By Anthony Montanaro, CPA, ABV, CFE, and Kevin Wilkes, JD
On March 3, 2021, the Small Business Administration (SBA) issued an Interim Final Rule that changed the PPP loan calculation methodology for IRS Form 1040, Schedule C, taxpayers. The change allows qualifying Schedule C taxpayers (e.g., independent contractors, sole proprietors, or self-employed individuals) to calculate the maximum loan amount using gross income. Previously, these borrowers were required to use 2019 or 2020 Schedule C net profit as the basis for computing the maximum PPP loan. The changes apply to both first and second draw loans. The new methodology only applies to loan applications submitted after March 3, 2021. Borrowers who already received PPP loans are not permitted to amend their loans to take advantage of the new methodology.
The last day to apply for and receive a PPP loan is March 31, 2021. Potential borrowers should submit applications immediately to ensure that lenders have adequate time to process and obtain approval prior to the deadline.
New Calculation Methodology
Schedule C taxpayers may elect to calculate the maximum loan balance based on either net profit or gross income. The gross income calculation varies, depending on whether an applicant has nonowner employees.
Calculation without employees – If a business has no employees apart from the owner, the applicant may elect to use net profit or gross income as reported on line 7 of Schedule C, limited to a maximum amount of $100,000. Next, the borrower calculates average monthly net profit or gross income by dividing the annual amount by 12 (e.g., $100,000 / 12 = $8,333.33). The average monthly net profit or gross income is then multiplied by 2.5 to determine the maximum loan amount ($8,333.33 x 2.5 = $20,833.33).
Calculation with Employees – Schedule C applicants with nonowner employees may elect to use either net profit or gross income to compute the maximum loan amount, but applicants using the gross income methodology must calculate “proprietor expenses” and employee payroll costs separately in determining the maximum loan amount.
The Interim Final Rule defines the owner’s share of a Schedule C taxpayer’s loan amount as “proprietor expenses.” Proprietor expenses encompass an owner’s business expenses and own compensation, but do not include employee payroll costs. For proprietor expenses, the borrower may elect to use net profit or gross income minus expenses reported on Schedule C lines 14 (employee benefit programs), 19 (pension and profit-sharing plans), and 26 (wages less employment credits). The expenses reported on Schedule C lines 14, 19, and 26 represent employee payroll costs and are subtracted from the owner compensation share of payroll costs if the owner uses gross income to calculate the loan amount to avoid “double-counting” these costs. “Proprietor expenses” cannot exceed $100,000.
Employee payroll costs are calculated and added to “proprietor expenses.” Employee payroll costs are calculated by adding gross wages and tips paid to each employee (plus pretax employee contributions for health insurance or other fringe benefits excluded from taxable Medicare wages), limited to $100,000 per employee on an annual basis. Do not include any employees whose principal place of residence is outside of the United States or employer contributions to employee group health, life, disability, vision, and dental insurance; retirement plan contributions; and state and local taxes assessed on employee compensation (state unemployment taxes).
Next, add total proprietor expenses to total employee payroll costs and divide by 12 to calculate the average monthly amount. Multiply the average monthly amount by 2.5 to calculate the maximum PPP loan amount.
Increased Scrutiny but Relaxed Eligibility Restrictions
The SBA has determined this new loan calculation methodology increases the risk of fraud or abuse. To combat the increased risk, the SBA removed the “good faith certification” safe harbor for borrowers with more than $150,000 in gross income electing to use the new methodology. These borrowers may be required to substantiate that “the uncertainty of current economic conditions makes necessary the loan request to support the ongoing obligations of the applicant.” Borrowers deemed by the SBA to have improperly certified the economic necessity of the loan would be required to repay the loan and could receive additional penalties. This increased scrutiny only applies to first-draw loans. Second draw borrowers are required to submit proof of a significant revenue reduction to qualify for the loan, which the SBA deems a sufficient basis for the economic necessity certification.
The Interim Final Rule also relaxed certain eligibility restrictions. The one-year lookback restriction relating to business owners convicted of nonfinancial fraud felonies was removed, allowing such applicants to qualify for a PPP loan. Business owners with prior convictions for felonies involving fraud, bribery, embezzlement, or a false statement on a loan application within the past five years remain ineligible. The SBA also eliminated the restriction barring applicants currently delinquent or defaulted on an SBA or other federal guaranteed loan within the last seven years. This includes student loans.
Qualified Uses of PPP Loan Funds
To qualify for loan forgiveness, PPP loan funds must be used for approved purposes. Schedule C taxpayers with no employees who elect to use net profit as the basis for calculating their PPP loan amount will be deemed to have used the full amount of the loan as owner compensation replacement and would qualify for forgiveness of the full loan amount. For Schedule C taxpayers with nonowner employees, owner compensation replacement is limited to the portion of the loan that represents proprietor expenses. The remaining loan amount must be spent on the following to qualify for forgiveness:
- Employee payroll costs (together with proprietor expenses, must equal at least 60% of total loan amount).
- Nonemployee costs (mortgage or real property interest payments, business rent payments, and business utility payments). Qualified expenses must generally be claimed as a deduction on the Schedule C used for the loan calculation.
- Covered operations expenditures.
- Covered property damage costs.
- Covered supplier costs.
