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Are Guaranteed Payments ‘Payroll Costs’ for New CARES Act Loans?

Posted on Apr. 6, 2020

Interim guidance on the new forgivable loans to small businesses under the latest coronavirus legislation answers basic questions but leaves some issues on the table for entities taxed as partnerships.

The interim rules were released by the Small Business Administration late April 2, just hours before businesses could begin applying for the new loan program aimed at keeping employees on their payroll during the economic downturn.

The guidance is relatively short and was issued quickly to get the program off the ground and money into businesses’ hands, but some practitioners aren't sure which type of payments constitute “payroll costs” necessary for the loans to be forgiven.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136), signed into law March 27, gave employers options for how to keep paying workers while the nation is on lockdown trying to halt the spread of COVID-19. Those options include an employee retention credit that provides a fully refundable credit against the employer’s portion of payroll taxes, but only $10,000 in wages per employee can be counted for all calendar quarters and the credit is capped at $5,000 per employee.

Employers can forgo that credit and instead apply for a new loan under the CARES Act to help with payroll costs. The CARES Act modified section 7(a) of the Small Business Act to create the Paycheck Protection Program, for which Congress authorized nearly $350 billion to provide guaranteed loans for businesses.

Businesses eligible for the loan include those with 500 or fewer employees with a principal place of residence in the United States, or other businesses in industries that meet applicable employee-based standards.

The businesses must have been in operation on February 15, 2020, and must have paid employee salaries and payroll taxes or independent contractors on a Form 1099-MISC. But the interim rules also state that independent contractors don’t qualify as employees under the program because independent contractors and sole proprietors can apply for the loans on their own.

Under the loan program, the lesser of $10 million or a specified amount under a payroll-based formula can be borrowed. The formula is mechanical, and the interim rules explain how it works: From the aggregate payroll costs for the last 12 months, subtract compensation in excess of an annual amount paid of $100,000, divide that amount by 12, and then multiply the average monthly payroll costs by 2.5.

But the hook is that the loan can be forgiven if at least 75 percent of the proceeds are used for payroll costs in the eight-week period after the loan was made and if employee and compensation levels are maintained.

‘Flying a Little Blind’

The definition of payroll costs in the CARES Act has some practitioners wondering if guaranteed payments to partners can count as payroll costs when determining the amount that may be borrowed under the above formula, as well as for purposes of satisfying the 75 percent use-of-proceeds test so the loans can be forgiven.

Partners who provide services to their partnerships generally can’t be employees of partnerships, so instead of receiving regular Form W-2 wages, they receive guaranteed payments that are reported on their Schedules K-1. Those payments are paid without regard to the performance of the partnership, they don’t reduce partners’ outside bases (except to the extent they reduce the partnership’s business income), and they are deductible for partnerships under section 162 as though paid to an unrelated person as an ordinary and necessary business expense.

The statute defines payroll costs broadly as any compensation to include items such as salary, wages, and commissions. However, the definition also includes “payments of any compensation to or income of a sole proprietor or independent contractor that is a wage, commission, net earnings from self-employment, or similar compensation.”

“As you can see, it does not expressly cover partners or guaranteed payments for services; it speaks to sole proprietors, independent contractors, and net earnings from self-employment,” Louis Vlahos of Farrell Fritz PC said. “If partners are to be covered, we have to apply something akin to an aggregate theory of partnership tax, where every partner is treated as ‘owning’ a piece of every underlying item of the partnership.”

Vlahos pointed out that although guaranteed payments are not treated as wages, they are treated as self-employment income — and they factor into the performance of the partnership similar to wages that are paid to employees.

“This should be compared to those S corporation shareholders who also happen to be employed by their corporation,” Vlahos said. Assuming they are reasonable, those salaries are treated as regular employee wages for almost all purposes, he said, adding that he thinks they will be considered payroll costs, subject to statutory limitations under the loan program.

“Why should guaranteed payments be treated differently?” he asked.

Anthony J. Nitti of RubinBrown LLP said that in recent conversations, lenders said they're concerned that they aren't prepared to start issuing these loans in general, but also that they're unsure how to treat partnership guaranteed payments.

Nitti said two banks recently said they had no idea how to treat guaranteed payments, but he said he doesn't think they should be considered payroll costs.

“As with all things in this bill, it’s fairly ambiguous,” Nitti said. “But guaranteed payments are self-employment income to the recipient and shouldn’t be payroll costs.”

Stuart L. Rosow of Proskauer Rose LLP said he thinks guaranteed payments should count as payroll costs of the partnerships to the extent that they’re treated as net earnings from self-employment.

“I would think that’s a partnership-level item that’s all part of payroll, subject to the limits in the statute,” Rosow said. He said that although there's no guidance, it seems the partnership is the borrower looking to meet its employment needs.

“We’re all flying a little blind here,” Rosow said.

Nobody Knows

The SBA and Treasury plan to release another tranche of guidance on self-employed individuals looking to use the loan program, and because the treatment of guaranteed payments hasn’t been addressed yet, it could be negatively inferred that partners will have to take the loans themselves against their self-employment income, Nitti said.

But another provision in the interim regulations is also creating confusion. The rules say that federal employment taxes imposed or withheld between February 15, 2020, and June 30, 2020, including FICA and income taxes, don’t count as payroll costs.

“I have no idea what the significance is of that period or how you factor it in when the time period isn’t even over,” Nitti said. Those items shouldn’t factor into the payroll costs at all but should instead factor into what is eventually forgiven, he said.

“Nobody knows how to make any sense of that — nobody,” Nitti said. “I’m getting emails all over the place trying to make sense of this.”

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