply with any applicable state or local laws, or its own internal policies, applicable to such transactions.
The above exception does not apply where the business owner is not simply a director or minority owner of a PPP lender, but is an officer or key employee of the PPP lender. Where the owner of an eligible business is also an officer of a key employee of a PPP lender, the eligible business can not obtain a loan from that PPP lender, although it may obtain a PPP loan from a different lender.
Additionally, a business that receives revenue from legal gambling is eligible for a PPP loan if it meets the existing standards of 13 CFR 120.110(g), or:
- The business’s legal gaming revenue (net of payouts but not other expenses) did not exceed $1 million in 2019; and
- Legal gaming revenue (net of payouts but not other expenses) comprised less than 50 percent of the business’s total revenue in 2019.
While the Third Interim Final Rule provides welcome guidance for sole proprietors and independent contractors seeking PPP loans, it also exposes a significant flaw in the PPP roll-out. The earlier lack of clarity about whether the term “payroll costs” encompassed owner income reported on IRS Form K-1 has undoubtedly left many partners and LLC members with PPP loans that covered their employees’ salaries but not their own compensation. One can only hope this issue will be addressed in subsequent rule-making or anticipated legislation that increases funding for the PPP.
If you have any questions about the PPP, please contact me at (516) 393-8292 or firstname.lastname@example.org.