Even more CARES Act help for small businesses
Since Congress passed the CARES Act in March, most advisors have become intimately familiar with the act’s Paycheck Protection Program relief package. But fewer are familiar with the ins and outs of several other potential solutions for small-business-owing clients, such as the economic injury disaster loan program, the employee retention credit and the option to defer the employer portion of payroll taxes. Here’s what advisors need to know as the coronavirus crisis drags on:
Emergency grants through the economic injury disaster loan program
Under Section 1110(e) the CARES Act creates emergency grants under the economic injury disaster loan program.
Through Dec. 31, 2020, the Small Business Administration is instructed to provide up to $10,000 to any business which self-certifies that it is eligible for an economic injury disaster loan (as discussed below) within three days after the SBA has received the application. Regardless of whether the EIDL application was ultimately approved (or denied), the applicant does not have to repay the advanced amount.
The SBA has indicated that applicants should use the streamlined online application to request funds.
While the SBA has capped loan amounts to $1,000 per employee, it appears that they may have taken some liberties in interpreting the CARES Act’s plain text. As while Section 1110(e)(3) of the law states rather succinctly that “The amount of an advance provided under this subsection shall be not more than $10,000”, there is no mention of placing any limit on the $10,000 amount based on the number of employees, nor on any other test.
More important details around economic injury disaster loans
The CARES Act also expands the longstanding EIDL program. Unlike loans issued under the PPP, loans via the IEDL program are only available directly via the SBA, and are applied for directly through its website, at https://covid19relief.sba.gov/.
Loans made under the EIDL program may be issued up to a maximum of $2 million, but will often be issued for less as determined by the SBA, based on a borrower’s need and ability to repay the loan.
All loans issued via the EIDL program will carry a fixed interest rate of 3.75% (2.75% in the case of non-profits) and have a maximum maturity of 30 years. Furthermore, payments for such loans may be deferred for up to one year from the date the loan is originated.
Eligibility for EIDL
While typically more restrictive, loans issued under the EIDL program from Jan. 31, 2020, through the end of 2020 (the so-called covered period under the CARES Act), may be issued to most businesses with 500 or fewer employees. Those businesses can include sole proprietors and independent contractors.
And while such businesses need to have been in operation by Jan. 31, 2020, to qualify for such relief, the typical (and longer) 1-year-in-business rule is waived by Section 1110(c)(2).
Note: Certain businesses, such as "sin" businesses, as well as those engaged in illegal activity, are ineligible for such loans.
Businesses must provide evidence of an economic injury, or a likely economic injury (essentially, a temporary loss of revenue as a result of the pandemic), as this will ultimately be used to determine the amount of the loan that the business receives. Notably, economic injury does not mean that a business is on the brink of disaster. Rather, such injury may consist of less severe harm caused by the crisis, such as a decrease in working capital, or increased expenses.
Furthermore, seeking a loan under the EIDL program does not require a business to make the same certification that such a loan is “necessary” due to economic uncertainty as a result of the COVID-19 crisis, as is required when submitting a PPP application.
How the EIDL program streamlines loans
Recognizing the need to get money out to small businesses as quickly as possible, the CARES Act simplifies and streamlines loans under the EIDL program. For one, while applicants seeking loans in excess of $25,000 will have to provide collateral to secure such loans, only loans in excess of $200,000 will require the business owner(s) to provide a personal guarantee.
Even the underwriting process is simplified. Notably, the regular EIDL requirement that a borrower exhaust other credit options prior to seeking a loan under the program is waived. Furthermore, the SBA is authorized to approve applicants based solely on their credit score (or other “alternative appropriate method”).
Eligible uses of EIDL program loan proceeds
Proceeds of EIDL program-issued loans may be used as working capital to pay a variety of expenses, such as payroll liabilities, accounts payable, fixed debts (e.g., rent, mortgage, and equipment and vehicle leases), and other bills that would have been able to be paid in absence of the COVID-19 crisis. Just as important, however, is a sound understanding of what such loan proceeds cannot be used for.
The use of proceeds to refinance long-term debt or the acquisition of new fixed assets is prohibited. Additionally, and perhaps somewhat surprisingly, the proceeds of loans issued under the EIDL may not be used to repair any physical damage to property or to replace such property.
