United States: Cares Act Loans And Business Tax Provisions And I.R.S. Announcements On Stranded Individuals

This article explains important provisions of the Corona Virus Aid, Relief, and Economic Security Act ("CARES Act" or "Act") signed into law on March 27, 2020. As will be seen, the CARES Act is an agglomeration of tax law and rules to assist small business. The concepts do not always mesh easily. It is effective as of May 5, 2020.

PAYCHECK PROTECTION PROGRAM ("P.P.P.")

The P.P.P. authorizes the Small Business Administration ("S.B.A.") to guarantee loans made by lenders on favorable terms to eligible small businesses affected by COVID-19. If qualified, Federally guaranteed loans are available in principal amounts of up to $10 million to be used for specified expenditures. If certain conditions are met, the loan may be forgiven in whole or in part with no adverse income tax consequences. The P.P.P. applies to loans of up to the lesser of $10 million or 2.5 times average monthly payroll.

Which businesses are eligible under the P.P.P.?

The following businesses are eligible to receive a loan under the P.P.P. provided they were conducting operations on February 15, 2020, as demonstrated by salary and payroll tax expenses on that day:

• Any U.S. business concern, veterans' organization, nonprofit, or tribal business concern that employs not more than greater of:
• • 500 employees having the U.S. as their principal place of residence, or
  • The standard in number of employees established by the S.B.A. for the industry of the borrower.
• A business with more than one location is eligible if it employs 500 or fewer employees per physical location and falls within the "accommodation and food services" sector with the North American Industry Classification System ("N.A.I.C.S.") code that begins with 72.
• Sole proprietors, independent contractors, and self-employed individuals may be eligible provided that proper documentation of business operations exists, such as Forms 1099–MISC received from clients and customers who make a payments to an independent contractor in the course of their businesses, or a tax return that reports business expenses on a Schedule C, Profit or Loss From Business (Sole Proprietorship), on Form 1040, Individual Tax Return, or a Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., issued by a partnership or L.L.C.

In determining whether a business concern qualifies for a P.P.P., is it looked at by itself or with affiliates?

For purposes of the determining the number of employees of an applicant to the P.P.P., the S.B.A. looks at the applicant and all its affiliates collectively. Business concerns and entities are affiliates of each other when one controls or has the power to control the other, or one or more third parties controls or has the power to control both. It does not matter whether control is exercised, so long as the power exists. Affiliation can exist under any one of the following four different sets of rules:

1. Affiliation based on ownership. Under this test, a concern is an affiliate of an individual, concern, or entity that owns or has the power to control more than 50% of the concern's voting equity. A minority shareholder may be in control for this purpose if the individual or entity has the ability under relevant organizing documents to prevent a quorum or block action by the board of directors or shareholders.
2. Affiliation arising under stock options, convertible securities, and agreements to merge. Under this test, the S.B.A. considers stock options, convertible securities, and agreements to merge (including agreements in principle) to have a present effect on the power to control a concern. Such options, convertible securities, and agreements are treated as though the rights granted have been exercised if the effect is to make each entity the affiliate of the other. This rule does not apply in order to break affiliation that exists under another rule. The rule is also not applied if the options, convertible securities, or agreements are based on the occurrence of conditions precedent incapable of fulfillment, speculative, conjectural, or unenforceable, or where their probability of materializing is extremely remote.
3. Affiliation based on management. Affiliation arises where the C.E.O. or President (or other officers, managing members, or partners who control the management) of a business concern also control the management of one or more other concerns. Affiliation also arises where the Board of Directors or management of one concern controls the Board of Directors or management of another concern, or a single individual, concern or entity controls the management of the applicant through a management agreement.
4. Affiliation based on identity of interest. Affiliation arises when there is an identity of interest between close relatives with identical or substantially identical business or economic interests. This includes fact patterns involving relatives, individuals, firms with common investments, or firms economically dependent through contractual or other relationships (e.g., an important vendor or customer where 85% of receipts originate with the other party over the last three fiscal years, on average). For relatives, this can include operating similar concerns in the same geography. For common investments, this can arise when individuals or firms own a substantial portion of multiple concerns in the same or a related industry, frequently, doing business with each other, or sharing resources, equipment, locations, or employees, or providing loan guarantees or financial or managerial support to each other. Once the S.B.A. makes the determination to aggregate interests, the conclusion can be rebutted by facts that demonstrate the absence of control. S.B.A. generally defers to the judgment of the S.B.A. lender on this count.

Affiliates must be disclosed on the application form. The affiliation rules for businesses are waived for businesses operating in the accommodation and food services industry, in addition to any business operating as a franchise that is assigned a franchise identifier code by the S.B.A.,² and certain businesses that received Small Business Investment Company financing.

Are foreign-owned business concerns eligible under the P.P.P.?

