Changes are coming fast and furious amid another hectic tax season. In this episode of CPA Conversations, we focus on two alterations that CPAs need to keep an eye on: the PPP loan calculation methodology and its effect on Schedule C taxpayers and the recently released IRS guidance on the employer retention credit. We discuss these matters with two representatives of Louis Plung & Company LLP in Pittsburgh: principal Kevin Wilkes, JD, and senior manager Tony Montanaro, CPA, ABV, CFE.
By: Bill Hayes, Pennsylvania CPA Journal Managing Editor
As we sit in the midst of another hectic tax season, the changes and guidance are coming fast and furious. So today we are taking the time to get updated on tax developments in two major areas: the PPP loan calculation methodology and its effect on Schedule C taxpayers, and recently released IRS guidance as it relates to the employee retention credit. To discuss these matters, today we are with Tony Montanaro, senior manager of consulting at Louis Plung & Company LLP in Pittsburgh, and Kevin Wilkes, principal at Louis Plung.
Can you tell us what the Small Business Administration's recent interim final rule on changes to the PPP loan calculation methodology means to Schedule C taxpayers?
[Wilkes] When you say Schedule C taxpayers, what we're really talking about here are folks where, on their 1040, they complete a Schedule C, and these tend to be independent contractors, small business owners, and similar folks that report income on Schedule C. Prior to the new legislation, these folks were required to basically report and claim the PPP loan based on net profit, and that was their only methodology. This served as a severe impediment to the ability of Schedule C filers to claim a PPP loan.
[Montanaro] The big impact here is really on the Schedule C taxpayers who did not show a profit on either their 2019 or 2020 Schedule Cs. Because of that, they were either completely prevented from obtaining a PPP loan, or they were only able to pay the loan minimal amount that really wasn't, quite frankly, worth it for them to apply for. This new methodology, however, which allows them to now use their top line gross revenue amount, is incredibly beneficial for these individuals now. Most of them before, not being able to obtain any PPP loan, are now able to most likely obtain the maximum PPP loan, which is approximately $20,000.
Is there a difference for Schedule C taxpayers with employees versus Schedule C taxpayers without employees?
[Wilkes] There's a big one. For Schedule C filers without employees, Tony just very succinctly summarized the key parameters. You're basically left saying, "Okay, do I want to apply on a gross profit basis or net profit basis?" And gross profit, which is just generally line seven for these folks without employees, is, as Tony suggested, it's going to be much, much more beneficial for these individuals. When you prorate it out, it's about 20,000 bucks, as Tony suggested, that these folks can get and claim on their Schedule C. For folks with employees, the calculation's a little bit more nuanced. So gross profit, you have to subtract some key components out to make sure that you're not double-counting the amount that's attributable to owner compensation, if you will, versus employee comp, and then you separately calculate the owner comp.
The notice basically dubs this proprietor expenses. So once you calculate proprietor expenses, you then add to that your employee expenses. That's the general gist of it. I'll let Tony get into some more nuance on that and explain in detail what you do and how you go about computing more precisely your maximum loan eligible amount. Because the other side of it is folks with employees are eligible for a larger draw.
[Montanaro] I think Kevin actually hit most of the key points here. As far as Schedule Cs with employees, you're going to basically do the same type of calculation that you would do if it was an LLC or an S-Corporation, where you look at your actual wage costs per the employees and then you can add in fringe benefits, such as healthcare, dental, all those similar items, to come up with a gross annual payroll cost. Then that amount, you get to use a monthly average of that for either 2019 or 2020 tax years, and calculate that out based on 2.5 times your average monthly amount.
Then, like Kevin said, we have this concept called proprietor expenses. Previous to these new guidelines, this was referred to as owner replacement compensation. If you do the methodology based on your gross revenue numbers, you would subtract out the payroll costs for your employees from your gross revenue number before doing that 2.5 average monthly calculation. If you do opt to use net profits, you don't have to subtract anything out for employee payroll cost. You just add that on top of the calculation based on your net profits.