Less surprising, however, are the restrictions on using such funds for bonuses, or for a variety of owner-related “compensation”, including dividends, disbursements to owners (other than for the performance of services [i.e., wages], or to pay most outstanding shareholder loans.
The EIDL program and the PPP are not mutually exclusive. Rather, the same business can qualify for and receive loans under both programs. Notably, if a business received an EIDL loan between January 31, 2020, and April 3, 2020, and the loan was not used for payroll costs, it does not affect eligibility for a loan under the PPP.
If, however, the same loan was used for payroll costs, the business must use a PPP loan to refinance the EIDL loan. The refinanced amount is added to the amount of the PPP loan the business would otherwise be eligible to receive, up to the $10 million cap.
Example #1: Pete’s Pets is a small business that has been struggling because of the COVID-19 crisis. In February, Pete applied for and received an EIDL loan for $50,000, which he has used for payroll purposes.
Pete has since decided to apply for a PPP loan. His average monthly payroll costs for the previous year are $30,000 per month. As such, if approved, Pete would receive a PPP loan for ($30,000 x 2.5) +$50,000 = $125,000.
In addition, regardless of whether the proceeds of such loans are used for payroll expenses or otherwise, a business cannot double-dip by using the proceeds of a loan under the PPP and EIDL program for the same costs.
The reality, though, is that this restriction really isn’t that limiting, as a business can use a PPP loan to cover one type of cost, such as payroll, and use the proceeds received from a loan under the EIDL program to cover different costs, such as rent.
It's worth remembering loans issued under the EIDL program are eligible for a wider array of expenses than those issued under the PPP.
To that end, it’s worth remembering loans issued under the EIDL program are eligible for a wider array of expenses than those issued under the PPP. Accordingly, there may be some expenses of a business for which only the proceeds of an EIDL may be used.
Note: Under the PPP, only qualifying expenses incurred in the first eight weeks following loan origination are available for forgiveness. And since the total loan may be up to 2.5 times the average monthly payroll (or roughly 10 weeks), that may mean some businesses have to spend some money on qualifying expenses, other than payroll, to have the full loan forgiven (or else they won’t spend enough on payroll costs in the only-8-week forgivable period.). However, a business that has seen growth or has otherwise expanded payroll over the last year may have current payroll costs sufficient to eat up 2.5 times the average of the prior year’s monthly payroll.
In addition, the maximum loan available under the PPP is limited to only 2.5 times the business’s average payroll expenses for the previous year (up to a maximum of $10 million). But there’s no guarantee that the economic damage to the business will be limited to that amount, even when looked at with respect to only payroll.
Thus, a business trying to maintain its employee headcount, but for which economic hardship as a result of the COVID-19 crisis persists well into the summer, or beyond, may need additional capital to fund payroll expenses once the proceeds of an initial PPP loan have been used up.
When the employee retention credit beats a forgivable PPP loan
While the Paycheck Protection Program may offer business owners the closest thing to free money they’ll ever see in their lifetimes, for others, a separate provision of the CARES Act may actually provide a better opportunity.
More specifically, Section 2301 of the CARES Act creates a new “employee retention credit.” The credit is a fully refundable credit against an employer’s payroll taxes for wages paid from March 12, 2020, through Dec. 31, 2020. Self-employment taxes, however, while ostensibly meant to replicate the combined employer-employee payroll taxes, are not eligible for this credit (in neither their entirety nor for just the "employer" portion of the tax).
The amount of the credit is equal to 50% of wages paid to employees, up to a maximum of $10,000 of wages per employee. Thus, the maximum credit that may be attributable to any single employee is capped at 50% x $10,000 = $5,000.
But there’s an additional catch.
To qualify for the credit in the first place, a business must either:
- Be fully or partially shut down in any calendar quarter in 2020 due to federal, state, or local restrictions limiting commerce, travel, or gatherings of large numbers of people; or
- Experience a significant decline in gross revenue as compared to the same calendar quarter from the prior calendar year. For purposes of "triggering" the employee retention credit, a significant decline is a drop in revenue of more than 50% compared to the same calendar quarter in the previous year.
If an employer qualifies for the credit because of a full or partial government-ordered shutdown, the credit will remain available until the business experiences a quarter in which it is not fully or partially shut down.
By contrast, if an employer qualifies for the credit because of a significant decline in revenue, then they will continue to qualify for the credit until the quarter after the first quarter in which 2020 revenue exceeds 80% of revenue from the same calendar quarter in 2019.
