SC&H’s Key Takeaways
- The new COVID-19 relief bill (“Consolidated Appropriations Act, 2021”) permits sole proprietors, independent contractors, and eligible self-employed individuals as first-time borrowers.
- Also eligible for round 2 of PPP are second-time borrowers who meet certain requirements, including a substantial revenue reduction in at least one quarter of 2020, as compared to 2019.
- The maximum PPP loan amount that a sole proprietor or self-employed individual can borrow is $20,833, unless the business has other employees.
- The maximum amount that a sole proprietor or self-employed individual can claim as Owner Compensation Replacement (OCR) is $20,833 which could make their entire PPP loan 100% forgivable.
- The forgiven amount a taxpayer claims as OCR can be used for any purpose and is tax-free.
- A borrower is likely not able to claim unemployment benefits during the 8-week or 24-week forgiveness period.
- Sole proprietors and self-employed individuals can claim forgiveness via the new simplified forgiveness application process.
With the Consolidated Appropriations Act, 2021 that was signed into law on December 27th, new Paycheck Protection Program (“PPP”) provisions were adopted that have a significant impact on self-employed individuals. The new round of PPP loans, or PPP2, will now permit first-time borrowers from the following groups:
- Businesses with 500 or fewer employees that are eligible for other SBA 7(a) loans.
- Sole proprietors, independent contractors, and eligible self-employed individuals.
- Not-for-profits, including churches.
- Accommodation and food services operations (those with North American Industry Classification System (NAICS) codes starting with 72) with fewer than 300 employees per physical location.
For those who received PPP loans previously, a second round of forgivable PPP loans are available, but only if the following additional eligibility rules are met:
- The business employs no more than 300 employees per physical location;
- The business has used, or will use the full amount of its first PPP loan; and
- The business has experienced at least a 25% reduction in quarterly revenues in at least one quarter of 2020, as compared to the same quarter of 2019.
PPP loan applications are available through banks and lending institutions qualified as SBA lenders.
The focus of this article will be on the impact these new provisions have on self-employed individuals and sole proprietors who file Schedule C (Profit or Loss from Business) or Schedule F (Profit or Loss from Farming).
How PPP Loan Forgiveness Works for the Self-Employed
Loan amounts for sole proprietors are calculated based on 2019 net profit (line 31 of 2019 Form 1040, Schedule C), divided by 12, to get a monthly “average” net profit. The monthly “average” multiplied by 2.5 is equal to the amount of PPP loan a sole proprietor can receive, subject to a maximum loan of $20,833.
Self-employed individuals can automatically receive two-and-a-half months’ worth of net profit forgiven through a mechanism called Owner Compensation Replacement (OCR).
Owner Compensation Replacement
Because sole proprietors do not pay themselves through payroll, the concept of OCR allows them to claim all or a portion of their loan to make up for lost income due to COVID-19. This is in contrast to businesses who must use their PPP loans on certain eligible expenses such as payroll, rent, covered mortgage interest, and utilities in order to be forgiven.
The maximum PPP loan a sole proprietor can receive is based on an annualized salary of $100,000 which caps the loan amount at the lesser of $20,833, or net income multiplied by 2.5/12. Note that this compensation cap applies across all businesses in which a taxpayer has an ownership stake. With this calculation, this is the entire PPP loan, assuming the loan did not factor in payroll costs associated with non-owner employees.
With this, there are important factors to consider. If a PPP loan number was assigned on or before June 5, 2020, a taxpayer can elect either an 8-week or 24-week forgiveness period. If the loan was taken after June 5, 2020, a 24-week forgiveness period is automatic. If an 8-week forgiveness period is elected, the maximum amount that can be claimed as OCR is $15,385 (8 weeks of earnings at an annual rate of $100,000). As a result of this limitation, any remaining PPP funds would need to be spent on qualified business expenses as mentioned above. Finally, if there is any amount of the loan left unforgiven, the loan can be repaid over 2 years (if taken out before June 5, 2020) or 5 years (if taken out after June 5, 2020) at a 1% interest rate. Finally, if a business is new (i.e., no Schedule C or F in 2019), a taxpayer can use the net profit from January and February 2020 that they would report on Schedule C to calculate the amount of loan. This amount is capped at $16,667 ($100,000 / 12 x 2).
Benefits and Drawbacks to Owner Compensation Replacement
There are some significant benefits to being able to claim PPP loan proceeds as OCR. Perhaps the greatest benefit is that since the entire loan can be forgiven under OCR, the proceeds from the loan can be used for personal purposes. Another significant benefit is that loan forgiveness is tax-free and, as a result of the new legislation, business expenses paid with forgiven PPP loans are tax-deductible.
Be careful, however, as some states may have different rules that impact on the deductibility of expenses paid with PPP loan funds.
One drawback to consider is that, since OCR is considered income for unemployment insurance purposes, it is not very compatible with unemployment benefits, including PUA (Pandemic Unemployment Assistance). A taxpayer must claim 10 weeks’ worth of net profit over the entire 24-week (or 8-week) forgiveness period. After the PPP covered period, though, a taxpayer can resume collecting unemployment benefits, if otherwise eligible.
Finally, note that it may not be advantageous to apply for forgiveness early. This is because if forgiveness is filed early, a taxpayer may not be able to claim the full 24 weeks of OCR because one can only apply for forgiveness on amounts already “spent”.
How to Claim OCR
To claim forgiveness based solely on OCR, a taxpayer should complete the PPP Loan Forgiveness Application, Form 3508S, and submit it to the lending bank along with any other bank-required documentation. Form 3508S is a simplified form, allowing for self-certification of eligibility for forgiveness.
We expect that the SBA may release updated loan forgiveness applications, including simplified versions, in order to address second-draw loan certifications and other technical changes associated with round 2.
Borrowers are required to retain relevant records of employment for four years and other records for three years as the Small Business Administration (SBA) may review and audit these loans to check for fraud.
With the new COVID-19 relief bill, self-employed individuals and sole proprietors who file Schedule C or Schedule F with their individual tax returns have a renewed opportunity to access capital to assist them through the COVID 19 pandemic. With the ability to claim Owner Compensation Replacement, a self-employed individual’s PPP loan could be completely forgiven and used for personal purposes. While the prospect of this is enticing, there are also traps for the unwary and it is important to stay up to date on ongoing changes in legislation and to discuss question and concerns with your tax advisor.
If you have any questions about how this will impact you, please reach out to the SC&H Group Team.