Yes, although the scope is not entirely clear as of the date of this article. Initially, foreign-owned businesses appeared to be expressly ineligible in the sample application form that was published. However, the troublesome language was deleted in the final application form published by the S.B.A. Anecdotal experience is mixed. Initially, most if not all foreign-owned businesses had their P.P.P. loan applications denied. This has now changed an F.A.Q. 44 discussed below suggests that U.S. subsidiaries can qualify if they meet requirements for the P.P.P.³ Outcomes may be dependent on the bank administering the program and foreign-owned enterprises may have greater chances of succeeding with smaller banks with which they are an important customer under an existing relationship.

The open question is whether guarantees by U.S. management will be required as is normally the case in other S.B.A. loans to foreign-owned businesses, such as the Economic Injury Disaster Loan Emergency Advance Program ("E.I.D.L."). For E.I.D.L. loans that are issued to business concerns that are not foreign-owned, guarantees are required from the owners of the business. For such loans issued to foreign-owned business concerns, security must be posted, and management guarantees are required. See pages 121 and 122 of the S.B.A.'s Standard Operating Procedure (SOP) 50 10 5(K), Subpart B, Chapter 2.

On what date must a business actually be operating?

The business must have been operating on February 15, 2020, as demonstrated by the payment of salary and payroll taxes or the payment of fees to independent contractors and the reporting of such fees on Form 1099–MISC in prior years.

In what circumstances can a business concern that meets the eligibility test be disqualified from applying for a P.P.P. loan?

A business concern can be disqualified in any of the following circumstances:

• It is engaged in any activity that is illegal under federal, state, or local law.
• The claim for employment relates to household help such as nannies or housekeepers.
• An owner of 20% or more of the equity of the business concern is incarcerated, on probation, on parole, presently subject to an indictment or has been convicted of a felony within the last five years.
• The business concern or any business owned or controlled by the concern or any of its owners has obtained a direct or guaranteed loan from the S.B.A. or another Federal agency that is currently delinquent or for which there has been a default within the last seven years and as a result caused a loss to the government.

How is the eligible loan amount determined?

An eligible borrower may borrow up to $10 million, subject to a cap. The cap is 250% of the average total monthly payroll costs incurred during the preceding year.

Payroll costs includes the sum of all payments for employee compensation, including salary, wages, commissions, cash tips, payment of vacation, parental-, family-, medical-, or sick-leave, allowance for dismissal or separation, payment required for group health benefits (including insurance premiums); payment of retirement benefits; or payment of state or local tax assessed on employee compensation. Employee compensation is capped at $100,000. In broad terms, this means that monthly salaries taken into account are capped at $8,333.33. Salaries paid to employees outside the U.S. are not taken into account.

For sole proprietors or independent contractors, the sum of payments of any compensation to a sole proprietor or independent contractor that is a wage, commission, income, net earnings from self-employment, or similar compensation, is taken into account up to $100,000 in a year.

How must the loan be used in order to be eligible for forgiveness, discussed below?

During the covered period, the proceeds of a loan received under the P.P.P. may be used for the payment of

• payroll costs,
• rent and utilities, and
• interest on any mortgage obligation and any other debt obligations incurred prior March 1, 2020.

Payroll costs consist of compensation to employees whose principal place of residence is in the U.S. Compensation includes salary, wages, commissions, or similar compensation. Also included are

• cash tips or the equivalent are included in compensation based on employer records of past tips or, in the absence of such records, a reasonable, good-faith employer estimate of such tips;
• payments for vacation, parental, family, medical, or sick leave;
• allowances for separation or dismissal;
• payment for the provision of employee benefits consisting of group health care coverage, including insurance premiums, and retirement;
• payment of state and local taxes assessed on compensation of employees; and
• for an independent contractor or sole proprietor, wage, commissions, income, or net earnings from self-employment or similar compensation.

Although at the time of this writing there is no official guidance on point, self-employment income in the context of a partnership generally is thought to be covered in self-employment income. The key issue here is the way self-employment income is measured for this purpose. One possible way looks to a partner's distributive share of income that is subject to self-employment tax. Another measure might be keyed to guaranteed payments received by partners.

What is the interest rate for a P.P.P. loan and the maturity date and is there a prepayment penalty?

The interest rate is 1% and the maturity date is two years from the date of issuance of the funds. The maturity date is significantly shorter than the maximum dated mentioned in the statute, which is ten years. The S.B.A. determined that a two-year term is sufficient because economic disruptions are expected to abate well before then. The maximum interest rate mentioned in the statue is 4% and the S.B.A. initially mentioned 0.5%. However, banks were reluctant to participate if the interest rate were that low.

There is no prepayment penalty on any payment made prior to December 31, 2020.

How does the forgiveness of the loan feature work?

