In our first article on the various programs the government has rolled out to help business owners, we summarized the various programs the government is offering to help businesses. In this article, we’ll take a deeper dive into one segment of the programs: loans.

At the risk of being overly basic, here are a quick few bullet points about what a loan is:

• In a loan, one party borrows money, called the borrower or debtor, from another party, called a lender or creditor

• The borrower is obligated to pay the money back in certain amounts and certain dates. The amounts and dates are highly customizable

• The borrower is obligated to pay back more than they borrowed. This is called interest, and is meant to compensate the lender for the risk they took and the other opportunities they passed on in order to lend to the borrower. As can be imagined, all other things equal, the riskier the borrower and/or the better opportunities the lender passed on, the higher the interest rate will be

• In order to mitigate the risk of the borrower not paying back the loan, sometimes borrowers might be required to post collateral. What this means is that the borrower will pledge an asset to the lender, that the lender can take in case the borrower doesn’t pay back the loan. The most typical example of this is a home that is used as collateral for a mortgage

• Another way a lender might mitigate the risk of the borrower not paying back the loan is to make the borrower sign a personal guarantee. This is relevant to business loans. What this means is that if the business is unable to pay back the loan, the owner(s) and/or officer(s) who initiated the loans will be required to reach into their own pockets to pay the lender back

Ok, so now that we understand some of the basics of what a loan is, let’s describe the loan programs that the government is sponsoring. 

Economic Injury Disaster Relief (EIDL)

This program existed before the COVID-19 pandemic, but many firms are utilizing it to borrow money. It is sponsored by the Small Business Administration (SBA), meaning the application is submitted to the SBA, which is a unit of the Federal government.

The maximum amount a business may borrow is $2 million, and the maximum interest rate is 3.75%. Businesses may request $10,000 as an advance that would be payable within three days of applying. The loan may be paid back over a period of up to 30 years. There are no provisions in these loans for forgiveness of the principal if the loan proceeds are spend a certain way, such as with the Payroll Protection loan we will look at later.

Only small businesses are eligible for these loans. Small businesses are defined as having less than 500 employees. There are also guidelines for what qualifies as a small business based on the industry the business is in.

The disclosures and forms with the EIDL are somewhat extensive. Applicants should be prepared to disclose business tax returns for the prior three years. In addition, major shareholders and managers of the business should be prepared to both disclose their personal income tax returns but also provide personal financial statements – meaning a statement of all their assets and liabilities – as part of the loan application. Major shareholders in this context mean those owning 20% or more of the business.

In practice, it seems like the most difficult part of this process is quantifying the damage the virus/pandemic has caused. The application form does allow for the application to put a question mark in the boxes where a dollar amount would otherwise be noted, if the applicant does not know the damages. Anecdotally, I have heard of practitioners estimating the damages by taking the difference in sales from pre-pandemic to post-pandemic, or doing the same with profit. From personal experience, when applying online, the form does not ask for a specific dollar amount of damages. When applying via paper, you still might need to quantify the damages or put a question mark in the appropriate boxes. The takeaway: apply online.

One last provision of EIDLs is a feature added to the program under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). This new provision is that businesses may request an immediate $10,000 grant under the program. Provisions of the legislation call for the $10,000 to be paid within three days of application submission. Again, this is anecdotal evidence, but I have heard from other practitioners that, despite the promise, the SBA has not been fulfilling this three-day fulfilment period to date. The $10,000 is indeed a grant; if the application is denied, the applicant still gets to keep the money.

More resources are available on the SBA’s website: COVID19Relief.SBA.gov

Payroll Protection Loan

This is a new program the government is rolling out in the wake of the pandemic. Like the EIDL, this loan is only available to small businesses, with much of the criteria – less than 500 employees, etc. – still applicable in determining who can receive these loans. Importantly, independent contractors and sole proprietors (folks that file a Schedule C on their tax returns to report their business income and expenses) are eligible for these loans. This is vital in today’s gig economy.

Before we get into how this loan is calculated – because it has some unique provisions – let’s go over some of the basic terms. The maximum interest rate on the loan is 4%, the first payments are due beginning six months after loan initiation, and the maximum amount that is permitted to be borrowed is $10 million.

Don’t stop reading though after the mechanics of the loan amount are described. There are important provisions that allow for the loan to be forgiven if the proceeds are spent in a certain way and spent in that certain way in a certain time frame.

