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Target Entities With PPP Loans Could Muddle M&A Deals

Posted on July 24, 2020

Businesses considering acquisitions of target entities that received a Paycheck Protection Program (PPP) loan should be wary of adverse consequences to employee retention credits that could occur without clarifying rules. 

The Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) included two incentives that encourage employers to continue paying workers during the COVID-19 pandemic: loans forgivable on a tax-free basis and refundable employee retention credits.

The benefits of the PPP forgivable loans and employee retention credits, however, are mutually exclusive — that is, an employer with a PPP loan can’t claim the credits. Also, if multiple entities are treated as a single employer under the aggregation rules and one entity obtains a PPP loan, all entities in the group are precluded from claiming the retention credit.

In the CARES Act, Congress directed Treasury to issue forms, instructions, regulations, and guidance as necessary for the recapture of employee retention credits taken by taxpayers that receive a PPP loan during a subsequent quarter.

Thus, it would behoove eligible employers to identify aggregated groups, determine which program would be more valuable for the group, and ensure its members don’t trip over the rules that could taint each entity for purposes of qualifying for the employee retention credit or trigger a recapture of credits taken.

The interplay between the two programs, however, remains unclear, with questions about potential foot faults within an aggregated group and the consequences for businesses involved in mergers and acquisitions, according to Libin Zhang of Fried, Frank, Harris, Shriver & Jacobson LLP.

Zhang, who spoke during a July 20 webinar sponsored by American Law Institute Continuing Legal Education, said the aggregation rule “uses preexisting tax concepts that are fairly well known to tax practitioners . . . and it’s generally based on more than 50 percent common ownership, with some special rules for constructive ownership and certain types of entities that provide services to each other.”

One aspect that hasn’t been fully resolved for businesses involved in M&As is what happens when a business acquires a company that has a PPP loan or has claimed the credits and that causes the aggregate group to have benefits from both tax provisions, Zhang said.

Zhang posited a scenario in which General MegaCorp — an aggregate group of companies that own different businesses — qualifies for and claims the tax credit for employees not working but still getting paid. 

“That’s fine, but unbeknownst to the mother ship, one member of the group owns a single hotel and applies [for] and obtains a PPP loan,” Zhang said. Because the group cannot obtain both a PPP loan and claim the credit, that could mean that all companies in the group lose their tax credits, creating an “awkward situation” when the members discover that has happened, he said. 

M&A Mayhem

Whether the implications should be different in the M&A context is unclear, according to Zhang.

If General MegaCorp acquires Lamar’s Body Shop LLC, which had obtained a PPP loan, and it becomes a member of the aggregate group — causing it to have a loan — that could thwart any plans of the group and its members to claim the employee retention credit, Zhang said. 

Zhang asked whether “the tax characteristic of having obtained a PPP loan carries along with the entity,” and therefore could invalidate the tax credits for all members in the group. 

Because the aggregate group is based on ownership of more than 50 percent, “you don’t even need to acquire all of Lamar’s Body Shop to have this issue,” Zhang cautioned. 

Questions frequently arise in M&A deals, but “the IRS and Treasury unfortunately have not provided any helpful guidance,” Zhang said.

Treasury and the IRS have clarified in an FAQ that employers that received a PPP loan and repaid it by May 18 will be treated as though they hadn’t received the loan for purposes of qualifying for the employee retention credit.

But absent guidance addressing repayments after that date, “many private equity and strategic buyers are reluctant to acquire a target company that has received a PPP loan because of the potential disqualification of significant employee retention credits by the acquiring aggregate group,” Gary Hecimovich of Deloitte Tax LLP told Tax Notes.

The employee retention credit is fully refundable and applied against the employer’s portion of payroll taxes, but only $10,000 of wages per employee can be counted for all calendar quarters, and the credit is capped at $5,000 per employee.

To be eligible for the credit, an employer must carry on a trade or business during calendar year 2020 and either completely or partially suspend operations in any calendar quarter of 2020 because of government orders limiting commerce, travel, or group meetings, or the employer must have a significant decline in gross receipts during the calendar quarter.