I wonder if you can tell us what the qualified uses of PPP loan funds are and how they affect the ability for loan forgiveness?
[Wilkes] There's some general parameters that folks have to follow in order to get the PPP loan forgiven. Essentially at least 60%, and we'll use Schedule C filers as an example, of an applicant's PPP on usage must relate to employee costs, and that's going to include both the proprietor expenses that Tony just discussed, as well as the employee payroll costs that he discussed. Then 40% can relate to non-employee costs, such as mortgage, real property interest, business rent payments, utility payments, things of that nature. Then there's some other useful categories that were recently added by updated guidance issued by the Biden administration, vis-a-vis the SBA.
[Montanaro] The SBA, in one of their previous new regulation updates, added some additional categories to the allowable costs for PPP loan forgiveness. Some of the more useful ones would be worker protection expenditures. So, any type of personal protection equipment, or maybe plastic barriers that have been put up to limit exposure. All of these will now qualify as forgivable costs for your PPP loan. There was a couple of additional items that were added as well. They're somewhat obscure. I actually haven't run into any clients that found them useful at this point. Certain things, like certain supplier costs, like additional costs that you would have incurred due to delays resulting from COVID shutdowns, property damage costs relating to some of the protests from last year. But the two main categories are going to remain, like Kevin highlighted. It's going to be the 60% payroll costs, which includes the proprietor expenses as well, and then in addition to that is the non-payroll items like utilities.
One of the big items to be careful about with utilities and these other non-payroll costs is that these expenses would have had to be claimed on the taxpayer's 2019 Schedule C as well. So, if they didn't have the utilities in 2019, they can't take them as forgivable expenses now.
There's going to be some increased scrutiny on borrowers due to the risk of fraud or the perceived risk of fraud, as it relates to this new methodology. What aspects of this new methodology cause it to be seen as susceptible to fraud?
[Wilkes] One aspect is that when the net-profit methodology is used, applicants already have an incentive to understate their net profit. Well, not understate it, but state it correctly on their tax return. You're not separating deductions out into different buckets. It's just your net profit and your net tax point income. You're not going to want to overstate that as much, because if you overstate that, you're going to be taxed more. I think that that was one aspect that was seen as a reduced risk of fraud relative to the gross profit. If you're using the gross profit, you're subject to limited subtractions on your Schedule C for the payroll cost that Tony alluded to. You're basically allowed to take a much larger portion as a loan that could eventually be forgiven without necessarily seeing any impact on your tax liability. Really, it's a classification issue.
It's a lot more difficult, I think, for the IRS and SBA and everybody else to scrutinize that. I think that's one primary concern: just the difference between the calculation basis of gross profits versus net profits and the ability to say, okay, well, I've got more gross profit, but my net profit didn't change as much. Therefore, I can still take out the maximum value of the loan without really generating taxable income or owner compensation, if you will, on your individual tax return.
[Montanaro] A lot of what they are identifying goes back to the economic uncertainty certification that was a hot topic here, going back to the beginning of the program. Effectively what that states is that anybody applying for a PPP loan is experiencing some type of economic uncertainty that makes the loan needed for them. This was a hot topic, again, first round loans. Eventually the SBA issued a rule. They called it a safe harbor, whereas anybody under $2 million in aggregate borrowings were deemed to have a safe harbor as far as that certification goes, which means they were all deemed to need that money. Anybody currently working with borrowers with loans over $2 million were probably aware now that the SBA is requiring the completion of Form 3509, which is the economic necessity questionnaire. This includes some questions about how operations revenue was impacted by COVID. They're asking questions about cash availability, certain types of spending, wages, a whole list of items.
