The Coronavirus Aid, Relief, and Economic Security (CARES) Act was enacted in late March and included several programs with income tax and payroll tax implications. However, several interpretational questions have persisted since that time. Fortunately, the IRS continues to issue guidance on these points. More specifically, new guidance addresses the deductibility of payroll expenses funded with Paycheck Protection Program (PPP) loans and the implementation of the employee retention credit.
IRS denies payroll deductions associated with PPP loan forgiveness
One of the key provisions of the CARES Act is the PPP that provides financial assistance loans and is intended to support the retention of employees during the COVID-19 pandemic. Eligible businesses can borrow amounts based on average payroll costs. Up to 100% of these loans are forgivable if the funds are used for payroll costs and other eligible expenses during the relevant testing window. The CARES Act states that any forgiveness of PPP loans is a nontaxable event to the recipient. However, the legislation didn’t explicitly describe the tax treatment of the payroll costs and other expenses that were funded by the forgiven loan.
To answer to this question, the IRS published Notice 2020-32 last week. The notice concludes that no deduction will be allowed for an expense if the payment of such amount results in forgiveness of a covered loan under the CARES Act. In reaching this conclusion, the IRS reasoned that existing guidance under Section 265 and other case law applied to PPP loans. Those rules preclude deductions when they relate to tax-exempt income. Some members of Congress have suggested that this position is contrary to their intent and have indicated that they would work on a legislative fix to reverse the conclusion of the notice. Such legislation faces an uncertain future at this time since it would likely be part of broader negotiations on the next round of COVID-19 stimulus.
The issuance of this notice is helpful as it clarifies the position of the IRS, despite being a different answer than taxpayers may have been expecting. In the short term, this means that any taxable income projections for the current year should be updated to reflect the disallowance of payroll and other expenses funded by a PPP loan that is anticipated to be forgiven. It’s also recommended that taxpayers continue to monitor legislative developments in case Congress chooses to provide for expense deductions. The first quarterly estimated tax payments for 2020 are currently scheduled to be due on July 15, so there’s still some time for Congress to act.
The Small Business Administration (SBA) in connection with Treasury has also provided additional guidance that answers some of the other open questions regarding PPP loans in its FAQ document. For additional guidance on this matter, please see our related PPP articles, including Paycheck Protection Program provides forgivable SBA loans and You’ve received your Paycheck Protection Program loan, now what?
Taxpayers have until May 14 to return PPP loans and retain employee retention credit eligibility
Recent developments related to the PPP loan program have caused some businesses to reconsider whether they should retain the loans. In particular, the SBA, in consultation with the Treasury, continues to update a series of FAQs related to PPP loans. One answer specifically targets the good-faith certification required for a PPP loan application and suggests that certain businesses may be unable to make that certification. The answer provides that businesses must consider “their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business.” As an example, it indicates that a public company with substantial market capitalization would be unlikely to be able to make that certification.
Continued focus on the good-faith certification has given some businesses cause to revisit their business plans, current capitalization, and expectations for the future. Businesses wishing to return their PPP loans have until May 14 to complete repayment and be automatically deemed by the SBA to have made the certification in good faith. This date was previously set at May 7.
PPP loans impact the ability of businesses to claim other incentives under the CARES Act. In particular, the mere receipt of a PPP loan would prevent an employer from claiming the employee retention credit (discussed in greater detail below). However, in light of the safe harbor for returning PPP loans, the IRS has issued guidance clarifying the interaction of PPP loans and the retention credit. Specifically, an employer that returns a PPP loan by the May 14 safe harbor date will be treated as if it hadn’t received the loan, which results in continued eligibility for the employee retention credit. This is welcome news since it provides a path for businesses to pursue employee retention credits in lieu of PPP loans.
IRS significantly expands guidance related to the employee retention credit
The CARES Act created a new employee retention credit to assist employers affected by the COVID-19 pandemic. The credit is available to eligible employers and is equal to 50% of up to $10,000 of qualified wages per eligible employee paid after March 12, 2020, through Dec. 31, 2020 (i.e., a maximum $5,000 credit per employee). Last week, the IRS has published a substantial update to its list of FAQs. While this is informal guidance posted to the IRS website, it does confirm the IRS’ interpretations of several key questions. It’s unclear whether the IRS will undertake a more formal guidance project for the retention credit such as issuing regulations, but we would expect any future guidance to closely follow the logic of these FAQs.
There is a large volume of guidance in the updated FAQs, so we recommend consulting the IRS website for specific points. This is especially important given the relative frequency with which the IRS is updating the FAQs. A summary of key items is included below.
Determination of eligible employer
For the retention credit, an eligible employer can be an entity with any number of employees. The eligible entity also must be economically affected by COVID-19 either due to: (1) the entity’s operations being fully or partially suspended as a result of a government order, or (2) a greater than 50% reduction in gross receipts for a calendar quarter when compared to the same quarter in the previous year. The FAQs explore those general requirements in greater detail and provide the following clarifications:
- Defining government orders: Orders, proclamations, or decrees from the federal government or any state or local government are considered “orders from an appropriate governmental authority” if they limit commerce, travel, or group meetings due to COVID-19 in a manner that affects an employer’s operations. A recommendation from the government isn’t sufficient. The order must also directly apply to the business. An order that indirectly impacts the business by making it difficult for its customers to frequent the business isn’t enough.
