Big PPP Loan Forgiveness Surprises Await Small Businesses

Over the last few months, I blogged about PPP loans maybe a dozen times. I answered hundreds of questions from readers and clients. And I’ve written a short e-book, “Maximizing PPP Loan Forgiveness” for the accountants who will help small businesses with their forgiveness applications.

And an insight from all this frenzied PPP activity: Big surprises await many borrowers.

PPP Surprise #1: PPP Loan Accounting Requires More Precision

A first surprise? Lots of small businesses will find they need to show more precision than usual in their accounting. But let me explain.

For business income tax returns, you can sometimes be imprecise. You don’t always need to worry about small amounts–like capturing every last dollar of tax deduction.

If you report some deduction on the wrong line? It usually doesn’t matter.

Further, if you plop some deduction into the wrong accounting period (this year instead of next year) or you do make an error? Regularly, not giant problem. Often you can fix the error, if you discover it, with an amended return. And sometimes you can fix a small error by just recording a correction in the current year.

PPP loan accounting, in comparison, requires way more precision.

You need to handle individual transactions correctly to get the right forgiveness amount. Like S corporation shareholder-employee insurance. Like partner self-employment earnings.

You need to do independent contractor vs employee classification right.

You need to get transactions into the right accounting period—because you don’t get another chance next year when you file next year’s tax return.

Finally? Say you do make a $100 PPP accounting error. That $100 error means you either cheat yourself or cheat the government $100 of forgiveness. The “marginal rate” equals 100%.

And what if the error is $1,000 or $10,000?

The unforgiving nature of PPP accounting? The extra precision required? That’s going to surprise folks.

PPP Surprise #2: Substantially More Documentation Than We’re Used To

Another surprise? How good a borrower’s documentation needs to be in order to substantiate the spending that leads to forgiveness.

Income tax returns work on an honor system in most cases. In nearly all cases, in fact.

You put down a number for some deduction. The IRS and state revenue agency almost always accept your amount. And that’s that.

In comparison, for PPP loan forgiveness, borrowers need to substantiate amounts with things like cancelled checks and substantiate timing using bank statements.

Further, for potentially forgivable costs like self-employed “owner compensation replacement,” mortgage interest, rent and utilities, a borrower needs to prove the cost has been paid consistently or historically.

The PPP loan forgiveness a self-employed person receives for owner compensation, for example? That doesn’t just depend on the borrower’s spending during the covered period. It depends on the previous year’s tax returns.

The PPP loan forgiveness a borrower receives for mortgage interest, rent and utilities spending? To get forgiveness, a borrower needed contracts in place before February 15, 2020.

Most borrowers won’t be used to supplying this level of documentation—stacks and stacks of paperwork. And some borrowers, frankly, lack the paperwork organization systems to do so.

Tax accountants often say stuff like, “Taxpayers lose on IRS audits when they can’t substantiate deductions.”

This PPP loan forgiveness process, in my opinion, will lead to similarly unhappy outcomes for similar reasons for many borrowers.

PPP Surprise #3: Some Borrowers Should Stop Worrying About Forgiveness

A final surprise to mention.

As you probably know, a borrower loses forgiveness if it spends too little on payroll costs, reduces headcounts, or makes excessive salary or hourly wage cuts.

A firm, for example, that cuts its workforce by a half might lose half its forgiveness.

This risk leads some borrowers to assume one should spend as much as possible on payroll… and then to avoid reductions in headcounts and pay rates.

But some borrowers need to stop worrying about forgiveness and instead focus on getting through the storm.

The Paycheck Protection Program Flexibility Act, signed into law in early June, lets a borrower consider the option of going into hibernation mode for 24 weeks. And that option may mean not only that a borrower survives the pandemic but that the loss of PPP loan forgiveness doesn’t matter anywhere near as much as one might guess.

Say, for example, that a borrower with $40,000 a month in average payroll costs receives a $100,000 loan. Further say that the borrower sees two options.

Option #1 uses the 8-week covered period spending window

The borrower can spend $40,000 a month on payroll and $10,000 a month on mortgage interest, rent and utilities.

Let’s assume for simplicity that four weeks equals a month.

In this case, that spending results in full forgiveness in a couple of months. And that’s great. But what if the economy hasn’t yet reopened?

Option #2 uses the 24 week covered period spending window

As an alternative, the borrower might halve its workforce and so spend only $20,000 a month on payroll but that same $10,000 a month on mortgage interest, rent and utilities.

Over six months, the borrower spends therefore $120,000 on payroll costs and $60,000 on mortgage interest, rent and utilities. So, a total of $180,000.

Note: Again, I’m assuming four-week months to keep the math simple.

That total $180,000 of eligible-for-forgiveness spending gets reduced by 50 percent because of the 50 percent reduction in the employee head count. And that means the borrower only receives $90,000 of forgiveness on the $100,000 PPP loan.

But in this case, maybe the borrower successfully uses the PPP loan funds to get through most of the really rough patch.

I’m thinking here about places like a restaurant or gym or preschool where public health directives have shuttered the doors. Or drastically curtailed operations.

The surprise here? Or maybe “surprises,” plural? Not only should some borrowers reduce headcounts and pay rates if that’s what it takes to survive, but these employers may not lose much forgiveness by taking this route.

Three Quick Comments to Close

First, I hope you’re not offended to read here that I think your small businesses surviving matters most. But we (your neighbors, customers, suppliers and so on) need you to get through this storm and then as soon as possible rehire folks and start supplying the products and services we all depend on.

Second, if you want to know exactly what documentation you need to substantiate your forgivable spending, grab a copy of the 3508EZ PPP Loan Forgiveness application form and instructions. They explain what documents a borrower needs to collect, supply and save.

And, third, regarding maybe considering reducing head counts or pay rates? To figure out how these actions impact your ultimate loan forgiveness, grab a copy of the 3508 PPP loan forgiveness application and instructions and use the PPP Schedule A form and worksheet to work through the two scenarios: the scenario where you don’t reduce headcounts or pay rates… and the scenario where you do.

Other Resources You Might Find Useful

Last week, I participated in a free webinar with the local SBA office and First Citizens Bank. You can view the webinar recording here.

We’ve got lots of resources here at the website including discussions of how a borrower loses forgiveness through FTE adjustments and reductions in salary or wage pay rates. But the full list of PPP posts appears here.