So effectively what they've done with this new methodology is for any Schedule C borrowers who are going to use that gross revenue methodology, and they have gross revenues of over $150,000, they are no longer going to get that safe harbor on the economic uncertainty certification. What this means is that they need to be able to defend against the SBA, some potential scrutiny from the SBA regarding why they thought they needed this loan. In the event that they're deemed not to have needed that loan, they're going to have to pay that money back, or they could be subjected to some potential other penalties.
[Wilkes] Tony, those requirements and mechanics of executing the increased scrutiny on these loans that you just discussed, those apply to first draw loans, correct? The second draw borrowers, they just need to show a significant drop in revenue. The SBA is a little bit less of a concern there where they've actually shown sufficient basis. Do you think, Tony, as part of the change now it has to do with more flexibility to potentially borrow more on behalf of these Schedule C filers than they could previously? Because it's hard to manipulate net, right?
[Montanaro] That's right.
[Wilkes] It seems to me like it's a more difficult number to play around with – your net profit – than it is with gross. I mean, I think those mechanics and the questions that you highlight do drive home, Tony, how they're going to scrutinize, especially I think these first draws loans. For the second draw, you do have to show that significant revenue drop in order to even qualify for the loan. Tony, that significant revenue drop, can you describe a little bit about how that's computed?
[Montanaro] Right, that is instructive for people who are concerned about applying for the first-round loan because of this additional scrutiny. The SBA, they've stated that if you qualify for a round two loan, which requires a 25% gross revenue reduction on a quarter-by-quarter comparison basis, which means looking at your 2020 quarterly revenue compared to that same quarter in 2019, which shows at least a 25% decrease in gross revenue. They say that qualifies as enough evidence of economic uncertainty, that there is no additional scrutiny on these round two loans. For anybody with round one loans, they may want to look at their quarterly revenue and determine how close are they to having a 25% decrease in one quarter of 2020 compared to 2019.
As we transition to the area of employee retention credits, the IRS recently issued Notice 2021-20 as guidance. What did that guidance entail for people?
[Wilkes] So in general, one of the big changes, just stepping back, is the Consolidated Appropriations Act of 2021. What that did is it now allows folks who claimed the PPP loan to also claim the employee retention credit during 2020. It's retrospective, Tony, I believe for wages paid after March 12, 2020.
[Montanaro] Yes, I believe so.
[Wilkes] During the 2020 calendar year. Somewhere around that date. In any event, whereas previously, if you applied for a PPP loan, you really couldn't also apply for an employee retention credit. This is a big change, and it's significant, but after this law was passed and signed into law in December of 2020, everyone was wondering, well, how are the mechanics going to work with respect to this? What's the interplay going to be like between the PPP loan and the employee retention credit? Tony's seen a lot of this where, before this guidance came out, we were telling folks, look, be careful how you fill out your PPP loan application before the new IRS notice came out, because we don't know how the IRS is going to treat the interaction between the PPP loan forgiveness and the ability of these applicants to claim the employee retention credit.
So before, for instance, let's just say you took out a $200,000 PPP loan, and you only had 250 grand of payroll costs in there, but on your application, you filled out your application in such a manner where you want to make sure, you don't want to put the minimum amount of flare on there though. You want to show that you really met that limit. You report all $250 grand of wages that you paid during the forgiveness period in that forgiveness calculation. Let's just say that was the only quarter that you could apply for the ERC. Well, it begs the question then, how does the computation work?
You included $50 grand more wages than you could have, or than you needed to, in the example that I just gave you, yet you filled it out, you claimed all $250,000 on the application. Can you still apply $50 grand of it, depending on your employee breakdown? Could you still apply the $50 grand to the ERC or are you stuck now and you're out of luck because you didn't understand, you didn't have a crystal ball when you filled out your PPP loan application that this adjustment was going to be in the Consolidated Appropriations Act? And you wanted to be in line quickly to apply for your PPP loan. The guidance that the IRS issued answered a lot of these really important questions.