The debt proceeds actually used to pay the following expenses during the eightweek period beginning on the date of the origination of a covered loan can be forgiven mostly or wholly free of income tax, provided that 75% of the proceeds of the P.P.P. are used to fund

• payroll costs (as defined above),
• interest payment on a covered mortgage obligation incurred before February 15, 2020, for which the debt is secured by a mortgage on real or personal property,
• payments of rent obligated under a lease in force before February 15, 2020, and
• payment of utility bills such as electricity, gas, water, transportation, telephone, or internet access for which service began before February 15, 2020

In principle, the amount of the loan used to pay the above expenses for the eight-week period can be completely forgiven. However, the forgiven amount of the loan can be reduced by several factors. As mentioned above, if the 75% allocation to payroll costs requirement is missed, the shortfall will not be forgiven. In addition, and assuming that the balance of the proceeds have been applied to other qualified items, a reduction in monthly average employee headcount or a reduction to any employee's salary greater than 25% will also reduce the portion of the loan that can be forgiven. The monthly average headcount during the period following receipt of funds under the loan is compared to the prior year.

Is forgiveness automatic?

The forgiveness of the loan is not automatic. The borrower must apply for forgiveness to the originating lender including the following:

• Documentation verifying the number of full-time equivalent employees on payroll and pay rates. Payroll tax filings, and unemployment insurance filings can be used for this purpose.
• Documentation including cancelled checks, payment receipts, transcripts of accounts verifying payments of other qualified expenses (including debt obligations incurred prior to March 1, 2020).
• Any other documentation determined to be necessary by the S.B.A.
• In addition, a certification is required from the borrower acknowledging that the amount of the loan that was used to pay the qualified expenses and that the documentation presented is true and correct. As a false certification is a felony, the individual making the borrower's certification has a personal interest in ensuring all representations are true.

The amount of the debt forgiven will not be treated as income from the forgiveness of debt, ordinarily subject to U.S. Federal income tax. Also, as the Federal government will repay the bank, it is expected that the debt forgiveness will not adversely affect credit scores.

Recent Developments

The S.B.A. P.P.P. program ran through all funds appropriated by April 16, 2018. Over 1.6 million loans were granted. As it turned out, some loans were made to publicly traded corporations that were likely not within the definition of a small business for purposes of the S.B.A. rules. Other loans were made to well-endowed universities who had the capital to continue to pay employees. Under public pressure and fear of criminal prosecution for the person signing the loan application, many of corporations and universities announced that the funds would be returned. Subsequently, S.B.A. P.P.P. Q&A guidelines were revised warning publicly traded corporations having substantial market value and access to capital markets that they likely are not able to make a good faith certification that the P.P.P. loan is necessary to support the ongoing operations of the applicant.

On April 24, 2020, a fourth stimulus package was signed into law, the Paycheck Protection Program and Heath Care Enhancement Act. It includes $310 billion to replenish the P.P.P. program, $60 billion for a separate emergency loan and grant program discussed below known as the Economic Injury Disaster Loan program, $75 billion for hospitals and health-care providers, and $25 billion for a new coronavirus testing program.

On April 23, 2020, the S.B.A. issued F.A.Q. 31, in response to the news stories mentioned above. It contains the following language:

The key issue for management and its advisers is to marshal facts carefully meeting the language of the certification regarding current economic uncertainty and the necessity of the loan to support the ongoing operations of the applicant. Helpful facts include year-to-year comparisons of actual and projected operating comparisons, impairment of credit capacity resulting from lost sales, plans already adopted to reduce head count and various costs, and the dedication of existing credit lines for other uses necessary in the business, such as seasonal working capital costs that cannot go unfunded without impairing ongoing operations.

On May 5, 2020, The S.B.A. published F.A.Q. 44. It contains the following language:

Many advisers read F.A.Q. 44 as providing a change in the way the 500-person headcount is applied so that all employees worldwide must be counted. However, that is not the only interpretation that is appropriate. F.A.Q. 44 must be read in conjunction with F.A.Q. 3. Both relate to businesses that are not seeking to qualify as a "small business concern," but nonetheless seeking to be eligible for a P.P.P. loan. F.A.Q. 3 establishes a 500-or-fewer-employee standard for eligibility as an alternative to the "small business concern standard." This alternative looks only to employees whose principal place of residence is in the United States. As the affiliate rule always applied in F.A.Q. 3, F.A.Q. 44 can be read to confirm that the applicant and all its affiliates must combine all U.S. resident employees, no matter which company is the actual employer. Once the combined total of all U.S. resident employees is determined under F.A.Q. 44, that number is applied in determining whether the 500-or-fewer-employee standard for eligibility is met under F.A.Q. 3, applicable to applicants that are not "small business concerns." No further guidance has yet been issued on this point and the ultimate decision likely will be controlled by the outcome of cases that will be brought by the S.B.A. in future years.

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Footnotes

1. Also contributing to this article are Andreas Apostolides, Neha Rastogi, and Lisa Singh.

2. See here.

3. See discussion at "Recent Developments" below.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.