The various ways the credit may be triggered to start, and stop, can create some really interesting dynamics.
Note that the various ways in which the credit may be triggered to start, and stop, can create some really interesting dynamics. More specifically, it’s possible for some businesses to never become eligible for the credit despite meaningful and sustained drops in revenue, while other businesses, which actually have much better 2020 outcomes, may qualify for the credit in multiple quarters!
Example #2: Abe’s Apples, Brianna’s Bananas and Claude’s Coconuts are three businesses which each had quarterly revenue of $250,000 per quarter in 2019. This year, all three are impacted by the COVID-19 crisis.
As shown in the image, Abe’s Apples experiences a sizable drawdown in the second quarter ($112.5K in 2020 vs $250K 2019, reflecting a 55% reduction in revenue, which qualifies him for the employee retention credit). He recovers relatively strongly in the third quarter and his revenue exceeds 80% of last year’s Q3 revenue. As a result, Q3 is the last quarter in which he remains eligible for the credit.
Brianna’s Bananas, on the other hand, experiences a more sustained drawdown throughout 2020, but one which never reaches the severity (as measured on a quarterly basis) as was experienced by Abe’s Apples. Her lowest quarter was in Q2, reflecting a revenue reduction of 45% ($137.5K in 2020 vs $250K in 2019).
Meanwhile, local government placed restrictions on Claude’s Coconuts, preventing the business from serving customers from the beginning of March 2020 through the end of the year. The restaurant, in which all the menu items feature coconut, pivoted nicely to takeout and delivery service, and experienced only minor declines in revenue (15% revenue reduction in each quarter throughout 2020).
As is apparent from the image, despite the fact that Claude’s Coconuts had the best year out of all three businesses, it was the only business eligible for the employee retention credit in all four calendar quarters, due to its government-imposed restriction to close its dining room.
Conversely, Brianna’s Bananas had the worst year. However, since the business was not shut down due to government order, nor did its revenues in any single quarter ever dip below 50% of the revenues from the same quarter during 2019, it never qualified for the credit.
And because revenue for Abe’s Apples dipped below 50% in the second quarter and did not exceed 80% of 2019 revenue until the fourth quarter, Abe was eligible for the credit for both the second quarter and the third quarter in 2020.
Choosing between a paycheck protection loan and the employee retention credit
It is critically important for small business owners — and their advisors — to understand that the employee retention credit and loans via the PPP and/or EIDL program don’t play nicely with one another. Rather, simply receiving a business interruption loan under either program makes a business ineligible for the employee retention credit.
More specifically, Section 2301(j) of the CARES Act states:
RULE FOR EMPLOYERS TAKING SMALL BUSINESS INTERRUPTION LOAN—If an eligible employer receives a covered loan under paragraph (36) of section 7(a) of the Small Business Act (15 U.S.C. 636(a)), as added by section 1102 of this Act, such employer shall not be eligible for the credit under this section.
In most instances, the ‘free money’ option provided for by the PPP will result in a better outcome for a business than using the employee retention credit. Despite that general rule, however, there are times where forgoing a PPP loan in lieu of the credit can actually result in a net benefit for a small business owner.
This is particularly likely in situations where a business has had to lay off employees (and does not anticipate being able to rehire them soon enough to avoid being penalized with respect to PPP loan forgiveness), and where average salaries of employees are relatively modest.
Example #3: Dave’s Delightful Diner is a small business located in an area that has been hit hard by the COVID-19 crisis and is partially shut down (delivery only) as a result of government orders during the second and third quarters of 2020. Prior to the second quarter, the diner employed 30 workers, who each made $36,000.
Now, due to the coronavirus crisis, the restaurant only employs 10 workers, who each continue to earn $36,000. Furthermore, diner does not anticipate a change in employee headcount before mid-Q3 2020, at the earliest.
The maximum loan available to Dave’s Delightful Diner under the PPP program would be 30 x ($36,000 / 12) x 2.5 = $225,000. Sounds pretty good, right?
But as we begin to impose the restrictions on loan forgiveness under Section 1106 of the CARES Act, that loan begins to look a lot less attractive.
Consider, for instance, the business will have only 10 x ($36,000 / 52) x 8 = $55,384.62 of payroll cost during the first 8 weeks after the PPP loan is received. But remember, the diner has also cut payroll by two-thirds, which means the amount spent on otherwise forgivable expenses must be reduced by two-thirds as well.
