For those of you fortunate enough to get a PPP loan, you must now turn your attention to maximizing your loan forgiveness. The key to maximizing loan forgiveness is having a good understanding of how loan forgiveness is calculated, how it is maximized, and avoiding unfavorable reductions. In this article we dive into the mechanics of loan forgiveness, learn the terminology, and describe the three tests applied that could potentially reduce forgiveness. With this understanding, we build a strategy that is summarized in the Top 10 Tips to Maximize Loan Forgiveness below.
Steps to Calculate Loan Forgiveness
Step 1: Understand Key Terminology
Covered period – the eight-week period beginning on the date the lender makes the first loan disbursement.
Payroll costs – for purposes of calculating loan forgiveness, payroll costs are defined the same as in the PPP application process when determining the original amount of the loan. These costs are broken down as follows:
Employer Payroll Costs:
- Salary, wage, commission or similar compensation
- Payment of cash tip or equivalent
- Payment for vacation, parental, family, medical, sick leave (excludes wages creditable under the Families First Coronavirus Response Act), for dismissal or separation
- Payment required for provision of group health care benefits including insurance premiums
- Payment of any retirement benefit
- Payment of state or local tax assessed on the compensation of employees
Sole Proprietor/Independent Contractor:
- The sum of payment of any compensation to or income of a sole proprietor or independent contractor that is a wage, commission, income, net earnings from self-employment, or similar compensation and that is not more than $100,000 in one year, as prorated for the covered period.
- The SBA has recently clarified that self-employment income earned by partners in a partnership is an eligible payroll cost of the partnership (up to the $100,000 limit per partner).
Ineligible Payroll Costs:
- Payments to sole proprietors and independent contractors via a 1099 payment are not eligible payroll costs. However, sole proprietors and independent contractors are eligible to apply for their own PPP loan.
- Compensation in excess of $100,000 for any individual (as prorated for the covered period) is not eligible. However, the full amount of benefits such as health insurance and retirement plan costs for these individuals is not limited.
- Federal payroll taxes such as Social Security, Medicare and Federal Unemployment taxes.
- Compensation of an employee whose principal place of residence is outside of the US.
Covered mortgage obligation: Is indebtedness or a debt instrument incurred in the ordinary course of business that:
- Is a liability of the borrower
- Is a mortgage on real or personal property, and
- Was incurred before February 15, 2020
Covered rent obligation: Is rent obligated under a leasing agreement in force before February 15, 2020.
Covered utility payment: Is payment for a service for the distribution of electricity, gas, water, transportation, telephone, or internet access for which service began before February 15, 2020.
Step 2: Calculate Eligible Amount of Forgiveness
The eligible amount of forgiveness equals the sum of the following costs incurred and payments made during the covered period (the 8 week period from the date of your first loan disbursement):
- Payroll costs
- Any payment of interest on any covered mortgage
- Covered rent obligation
- Covered utility payment
Pro Tip! To maximize the eligible amount of forgiveness you must fully spend the loan proceeds on these costs during the 8 week covered period. However, the eligible amount of forgiveness may be reduced under the tests explained below in Step 3.
Step 3: Understand the Three Tests that Reduce the Eligible Amount of Forgiveness
Test 1 – Overall Expenditure Test:
The SBAs Interim Final Rules explain that not more than 25% of the loan forgiveness amount may be attributable to non-payroll costs.
Example: Assume the eligible amount of forgiveness is $10,000 with $6,000 spent on payroll costs and $4,000 spent on covered rent and utilities during the covered period. As the borrower only spent $6,000 on payroll costs, a total of only $8,000 ($6,000 / 75%) is forgivable, so only $2,000 of the $4,000 of covered rent and utilities will be forgiven.
Test 2 – FTE Reduction Test:
In general, the eligible amount of forgiveness is reduced based on results of 1 of 2 tests based on Full-Time Employees (FTEs):
FTE Reduction Test 1 = Average FTEs per month during the Covered Period / Average FTEs per month from [February 15, 2019 to June 30, 2019], or
FTE Reduction Test 2 = Average FTEs per month during the Covered Period / Average FTEs per month from [January 1, 2020 to February 29, 2020].
Example: Assume a borrower has $10,000 eligible for forgiveness and has an average of 5 FTE’s during the covered period as compared to 6 FTE’s under test 1 and 7 FTE’s under test 2. Test 1 is most advantageous to the borrower as 5/6 of eligible forgiveness is allowed. This reduces the eligible amount of forgiveness by 1/6 or $1,667 (1/6th of $10,000).
Pro Tip! The borrower can use either FTE Test 1 or 2 (whichever is more favorable).
Test 3 – Wage Reduction Test:
In general, the eligible amount of forgiveness is reduced if the total salary or wages of any employee during the covered period has been reduced below 75% of wages with respect to that employee during the most recent full quarter during which the employee was employed before the covered period. In most cases this means comparing wages in the covered period vs 75% of Q1 2020 wages (on an employee by employee basis).
