The latest update on small business loans that are forgivable on a tax-free basis has some practitioners claiming that the government is changing the rules in the middle of the game.
The interim final rule released August 24 further clarifies what it means to be an owner-employee for purposes of loan forgiveness — a topic that has caused headaches for Paycheck Protection Program borrowers since the Small Business Administration first used the term months ago but didn’t define it.
The term owner-employee was introduced by the SBA in an interim final rule released in May that placed caps on the amount of compensation that could be paid to owner-employees and still be forgiven. But the term wasn’t defined, leaving practitioners in the dark until an interim rule released in late June attempted to clarify the issue.
In the latest guidance, the SBA says owner-employees with an ownership stake of less than 5 percent in a C corporation or S corporation aren’t subject to the owner-employee compensation rules. The rule says the exemption is meant to cover owner-employees who don’t have a meaningful ability to influence decisions on how loan proceeds are allocated.
“The question of how much ownership was ‘enough’ ownership to trigger the owner limits was one that had been a problem for quite a while,” Edward K. Zollars of Thomas, Zollars & Lynch Ltd. told Tax Notes. “I did worry that any ownership would be enough to trigger inclusion and, given how the SBA worded the less-than-5-percent-ownership exception, that was how they viewed it.”
Zollars said some advisers had looked to the loan application and its reference to 20 percent ownership in entities for guidance on what it meant to be an owner-employee. That reference didn’t say it counted for forgiveness, but with nothing else out there on the topic, the advisers worked with that reference, he said.
Because other SBA regulations also referenced a 20 percent ownership stake for other items, some thought that would be the threshold for ownership. Those advisers aren’t happy with the 5 percent threshold in the latest rule, Zollars said.
“What did surprise me a bit was that they did not apply a general purpose 5 percent ownership test, but rather limited the 5 percent test to corporate shareholders,” Zollars said.
For limited liability company owners, it seems that a 4 percent owner who’s in the member-manager class will be subject to the owner rules and caps on compensation, Zollars said. However, if the LLC had elected to be treated as an S corporation, that member would be exempt from those limits, he said.
“I suspect the reason is due to the issue of coming up with how to deal with how much income replacement that minority interest holder has if the SBA doesn't just use 2½ months of last year's self-employment income as deemed replacement, but it does create a quirky difference based on tax entity selection for a PPP borrower,” Zollars said.
Eric J. Kodesch of Lane Powell PC said the 5 percent ownership threshold is welcome. A threshold was needed because it didn’t make sense to treat a 0.1 percent owner the same as a 100 percent owner under the PPP rules, he said. The 5 percent threshold is a bit low, but it’s better than nothing, he added.
The PPP, created by the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136), generally offers loans to businesses with fewer than 500 employees that are forgiven on a tax-free basis if a specified portion of the loan is spent on payroll costs over a covered period.
Initially, the SBA and Treasury said that for a loan to be forgiven tax free, at least 75 percent of it must be used on payroll costs. But Congress changed that by enacting the Paycheck Protection Program Flexibility Act of 2020 (P.L. 116-142), which extended the covered period from eight weeks to 24 weeks and reduced to 60 percent the amount required to be spent on payroll to qualify for loan forgiveness.
The government also updated the standard loan forgiveness application and instructions in June to incorporate changes made to the program by the recent legislation.
The new rule limits the amount of rent payments to related parties that are eligible for forgiveness. It says rent or lease payments to related parties qualify for forgiveness as long as the payments don't exceed the amount of mortgage interest owed on the property during the covered period attributable to space rented by the business, and the lease and mortgage were entered into before February 15.
Any ownership in common between the business and the property owner is a related party under the rules. And while rent or lease payments to a related party could be eligible for forgiveness, mortgage interest payments to related parties don’t qualify for forgiveness, the rule said.
The rule also says non-payroll amounts attributable to a business operation of a tenant or subtenant of a PPP borrower aren’t eligible for forgiveness. In one example in the rule, a borrower has a mortgage on an office building it uses, and it leases a portion of the building to other businesses. The rule says the portion of the mortgage interest eligible for forgiveness is limited to the percent share of the fair market value of the space that is not leased to other businesses.
“I understand the decision that SBA has made as it pertains to the self-rentals because it sort of piggybacks off of the owner-employee designations,” Adam Markowitz of Howard L Markowitz PA CPA said. “It does feel, in part, that allowing business owners to allocate 40 percent of their PPP money to self-rental would be sort of piggish. On the surface, this makes some sense.”
However, it appears the rule punishes building owners for having paid off the mortgage on their buildings, Markowitz added.
Markowitz said taxpayers are generally required to charge fair value rent on commercial buildings, which is enforced heavily by his home state of Florida because of its commercial rent sales tax.
“If the state allowed us to just use the mortgage as ‘fair value,’ I wouldn't have a problem with this in general,” Markowitz said. “But if I tried to assign one of my clients who owns his/her building rent that was equivalent to, say, a 15-year-old mortgage, I'd get crushed in a sales tax audit.”
Markowitz added that his clients are still paying sales tax on their building rent even if they aren't physically getting the rent because the state could come in and impute the sales tax based on the rent that should have been paid.
“Yet here with PPP, that rent that effectively has to be paid and is taxed at the state level here in Florida cannot count toward PPP,” Markowitz said.
Winners and Losers
Kodesch said the SBA is changing the rules in the middle of the game and is picking winners and losers.
Many businesses rent from owners — regardless of whether they’re related — that don’t have a mortgage. Rent generally also covers mortgage principal loan amounts, property taxes, and maintenance, he noted.
“Nothing in the CARES Act or [the PPP Flexibility Act] limits forgivable rent based on the mortgage interest paid by the landlord and renters made forgiveness projections based on the rent actually paid,” Kodesch said. “It does not make sense to treat two similarly situated businesses differently with respect to rent payments based on whether the landlord is related and the mortgage interest paid by the landlord.”
A rule targeting above-market rent could make sense, but there is no indication that that’s what the SBA is targeting, and this rule would limit forgiveness for an FMV (or even below-market) rent, Kodesch said.
“Even worse, the SBA did not give a policy basis for this new rule. Instead, it provided a conclusory statement without any supporting data or analysis,” Kodesch said.
Kodesch also noted the complexity added by the new rule.
“The limitation is relatively simple to calculate when there is an overlap between the operating business and the landlord entity,” Kodesch said. “However, the rule leaves open a multitude of unanswered questions, including how to account for differences in ownership or whether or how you look through owners that are trusts.”
Amal U. Dave of Arent Fox LLP said the related-party rental rules seem reactive and unnecessary in light of the requirement that any lease for which PPP proceeds are used had been in place on February 15 and that 60 percent of the proceeds be used for payroll.
Dave said what should be relevant to the SBA and Treasury is whether the lease is a legitimate obligation of the borrower. If it is, it shouldn’t matter whether the lease payment covers only interest obligations of the landlord, or some other amount, he added.
“Failing to pay principal would be a payment default for the related-party landlord just as failing to pay interest would be, and failing to pay property taxes can lead to costly liens and other consequences,” Dave said. “It’s perfectly reasonable to provide for audits of lease payments to make sure they reflect bona fide payment obligations of the borrower. But to curtail lease payments for one group of landlords seems arbitrary.”