Now, on to how this loan is calculated. We’ll split this into two parts, because it is a slightly different procedure depending on if we are a business with employees and payroll or if we are an independent contractor/sole proprietor.

1. Businesses with employees

For businesses that pay a payroll, the loan amount is calculated as 2.5 multiplied by the business’ average payroll over the last twelve months. In practice, the guidance has been to use your April 1, 2019 through March 31, 2020 payroll. For new businesses – with guidance indicating that the definition of a new business is one that began in 2020 – the business should use its average payroll for January 2020 plus February 2020.

In this context, “payroll” refers to wages paid to employees, whether they are salaries, wages, holiday pay, vacation pay, etc. An important provision is that the per-employee amount you are allowed to include is capped at $100,000. So if an employee earned $200,000 from 4/1/2019-3/31/2020, only $100,000 can be included. A related provision is that even if the employee did not earn $100,000 during this time, if their annual salary was greater than $100,000, the calculation only allows you to use a pro-rated amount. This would be relevant if say, in December of 2019 you hired an employee for $150,000/year. S/he would not have earned $100,000 by March 31, 2020. That employee would have worked for four months, so you are allowed to include ($100,000 ÷ 12) x 4 = $33,333 in the calculation of the average payroll. This can get a bit tricky.

One last note here, which is important, is that non-cash compensation paid to employees – think health insurance premiums or retirement plan contributions – are also included in the payroll costs used to calculate the loan. Even if an employee’s comp is capped out at $100,000 you can still include his/her non-cash compensation amounts when calculating payroll costs for purposes of the loan.

2. Independent Contractors/Sole Proprietors

Many – maybe even most – independent contractors and sole proprietors don’t pay a payroll. They receive income from their clients or customers, pay their business expenses, and keep what is left over. So does no payroll mean no loan? The answer here is no.

So how is the loan amount calculated? It is based on your net earnings from your independent contractor/sole proprietor activity. Again, there is a cap of $100,000 on this amount, same as with the loan calculation above for businesses with payroll. This illustrates an important point: the maximum amount of the loan for an independent contractor/sole proprietor is $20,833. This is calculated as $100,000 ÷ 12 months (to calculate average month) x 2.5 (the loan multiplier).

3. Loan Forgiveness

The best feature of the PPP loan is that, when the borrower spends the money in a certain way, the loan does not need to be paid back. Thus, instead of a loan, this basically becomes a type of grant.

Naturally, this must have you wondering what you have to spend the loan proceeds on to get the loan forgiven. Let’s start with the easy part. One quarter (25%) of the loan may be spent on utilities, rent and mortgage interest combined. Thus if your loan is $100,000 and you spend $25,000 on those categories, $25,000 will be forgiven. The remainder, 75%, must be spent on payroll. The language can be somewhat technical here, but bottom line is the 75% represents wages you pay employees. It does not include employer payroll taxes, such as the employer share of social security tax, Medicare tax, or state unemployment taxes.

Like you can include non-cash compensation (health insurance premiums, retirement plan contributions, etc.) when calculating the loan, you can also include these amounts as payroll costs for purposes of computing loan forgiveness.

Businesses should be prepared to provide payroll records and proof of rent, utilities and mortgage interest paid to the bank they took the PPP loan from in order to apply for forgiveness. Forgiveness is not automatic; it must be applied for.

One more very important note is that the government is attempting to support employment and discourage employers from firing people and/or decreasing salaries, so if an employer does one or both of those things, the amount of the loan that can be forgiven may be decreased. These calculations can be a bit complicated so contact a CPA to help you through these scenarios.

For people that are self-employed, the loan forgiveness provisions have yet to be fully clarified by the government, however, as payroll costs for determining the loan amount are synonymous with their net profit as a sole proprietor/independent contractor, guidance indicates that such payroll costs will be the same for purposes of computing loan forgiveness. In other words, the net profit of the business in the eight weeks following the loan will be considered “payroll costs” and can thus be used as the basis for applying for forgiveness. Independent contractors/sole proprietors should be prepared to provide their bank a statement showing their income and expenses for this eight-week period in order to apply for loan forgiveness.
Two more final notes deserve quick, but important, mention. The first is that a business can apply for both an EIDL and PPP loan; however the loans may not be used for the same purposes. Second, if a business elects to apply for a PPP loan, it may not also claim the Employee Retention Credit, a subject which we will discuss further in our next article.

More information on the PPP loans can be found online at the Small Business Association website.