[Montanaro] This was really one of the areas where the IRS guidance fit into what we were hoping and expecting to see. Overall, generally how this is going to work is you can claim both the PPP forgiveness, as well as the ERC. You just can't use the same wages or healthcare costs to do both. What this means is allocating those costs between the employee retention credit versus those costs that you're going to be claiming on your PPP loan forgiveness form. As Kevin was getting into there, the IRS gave us a nice little gift here on this. There were some concerns about if a lot of people were including way more payroll costs on their PPP loan application than they actually needed for loan forgiveness. The IRS is going to allow us to effectively use the minimum amount of payroll costs needed to obtain full loan forgiveness as being the necessary costs allocated to your PPP loan.
[Wilkes] In that example we just discussed, where you have $50 grand of, I'll say, hanging payroll costs, you no longer have that now that this notice is out?
[Montanaro] That's right.
[Wilkes] An applicant that includes $250 grand on their application, and say they only needed $200,000, you can say, okay, well now that $50,000, if it's otherwise creditable, and we can talk a little bit more about what's creditable in a little bit here, but as long as that $50 grand is creditable, away you go. Another way to think about it is give another variant of that. If you have the example where you've got payroll costs that exceeds the 60% required threshold, let's say it's $130 grand, and you've got $70 grand in non-payroll costs, but you included more payroll than you had to on your application, you can still adjust down to your minimum amount that that's necessary, your $130,000.
[Montanaro] That's right. The important thing is hitting that minimum required payroll cost, which is 60% of the total loan. So, if you have additional non-payroll expenses that can equal 40% of your loan balance, then they're going to take those into consideration first and then add in the remaining payroll costs to get to your total loan forgiveness. And then anything over that, those payroll costs are freed up for the employee retention credit.
I know you guys talked a little bit about maybe getting into a little bit more of the mechanics of the employee retention credit and what's there. What are the important things that we should throw out to people?
[Wilkes] Just as a reminder, the employee retention credit is basically eligible employers and they can have 100 or fewer full-time employees in 2019, or you can have employers with 100 full-time employees or more under certain instances, but you can generally claim the credit if you're impacted by a disaster, in which COVID-19 is obviously a nationwide disaster. For employers, if you have an average of 100 or fewer full-time employees in 2019, generally your credit's limited to 50% of qualified wages, limited to $10 grand per employee per year, or $5 grand per employee. You've just got to be in a disaster area and adversely impacted by COVID.
But for employers with 100 full-time employees or more, you could still claim the credit, but you can only claim it with respect to wages paid to employees who are not providing services due to government-ordered shutdowns. There's certain required aggregation rules to determine head count here, so you've just got to be mindful of that.
[Montanaro] So, there's two ways to qualify for it. Assuming you hit, the employee headcount is under the 100 or 300, depending on what year you're talking about, you have two ways to really qualify for the credit. You can either have a significant reduction in revenue, and, again, we're going back to that quarter-by-quarter comparison. You're looking at your 2020 quarters compared to 2019 quarters. Or once we get into the 2021, we're going to be comparing the 2021 quarters, again back to 2019. So, for 2020 tax year, you're going to need a 50% or more revenue decrease on a quarterly basis. That's a fairly high bar to hit for a lot of companies.
The second way you can qualify for it is if you've been shut down or partially shut down as a result of the COVID-19 virus. A lot of restaurants, if you're still operating under some type of government restriction where you cannot fully reopen, or you can only have so many tables, you're going to qualify for that automatically, even without the revenue reductions. It really is a case-by-case basis. Each company needs to assess this to determine if there is something impacting them where they may qualify for this credit, even if they don't hit the revenue reduction requirements.
Then, going into 2021, the credit really expands. It is far more lucrative than it is in 2020. The revenue-reduction requirement is reduced from 50% to only 20% on a quarter-by-quarter basis, and the credit can be claimed each quarter that you qualify. Another important thing here is, if you qualify for the credit in one quarter based on a revenue reduction, you actually get to claim that credit for two quarters. You get to claim it for the quarter that you incurred the revenue reduction, and then the following whole quarter, you get to claim it. The way the rule is written is it's the quarter that you recover is the last one that you can claim it for.