Example: Assume employee A had $15,000 of wages during Q1 2020. Assume employee A had $10,000 wages during the covered period. The wage test seemingly requires 75% of Q1 wages to be paid in the 8 week covered period. If that is the case, then $11,250 of wages is required to be paid during the covered period. However, in our example only $10,000 was paid. This results in a $1,250 reduction in forgiveness.
Pro Tip! For purposes of the wage reduction test, you only examine employees who did not receive, during any single pay period during 2019, wages or salary at an annualized rate of pay in an amount more than $100,000. In other words, if an employee earned less than $100,000 overall during 2019, it may be of benefit to dig a little deeper. For example, suppose your employee received compensation of $8,000 per month in Jan– Nov, but received $9,000 of compensation in December. That employee’s annualized compensation is $108,000 (based on annualized December). Therefore, that employee is not tested in the wage reduction test.
Step 4: FTE and Wage Restorations before June 30, 2020
FTE and Wage restorations before June 30, 2020 appear to be favorable tools that the borrower my use. Unfortunately, at this time, the mechanics of these restorations are not well defined! The law suggests opportunities to restore reductions calculated under FTE Test and Wage Test, but the law doesn’t give us the detail on how this will be accomplished. Here is what the law generally says:
Restoration of FTEs – If during the period beginning on February 15, 2020 and ending on April 26, 2020 there is a reduction in the number of FTEs (as compared to February 15, 2020); and, no later than June 30, 2020, the eligible employer has eliminated this reduction in the number of FTEs, then the amount of loan forgiveness shall be determined without regard to a reduction in the in the number of FTEs.
Restoration of Wages – If during the period beginning on February 15, 2020 and ending on April 26, 2020 there is a reduction in the salary or wages of one or more employees of the eligible recipient (as compared to February 15, 2020); and, no later than June 30, 2020, the eligible employer has eliminated this reduction in the salary or wages of such employee, then the amount of loan forgiveness shall be determined without regard to a reduction in the salary of one or more employees as applicable.
We need further clarification from the SBA and Treasury to help us better understand how FTEs and Wages can be restored before June 30, 2020. Again, at this time, it is not clear how this will be interpreted.
Pro Tip! Don’t forget the Overall Expenditure Test must be satisfied at all times to maximize forgiveness! The FTE and Wage restoration tools only have the potential to restore reductions under their respective tests.
Step 5: Compile Required Documentation:
Loan recipients seeking forgiveness are required submit to the lender that services the covered loan an application of the following:
- Documentation to verify the number of FTEs and documentation for pay rates including payroll tax filings submitted to the IRS, state payroll filings, and unemployment insurance filings.
- Documentation including cancelled checks, payment recipients, transcripts of accounts, or other documents verifying payments on covered mortgage obligations, payments on covered lease obligations, and covered utility payments.
- Certification that documentation presented is true and correct and the amount of which forgiveness requested was used to retain employees, make interest payments on covered mortgage obligations, make payment on a covered rent obligations, or make covered utility payments.
Pro Tip! Set up a separate bank account to accept the loan proceeds and meticulously track loan forgiveness expenditures as they are incurred.
Top 10 Strategies for Maximizing PPP Loan Forgiveness:
- Set up a separate bank account to receive loan proceeds, isolate cash, and track expenditures meticulously.
- Mark your calendars! Mark your calendars 8 weeks out from the date you receive loan proceeds as “End of the Covered Period”. Be sure to manage expenditures before this date.
- Spend, spend, and spend. If possible, be sure to incur and spend all loan proceeds within the 8 week covered period!
- Ensure that at least 75% of expenditures are for payroll costs.
- Meticulously track expenditures ensuring monies are spent on forgivable costs (defined earlier) including:
- Payroll Costs (remember payroll costs is a broad term that includes health insurance premiums and retirement plan contributions).
- Covered Mortgage Interest
- Covered Rent
- Covered Utilities
- Measure your average monthly FTEs from February 15, 2019 to June 30, 2019 and then measure from January 1, 2020 to February 29, 2020.
- Which period has the lowest average? For convenience we call this the minimum required FTE amount.
- Ensure your FTEs are at least as high as the required FTE amount during the 8 week covered period.
- Measure employee compensation for First Quarter (Q1) 2020 on an employee by employee basis (get out your payroll records)
- Calculate 75% of Q1 2020 employee payroll (again on an employee by employee basis). For convenience we call these the required wage amounts.
- Ensure your employee-by-employee wages are at least as high as their required wage amounts during the 8 week covered period.
- For this test, you may disregard employees with annualized compensation in excess of $100,000.
- Don’t bank on the June 30, 20 FTE and wage restoration rules at this time. These rules are not clear and we need further guidance from Treasury and the SBA to manage these rules effectively.
- Make a plan. Plan out your expenditures for the 8 weeks ahead. Be sure to allow time for evaluation of final expenditures during the final week.
- Consult with your tax advisor frequently as Treasury and SBA are regularly issuing new rules.