Under the Paycheck Protection Program (PPP), borrowers first apply for a loan and then, eight weeks after cash is disbursed, they apply for loan forgiveness.
As of April 13, Small Business Administration guidance had not included any information for the particular issues faced by self-employed individuals regarding PPP loans even though banks began accepting applications from self-employed individuals on April 10 and advisers are urging speedy applications because of program delays and possibly the exhaustion of the $349 billion allocated by Congress to the program.
Guidance is particularly important for loan forgiveness of the self-employed because mechanical application of the statute yields counterintuitive results. We say the results are counterintuitive because they imply that self-employed individuals whose business remains healthy get near-complete forgiveness while self-employed individuals not generating revenue could get nothing.
Guidance is also important because it could be easy for self-employed individuals to arbitrarily increase salaries and wages to themselves and to family members during the eight-week loan forgiveness period. Over 26 million individual taxpayers in 2017 reported self-employment income on Schedule C of Form 1040.
Uncertain
The PPP was signed into law as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) on March 27.
Interim final guidance was released by the SBA on April 2. A set of frequently asked questions is updated regularly by the SBA. The latest version is dated April 8. The CARES Act requires that “not later than 30 days after the date of enactment of this Act, the Administrator shall issue guidance and regulations” regarding loan forgiveness. The April 2 interim guidance states that the SBA will issue more guidance on loan forgiveness.
Some commentators were hoping for a separate form for the self-employed to spare them the confusion and complexity created by the current form (SBA Form 2483) that is clearly designed for businesses with employers. But none is available.
Illogical
Central to the calculation of loan amounts and loan forgiveness for all PPP borrowers is the concept of payroll costs.
For eligible small businesses and nonprofit institutions, payroll costs are wages and salaries paid (limited to $100,000 per employee on an annualized basis) plus benefits paid by the employer (mostly health insurance and retirement benefits). For “eligible self-employed individuals”— those with self-employment income (as defined under section 1402) paying self-employment tax — payroll costs include:
the sum of payments 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 in an amount that is not more than $100,000 in one year, as prorated for the covered period.
For determining the loan amount (section 1102 of the CARES Act), the covered period is a prior period (generally one year in length). For determining loan forgiveness (section 1106), the covered period is the eight-week period beginning on the date of loan origination.
The maximum loan amount is 2.5 times average monthly payroll costs. That is over a period equal to 20.83 percent of a year or approximately 76 days.
The amount of forgiveness, not to exceed the loan amount, is payroll costs plus interest, rent, and utilities during the eight-week post-origination period. Eight weeks is 15.34 percent of a year or 56 days.
The interim final guidance added the restriction (not in the statute) that non-payroll costs (interest, rents, and utilities) could not exceed 25 percent of the total loan forgiveness amount.
In the absence of SBA guidance, practitioners quite logically are directing self-employed individuals to look to line 31 of Schedule C (“net income of loss”). In general, line 31 equals “gross receipts or sales” less “total expense” and “expenses for business use of your home.”
Some commentators talk about summing the amount recorded on Forms 1099. This would be an incomplete calculation for self-employment income if the self-employed individual has expenses. Also, shouldn't self-employed income on line 31 be multiplied by 0.9235 as in line 4 of Schedule SE to account for the deductibility of the 7.65 percent employer portion of payroll tax?
To illustrate a fundamental problem in the computation of loan forgiveness for self-employed individuals, let’s keep matters simple. Let’s assume self-employment income is indeed payroll cost for self-employed individuals and that the individual in our example has no wage costs or other business expenses. If average monthly self-employment income is $6,000, the maximum loan amount will be $15,000.
Now in the post-origination period, let’s look at two possibilities. First, the self-employed individual has a small reduction in business receipts because of the COVID-19 crisis. (Note: It could be possible there is no reduction in receipts and a business can be eligible for forgiveness. The only distress-related requirement in the statute is vague and probably unenforceable: “that the uncertainty of the current economic conditions makes necessary the loan request to support the ongoing operations of the eligible recipient.”)