[Wilkes] So, Notice 2021-20, that relates to the 2019 credit. That's the annual credit that's limited to 50% of qualified wages, which is further limited to $10,000 bucks per employee. For employers with 100 or fewer, they have to have that adverse impact on revenue that you cited. They also have to be in the disaster area, which everyone would be, and for the folks with 100 or more, they've got to actually have that shutdown with the revenue reduction. Then 2021, we're still waiting for guidance on that, aren't we? Some of the specifics on it?
[Montanaro] That's right. We know the general outline on it. There's some information on how to claim that for 2021 out there now and some other things, but the IRS has this giant FAQ page where they answer all these questions about the employee retention credit, all the details. They're really into some of the real details, but that has not been updated for the 2021 credits. We're not sure how much of that is going to change. It may not change at all, but the IRS still has not come out with the updated guidelines.
[Wilkes] Further compounding things is that we have the American Rescue Plan, which I believe is expanding the timeframe during which employers can claim these credits. We've got to dive into that and also really sink our teeth into it. Because, as Tony suggested, we've got a pretty good idea as to the framework, particularly with respect to the Consolidated Appropriations Act, as to how this is going to work. Like what's a significant impact? How do you prove it? You're going to get to this in subsequent questions, but how do you go about claiming it? We feel pretty comfortable because you've got this Notice 2021-20, but now we've got this new law hanging out there with the American Rescue Plan, which was signed last week, and we may be either doing some more of these podcasts or drafting some more blogs about this as this continues to unfold and evolve in real time.
That's a pretty good summary, I think, of everything that we know today about 2019. Tony, what you hit on was absolutely critical there versus the annual nature of the 2019 credit, was limited to basically $5,000 bucks per employee versus a quarterly credit right now for ... I'm sorry, I keep saying 2019. 2020 versus a quarterly ... Yeah, it's 2020, not 2019. Versus a quarterly credit for 2021. It gets confusing because you're comparing your revenue relative to 2019.
How does an employer go about claiming the employee retention credit?
[Wilkes] The notice goes through in detail as to the mechanics for doing that. To the extent you've already filed a form, and this relates to 2020 ERCs, a general mechanism that you use to file an amended return and claim the credit retroactively is Form 941X. To the extent you've already filed a 941 with respect to wages that you've already filed, what you don't want to do is file a subsequent Form 941 to go ahead and change that and claim the ERC for a previous quarter. You generally want to use the 941X. There are some exceptions for PPP borrowers who didn't receive loan forgiveness for reason of a decision with their section 7AG of the Small Business Act. Those can use a special fourth quarter procedure for the fourth quarter of 2020. I really think that's beyond the scope of this though. Generally, you're going to want to use a 941X.
[Montanaro] It's important to note that they want you to file the 941X for each quarter in which you are claiming the credit. If you're going to claim the credit for quarters two and three, you're going to need to amend your 941s for both of those. That is how this credit works. It's a credit against your payroll taxes. For 2020, I believe it goes against your Social Security withholdings. 2021, I believe it only goes against Medicare withholdings.
How will claiming the employee retention credit affect the deductibility of expenses?
[Wilkes] Basically when you claim the ERC, it reduces corresponding deductible expenses for U.S. federal income tax purposes. More specifically, deductions for qualified wages, healthcare expenses, that's going to be reduced by the amount of ERC received, but it does not, and Tony alluded to some special circumstances for Social Security and Medicare. It doesn't reduce its deduction for the employer's share of Social Security and Medicare tax on any portion of the credit. Of course, the other thing to note is that having a tax credit isn't generally the same thing as income. There's some question here though when it's payroll related like this. No portion of the ERC is included in the employer's gross income, and that's the other thing that's important to note.