- Covered worker protection expenditures.
Note: the final three items in this list represent additional costs incurred due to COVID-19 or certain protests during 2020.
IRS Issues Updated Guidance for Employee Retention Credit
On March 1, 2021, the IRS issued Notice 2021-20, Guidance for Employers Claiming Employee Retention Credit Against Payroll Tax for 2020. The guidance does not address changes made to the Employee Retention Credit (ERC) for qualified wages paid after Dec. 31, 2020. The IRS will address 2021 credits in future guidance.
The Taxpayer Certainty and Disaster Relief Act of 2020 (Relief Act) made retroactive changes to ERCs available for qualified wages paid after March 12, 2020, and before Jan. 1, 2021. These changes primarily relate to determining eligibility for the credit. The credit amount for this period is generally 50% of qualified wages paid (which also includes payments for group health insurance), limited to $10,000 in wages per employee. For employers that averaged 100 or fewer full-time employees in 2019, generally all wages paid qualify for the credit. Employers with more than 100 full-time employees may also claim the credit, but only for wages paid to employees who were not providing services due to government-ordered shutdowns. To determine the full-time-employee headcount, there are required aggregation rules for related entities and employers must maintain adequate records to substantiate eligibility and qualified wage determination.
Interaction with PPP loans – Significant changes were made by the Consolidated Appropriations Act of 2021 beyond extending the credit through June 30, 2021, and changing the computation. It also allows PPP borrowers to claim the ERC. Qualified wages included on a PPP Loan Forgiveness Application are ineligible for the ERC. Eligible PPP loan borrowers claiming the ERC are deemed to elect under Section 2301(g)(1) of the CARES Act to exclude certain qualified wages for purposes of the ERC.
If a borrower included more payroll costs on a PPP loan forgiveness application than necessary to support the amount of PPP loan forgiven, the excluded payroll costs will be limited to the minimum amount of payroll costs, together with any other eligible expenses, necessary to reach the forgiveness amount. This allows borrowers who included all eligible payroll costs incurred during the covered period to treat excess payroll costs as qualifying costs for purposes of the ERC.
For example, assume a qualifying employer with a $200,000 PPP loan reported $250,000 in payroll costs on its PPP loan forgiveness application. Since only $200,000 of the costs reported were necessary to obtain full forgiveness of the PPP loan, the $50,000 in excess payroll costs may be treated as qualifying expenses for the ERC. Assume the same facts, but the borrower also included $70,000 of qualified nonpayroll costs on the PPP loan forgiveness application. In this scenario, the minimum amount of payroll necessary to support loan forgiveness equals $130,000 ($200,000 - $70,000 = $130,000). When calculating the minimum necessary payroll costs, employers should be careful to include sufficient payroll to meet the 60% threshold required by PPP loan forgiveness rules.
Claiming the ERC – To claim the ERC for newly eligible PPP loan borrowers, employers must generally file an amended quarterly tax return (Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund) for the relevant quarters during which eligible wages were paid. For example, a PPP loan borrower who, after obtaining loan forgiveness, determines it incurred $50,000 in payroll costs exceeding the minimum amount necessary for full forgiveness may file Form 941-X for the applicable quarters to claim the ERC. Employers should not use a subsequent Form 941 to claim an ERC for qualified wages paid during a previous quarter.
The one exception relates to PPP borrowers who did not receive PPP loan forgiveness by reason of a decision under Section 7A(g) of the Small Business Act. Such employers may use the special fourth quarter rule, allowing them to claim any eligible ERC on the fourth quarter 2020 Form 941 for qualified payroll costs paid during the second and third quarters of 2020. Eligible employers are not required to file using this option and may instead file Form 941-X for each quarter.
Impact on Deductibility and Additional Guidance – Claiming the ERC reduces deductible expenses for U.S. federal income tax purposes. The deduction for qualified wages, including health plan expenses, is reduced by the amount of ERC received. The employer does not reduce its deduction for the employer’s share of Social Security and Medicare tax by any portion of the credit. No portion of the ERC is included in the employer’s gross income.
The IRS Notice also includes detailed examples to assist employers with various questions. Topics addressed include eligibility requirements, calculating full-time employees, determining what qualifies as a “full or partial suspension” of operations, affiliation/aggregation rules, inclusion of “gross receipts” for tax-exempt and for-profit entities, and eligible wages for the credit. While not exhaustive, the IRS Notice does answer many commonly asked questions.
Into 2021 – As noted earlier, the IRS Notice does not provide guidance on claiming the expanded ERC for 2021. The 2021 ERC maximum amount increases to $7,000 per employee, per quarter while also expanding eligibility requirements. It is expected that the quarterly Form 941 will continue to be the primary means to claim the ERC, with options for advance payments. However, these questions will be addressed in future IRS guidance.
Anthony Montanaro, CPA, ABV, CFE, is senior manager, consulting, for Louis Plung & Company LLP in Pittsburgh. He can be reached at firstname.lastname@example.org.
Kevin Wilkes, JD, is principal for Louis Plung & Company in Wexford. He can be reached at email@example.com.
For more on how claiming the employee retention credit could impact Paycheck Protection Program (PPP) loans, check out PICPA's Employee Retention Tax Credit and PPP Update Town Hall
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