Let’s say that reduction is from $6,000 to $5,000. Loan forgiveness in this case is equal to eight weeks of payroll costs. Annualized payroll costs are reduced from $72,000 to $60,000. The fraction of the year equal to eight weeks is 0.1534. The forgivable amount is $9,204 (equal to 0.1534 times $60,000). That’s about 61 percent of the loan amount.
Now what happens if the self-employed individual’s business completely dries up? In that case, payroll costs in the eight-week period are zero and loan forgiveness is zero.
To the extent one policy goal of the CARES Act is to provide relief to those most in need, this result does the opposite of what is intended: Relatively healthy businesses get significant forgiveness, and distressed businesses get no forgiveness.
What’s worse is that the healthy business is grossly overcompensated. For the eight-week period after the funds are disbursed, our first self-employed individual receives $9,204 from customers plus $9,204 in loan forgiveness from the SBA. Our second self-employed individual receives zero from customers and zero in loan forgiveness.
This is where you say: That can’t be right. So, what can be done?
One possibility (contrary to the statutory language) would be to exclude self-employment income from the loan forgiveness amount. This prevents excessive loan forgiveness, but it does nothing to help the self-employed who are generating no revenue.
Another possibility would be to allow self-employed individuals to pay themselves wages (no larger than self-employment income in the prior year). This prevents the zero-revenue self-employed from being shut out. But it would be equivalent to making loan forgiveness available to all small business — including healthy businesses.
Perhaps this is what Keith Hall, president and CEO of the National Association for the Self-Employed, had in mind when during an April 10 podcast he made the somewhat startling statement: “It is my expectation, from a practical standpoint, that these PPP loans for 1099 people will be forgiven.”
A third possibility would be a variant of the second that allows the self-employed individual to pay himself or herself wages, but these new wage amounts cannot exceed the difference between prior self-employment income and new self-employment income. This would still allow self-employed individuals total forgiveness, but at least it would prevent forgiveness that makes the business better off than it was before the crisis.
Pliable
As suggested by the prior paragraphs, a self-employed individual has a large incentive to pay himself or herself compensation that can be labeled wages in order to increase loan forgiveness whenever the loan forgiveness amount during the eight-week period is less than the maximum loan amount. In general, the business owner receives 100 percent compensation for a marginal increase in wages.
If the 25 percent cap on non-payroll costs is binding, the business owner receives 133 percent compensation for a marginal increase in wages. If Congress clarifies that deductions don't have to be reduced by the loan forgiveness amount (so that loan forgiveness payments are in effect truly nontaxable) the business owner receives 100 plus "t" percent compensation for each additional dollar of wages, where t is the owner's tax rate.
So far, this discussion has assumed the self-employed individual is a sole proprietor reporting business income on Schedule C. If the self-employed individual files as an S corporation, that individual would likely be paying himself or herself the lowest reasonable compensation possible (to minimize 7.65 percent payroll taxes), with the remainder of subchapter S corporation profit not subject to employment tax (section 1402(a)).
Self-employment income for the PPP piggybacks on the rules for self-employment income under section 1402. So subchapter S shareholders (and limited partners in partnerships) can only include in payroll costs the reasonable compensation (and guaranteed payments) they pay themselves. These payroll costs are used to compute the maximum loan amount and loan forgiveness. Thus, good tax planning of the past is severely penalized by the PPP.
But what is to prevent the self-employed subchapter S corporation from jacking up wages by recharacterizing distributive shares as reasonable compensation for services provided? That increases employment taxes, so strictly speaking, the IRS should have no objection to such a maneuver. Will the SBA write regulations to prevent this?
Please keep mind that it is an open question whether the SBA has the authority to implement any such suggestions, given the language in in the statute.
Tired of Waiting
On these pages we have praised the administration and Congress for the size and speed of the economic relief package. But while we can give high grades to the macroeconomics of the CARES Act, the microeconomics are lacking. At a minimum, the statute should be clarified and simplified. And perhaps some of the fundamental building blocks need to be overhauled.
Further, the quality and speed of SBA guidance have been inadequate. Of course, the agencies and congressional staff have been working diligently under stressful conditions to provide relief of unprecedented scope at unprecedented speed. We are pointing out problems not to criticize, but with the hope of taking the first step to making improvements if possible, whenever possible.