Recent guidance clarifies that retirement contributions for unincorporated sole proprietors are excluded from payroll costs in calculating the maximum loan amount under the Paycheck Protection Program (PPP)—and so can’t be forgiven under the terms of that program.
Specifically, the Small Business Administration on April 20, 2020 published a 3rd Interim Final Rule with guidance for individuals with self-employment income who file a Form 1040, Schedule C. After analysis, it seems clear that the rules for self-employed individuals in the 3rd Interim Final Rule and the two sets of Treasury FAQs on the PPP that have been updated on April 24, 2020 and April 28, 2020 are consistent with the statutory intention of the CARES Act.
Background
The 1st Interim rule that was published laid out the basic structure of the loan program. The second Interim Final Rule provided rules on promissory notes, authorizations, and eligibility for loans. The 3rd final interim rule provides rules for self-employed individuals filing Form 1040, Schedule C. Let’s take a quick look at the rules for self-employed individuals.
First, the 3rd Interim Final Rule applies only to self-employed individuals who file Form 1040, Schedule C, like sole proprietors, partnerships, and LLC’s—not C or S corporations. This results in different treatment of retirement contributions in the amount of the loan and loan forgiveness, depending on whether the business is incorporated. Under the 3rd Interim Final Rule, a self-employed individual is eligible for a PPP loan if:
- they were in operation on Feb. 15, 2020;
- they are an individual with self-employment income (such as a sole proprietor or independent contractor);
- their principal place of residence is in the United States; and
- they filed or will file a Form 1040, Schedule C for 2019.
Second, partners may not submit separate applications. Partnerships can only get one PPP loan, where the self-employment income of general active partners are reported as payroll costs (limited on an annualized $100,000 basis for each partner). Although the 3rd Interim Final Rule does not discuss loan calculations for partnerships, the April 24, 2020 Treasury FAQs do, and the same principles discussed below for sole proprietors apply for partnerships[1].
If a self-employed individual has not filed Form 1040, Schedule C for 2019 yet, they can still get a PPP loan, but must provide the same information used for filing to substantiate the loan.
Do You (or Your Client) Employ Other Individuals?
The 3rd Interim Final Rule calculates the amount of the loan based on whether or not the self-employed individual employs other individuals.
If there are no employees to consider, the Form 1040, Schedule C for 2019, line 31 net profit amount, is first limited to $100,000 (if necessary) to establish the payroll cost. This payroll cost is then divided by 12, and then multiplied by 2.5—and then to that result, is added the amount of any Economic Injury Disaster Loan (EIDL), (reduced by any EIDL COVID-19 loan, if applicable) that the self-employed individual wants to refinance that was made between Jan. 31, 2020 and April 3, 2020 to get the maximum loan amount.
Note: If the above calculation produces a result of zero or less, a PPP loan is not available. Note also that line 31 net profit does not include any retirement contributions made (those are instead reported on line 15, Schedule 1 of Form 1040). Further, the self-employed individual also must provide documentation that they were in operation on or around Feb. 15, 2020.
If there are employees to consider, payroll costs are determined by adding together:
- line 31 net profit amount on Form 1040, Schedule C (capped at $100,000 annualized). If this amount is less than zero, set at zero.
- 2019 gross wages and tips paid to employees (who reside in the U.S.) using 2019 IRS Form 941, line 5c, column 1, for each quarter. Cap at $100,000 annualized for each employee.
- 2019 health insurance contributions (Schedule C, line 14) and 2019 retirement contributions for employees (Schedule C, line 19), and state and local taxes on employee compensation.
These are the payroll costs if there are employees. Then, as above, divide by 12, and multiply by 2.5, and add in any EIDL loan (reduced by any EIDL COVID-19 loan, if applicable) that you want to refinance that was made between Jan. 31, 2020 and April 3, 2020, to get the maximum loan amount. Note that the only retirement contributions used in calculating payroll costs and the maximum amount of the PPP loan are those made for the firm’s employees, not for the owner/self-employed individual. Documentation of the retirement and health insurance contributions made for employees must be provided, as well as the Form 941.
Also, expenses between Jan. 1, 2020 and Feb. 14, 2020 may not be considered because of the lack of verifiable documentation. The 3rd Interim Final Rule notes that additional guidance will be issued for individuals with self-employment income who were not in operation in 2019 but who were in operation on Feb. 15, 2020 and who will file a Form 1040, Schedule C for 2020.
Limitations on Loan Forgiveness for Owners
Finally, the 3rd Interim Final Rule provides information on the amount of the PPP loans that are eligible for forgiveness. Forgiveness applies over the 8-week period following the first disbursement of the loan[2].
As with the 1st Interim Final Rule, at least 75% of the PPP loan must be used for payroll costs. Forgiveness for owner compensation replacement is based on 2019 net profits and is limited to eight weeks (8/52) of the 2019 net profit (limited to $100,000) and does not include retirement benefit costs for owners, only for employees.
The 3rd Interim Final Rule describes in some detail why the 8/52 forgiveness rule is intended to prevent a windfall on owner replacement compensation.
Most self-employed individuals have few of the overhead expenses that qualify for limited forgiveness under the CARES Act, and a windfall would result if the entire amount of the PPP loan (2.5 times monthly payroll, which is about 10 weeks of payroll) were to be forgiven rather than only taking into account 8/52 of the 2019 net profit.
For more details on the step-by-step loan calculations, see the Treasury Dept.'s FAQs.
Martin L. Pippins, MSEA, is Executive Director of ASEA and ARA Director of Regulatory Policy.
Footnotes
[1] For more information on how partnerships’ K-1 returns are used to calculation PPP loan amounts, see Q&A-4 in the April 24, 2020 FAQs.
[2] Just before this article was posted, IRS released Notice 2020-32, providing that IRC section 265 disallows a deduction for an expense to the extent the expense was forgiven under a PPP loan. This treatment would prevent a double tax benefit. Presumably, this would apply to retirement contributions that are included in payroll costs that are forgiven under a PPP loan.
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