As a result, the most ‘free money’ from a PPP loan that Dave’s can qualify for would be $52,384.62 / 3 = $18,461.54. Not a deal. But certainly not the best Dave’s Delightful Diner can do.
Consider this: If Dave’s Delightful Diner used the employee retention credit to help shore up cashflow, total salary paid to each employee would be $36,000 / 2 = $18,000 for the second and third quarters. For purposes of determining the employee retention credit, however, those salaries are capped at $10,000 each.
Nevertheless, applying the 50% employee retention credit on 10 workers’ salaries who each earned at least $10,000 in wages, results in a 10 x $10,000 x 50% = $50,000 employee retention credit! That’s nearly three times(!) the "free money" that Dave’s Delightful Diner would have received if it had forgone the employee retention credit and opted for a forgivable loan under the PPP.
Of course, each situation must be evaluated on its own merits. For instance, while the credit clearly results in more net dollars to Dave’s Delightful Diner in the example above, that would be irrelevant to the business if it didn’t have the money to pay the 10 employees left in the first place. Thus, even in some situations where opting for the credit makes more financial sense in the long-run, a cash-strapped business may still benefit more from an SBA loan to make sure they stick around long enough to see the long-run.
Note: In situations where the employee retention credit would provide more net dollars to a cash-strapped business than the "free money" available via the PPP, the business should make an extra effort to try and secure a non-SBA loan. Such a loan would not impact their eligibility for the employee retention credit.
Payroll tax deferral
Yet another benefit for small businesses created by the CARES Act is the allowable deferral of payroll taxes through the end of 2020. More precisely, eligible employers are able to defer half of their remaining 2020 payroll taxes until Dec. 31, 2021, while the other half will be due on Dec. 31, 2022.
Notably, the employee retention credit is disallowed for businesses receiving loans under the PPP programs; similarly, the ability to defer payroll taxes as described above is only eliminated for those who have any or all of their PPP forgiven (or who have debt canceled under the Treasury Program Management Authority). More specifically, Section 2302(a)(3) of the CARES Act states:
EXCEPTION—This subsection shall not apply to any taxpayer if such taxpayer has had indebtedness forgiven under section 1106 of this Act with respect to a loan under paragraph (36) of section 7(a) of the Small Business Act (15 U.S.C. 636(a)), as added by section 1102 of this Act, or indebtedness forgiven under section 1109 of this Act.
Furthermore, while self-employed people may not use the employee retention credit for self-employment taxes, the payroll tax deferral option is available to self-employed persons for the employer portion (half) of their 2020 self-employed tax liability under Section 2302(b)(1), which states:
IN GENERAL—Notwithstanding any other provision of law, the payment for 50 percent of the taxes imposed under section 1401(a) of the Internal Revenue Code of 1986 for the payroll tax deferral period shall not be due before the applicable date.
Accordingly, 50% of 2020 self-employment taxes are due as normal, 25% of 2020 self-employment taxes are due on Dec. 31, 2021, and the remaining 25% of 2020 self-employment taxes are due on Dec. 31, 2022.
Small business owners, including self-employed persons, who do not have loan amounts forgiven as described above, can combine the payroll deferral benefit with other relief available to them. For instance, a small business could decide to combine the use of a loan under the EIDL program with the ability to defer payroll taxes as allowed under this provision. Similarly, a business which opts to use the employee retention credit could use the credit to offset as much payroll tax as possible while delaying payment of 50% of tax in excess of the credit to Dec. 31, 2021, and payment of the other 50% to Dec. 31, 2022.
Opportunity for financial advisors
The coronavirus crisis created unprecedented challenges for small business owners in what is seemingly the blink of an eye. Thankfully, though, Congress acted quickly and decisively with the creation of the CARES Act.
The good news is that the act creates a variety of potential opportunities for relief for small business owners. The bad news is that the myriad of opportunities can create confusion, and many business owners may not select the best option – or options – to meet their business needs. Complicating matters further is the fact that due to the limited supply of certain relief, such as the currently available amount of PPP loans, there is an urgency to act as quickly as possible.
Ultimately, advisors have an even-greater-than-usual ability to help small business owner clients understand their complex options and to guide them toward an appropriate solution. Getting this right has the potential to help both business owners, themselves, and the many families they may support via their business’s employment of others.