- Termination of government order: Entities that are partially or fully suspended due to a government order remain eligible only until the government order is lifted.
- Application of multiple orders: Employers that operate in locations across many jurisdictions and are subject to state and local governmental orders limiting operations in some, but not all, jurisdictions are considered to have a partial suspension of operations. This same principle also applies when only one member of an aggregated group is subject to a government order.
- Treatment of essential businesses: An essential business that is allowed to continue operations under a government order isn’t considered to be partially or fully shut down due to such order. However, an essential business may be considered to be partially or fully shut down if its suppliers are subject to the government order and are unable to supply critical goods or services.
- Gross receipts testing for new businesses: Specific rules apply to the comparison of gross receipts for businesses that began operations during 2019. This generally results in the gross receipts for the first quarter of operations being used for prior quarters during that year. Thus, a business that began operations in the second quarter of 2019 would use its second quarter gross receipts for both the first and second quarters of 2019.
- Gross receipts testing for acquired businesses: An employer that acquires a business can include the gross receipts of the acquired business in the test, if such information is available. This safe harbor applies regardless of the form of the acquisition. This rule is expected to help acquisitive businesses qualify because it will likely increase the 2019 gross receipts to which the 2020 gross receipts will be compared to.
- Gross receipts & tax-exempt organizations: The IRS has indicated that it plans to issue future guidance to address how tax-exempt organizations will determine gross receipts for the purpose of analyzing whether the organization had a significant decline in gross receipts.
- Treatment of self-employed individuals: Self-employed individuals aren’t eligible for the credit with respect to their own self-employment earnings. Self-employed individuals who employ other individuals in their trade or business qualify so long as they otherwise meet the requirements.
Qualified wages
The determination of qualified wages is different for employers with 100 or fewer employee and those with more than 100 employees. An eligible employer that averaged 100 or fewer employees may treat all wages paid to employees during an eligible quarter as qualified wages. However, an eligible employer that averaged more than 100 employees may only treat wages paid for the time an employee isn’t providing services for a qualified reason as qualified wages. Furthermore, the IRS FAQs provide the following with respect to qualified wages:
- Counting of employees: Determining the number of employees of the business looks to its employees in 2019. An employee includes any person that averaged at least 30 hours of service per week or 130 hours of service in the month. Adjustments are made for employers that began operations in 2019 and 2020.
- Qualified wages for more than 100 employees: Qualified wages can include a portion of wages when an employee is still providing some services. For example, reducing hours by 50% but only reducing wages by 40% means that 10% of wages are qualified wages. The guidance does note that a decline in productivity should not be considered. Therefore, for salaried employees who are working remotely, an employer can’t make a determination that the employee is only 70% productive to conclude that 30% of their wages are paid for not providing services. The employer must base its determination on the actual amount of time that the employee is providing services compared to total standard time based on any reasonable method.
- Increase in wages: Wages paid by eligible employers that averaged more than 100 full-time employees during 2019 may not exceed what the employee would have been paid for working an equivalent duration during the 30 days immediately preceding the end of the full or partial suspension of operation or the first day of the quarter in which the employer experienced a significant decline in gross receipts.
- Treatment of paid time off: Eligible employers with more than 100 employees in 2019 may not treat amounts paid for previously accrued vacations, holidays, or sick days as qualified wages.
- Health plan expenses for furloughed workers: Employers with more than 100 employees who do not pay any wages for furloughed employees may treat all health plan expenses paid on behalf of employees who are not providing services as qualified wages. Previous guidance required at least some wages to be paid in order to get this treatment, so this is a welcome change. If employees are still providing some services, then allocations must be made.
- Payment to former employees: Payments, including severance payments, made to former employees after termination of employment aren’t considered qualified wages.
Interaction with other programs
- Coordination with PPP loans: As discussed above, an employer that received a PPP loan, but repaid the loan by May 14 will be treated as if the employer didn’t receive a PPP loan for the purposes of the employee retention credit. Otherwise, employers that receive PPP loans are precluded from claiming the retention credit.
- Coordination with other credits: An eligible employer may not treat any wages that the employer received a credit for under the qualified sick and/or family leave wages as qualified wages. Also, any wages taken into account for the credit for family medical leave under Section 45S can’t be accounted for the retention credit. Overall, an eligible employer may receive both the paid family and medical leave credit and the employee retention credit for the same employee, but not for the same wage payments.
A detailed analysis of the employee retention credit, including a comparison with other payroll tax incentive programs, can be found here.
IRS guidance will be posted on the IRS coronavirus resource site. Please contact a member of our National Tax Office for further assistance.