An eligible employer may elect not to apply the employee retention credit for any calendar quarter by not claiming the credit on the employer’s employment tax return.

Qualifying small businesses can forgo the credit and instead apply for a PPP loan that is generally forgivable on a tax-free basis if a specified portion of the proceeds is spent on payroll costs over a covered period and employee levels are retained.

The Art of Negotiation

When questions concerning a target entity’s PPP loan arise, the parties involved in the transaction have considered different approaches, according to Zhang

For example, in some deals the parties have agreed to covenants, while in others they have altered the structure of the transaction to avoid the issue, Zhang said.

Hecimovich noted that acquiring companies are conducting due diligence on the target entity’s PPP loans, including whether the balance will likely be forgiven.

If the PPP loan is relatively small compared with the acquiring group’s potential loss of the employee retention credit, one option is to structure the deal as an asset sale rather than an equity sale, Hecimovich said. In an asset sale, “the target entity that received the PPP loan never joins the aggregated group and the PPP loan obligation” doesn’t transfer to the new group, he explained, but added that an asset sale generally isn’t a feasible option because of other legal liability considerations. 

Thus, many acquiring groups are considering whether the target entity should be required to repay the PPP loan, Hecimovich said. If the PPP loan is repaid before the target entity is acquired, the acquiring group may be viewed as never having received a PPP loan, he said.

But there is some risk that this position could be challenged if the loan is repaid after May 18, 2020,  Hecimovich said. Therefore, the parties will negotiate who bears “the risk that the retention credit will be recaptured without a legislative change or additional administrative relief,” or alternatively, agree to adjust the purchase price for the loss of the employee retention credit, he said. 

Potential Legislative Fix

Hecimovich pointed out that the Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act (H.R. 6800), passed by the House in May, provides a new “no double benefit” rule that would resolve the M&A quandary. 

In the HEROES Act’s provision to improve coordination between the PPP program and the employee retention credit, payroll costs for purposes of determining loan forgiveness would exclude qualified wages taken into account in determining the credit. 

That means an eligible employer could “claim the employee retention credit in any quarter the operative rules are satisfied” if it hasn’t elected out for the quarter, Hecimovich said. But when the employer claims the credit on qualified wages, those wages must be excluded from the payroll costs “during the covered period for purposes of determining PPP loan forgiveness,” he said. 

“The new no-double-benefit [rule] should generally fix the [M&A] problem and permit an aggregated group that has already claimed the employee retention credit to acquire a target company that has received a PPP loan without triggering a recapture of the employee retention credit,” Hecimovich said. 

The target entity “should continue to qualify for PPP loan forgiveness as long as [it] does not claim an employee retention credit on the same qualified wages after it joins the aggregated group,” he added. 

Hecimovich pointed out that under the proposed legislation, Treasury and the Small Business Administration must provide additional guidance on “what constitutes qualified wages for employee retention credit purposes when a PPP loan is not forgiven and the employer has elected out of qualification for the employee retention credit.” 

“Presumably that guidance will address the ability of one or more members of the affiliated group to elect out of the employee retention credit for the purpose of counting qualified wages as good payroll costs for PPP loan forgiveness, while other members of the controlled group should remain eligible to claim the employee retention credit on their qualified wages,” Hecimovich said. 

Administrative Remedy

In the absence of a retroactive legislative fix, Hecimovich suggested that Treasury and the SBA amend FAQs to clarify that “a repayment of PPP loan proceeds any time before loan forgiveness should not disqualify the aggregated group from claiming the employee retention credit.”

Hecimovich pointed to principles under the general rescission doctrine as the basis for permitting loan repayments to nullify a transaction as long as the parties are restored to status quo ante. Guidance of that nature appears “to be within the scope of administrative relief that can be provided” if there’s no legislative solution, he said. 

According to Hecimovich, the dilemma for acquiring entities stemming from the no-double-benefit rule will be exacerbated if Congress enhances the employee retention credit — as proposed in the HEROES Act — by increasing the cap from $5,000 per employee to $36,000 per employee.

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