Two key provisions included in the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”)—the Paycheck Protection Program (PPP) and the Employee Retention Tax Credit (ERTC)—are raising surprising new issues in M&A transactions. The CARES Act prohibits a company that receives a PPP loan from claiming the ERTC and treats affiliated entities as a single employer for purposes of the ERTC. It is unclear whether a company will lose previously claimed and future ERTCs when the company (or its affiliates) acquires, or is acquired by, a company that received a PPP loan.
CARES Act Provisions
The CARES Act allowed certain small businesses to obtain forgivable loans under the PPP in an effort to provide additional funds during the COVID-19 crisis, largely to be used to pay employee compensation. Under the PPP, eligible businesses can have their loans forgiven as long as they use at least 60% of the total loan proceeds to cover payroll costs, utilities, rent and mortgage interest and retain employees at required levels. Loan forgiveness amounts will be reduced proportionately unless employees are rehired or reinstated by December 31, 2020. For more information on the Paycheck Protection Program, please refer to our Program Summary and Paycheck Protection Flexibility Act client notes.
The CARES Act also created the ERTC as a refundable payroll tax credit to incentivize employers to retain employees. The ERTC permits eligible employers claim a tax credit on up to 50% of eligible wages paid to employees from March 13, 2020 through December 31, 2020. To be eligible, employers must have (1) operations fully or partially suspended due to a COVID-19-related shut-down order or (2) gross receipts decline by more than 50% compared to the same quarter in the prior year. The ERTC is capped at $10,000 of compensation per employee, inclusive of health benefits to such employee. For eligible employers with 100 or fewer employees, all employee wages paid qualify as eligible wages for the purpose of the ERTC.
The CARES Act provides that employers cannot avail themselves of both the PPP and the ERTC, and the CARES Act specifically authorizes Treasury and the U.S. Internal Revenue Service (the IRS) to promulgate regulations providing for the recapture of the ERTC if the recipient later receives a PPP loan. Further, the CARES Act provides aggregation rules for employers pursuant to which all members of a controlled or affiliated group under Sections 52(a) or (b) of the Internal Revenue Code (the “Code”) (i.e., generally ownership of 50% or the vote and value) or Sections 414(m) or (o) of the Code, in each case, are aggregated and treated as a single employer. If multiple entities are considered to be one employer under the aggregation rules and one of those entities takes a PPP loan, then none of the other entities in the aggregated group can benefit from the ERTC.
The CARES Act also allows employers to defer (1) 50% of the payment of the employer portion of any Social Security payroll taxes that would otherwise have been required to be paid between March 27, 2020 and December 31, 2020 until December 31, 2021 and (2) the remaining 50% of such Social Security payroll taxes until December 31, 2022 (the “Payroll Tax Deferral”). While the CARES Act originally prohibited a taxpayer from both having a PPP loan forgiven and continuing to benefit from the Payroll Tax Deferral, the PPP Flexibility Act of 2020 provides that a taxpayer can continue to benefit from the Payroll Tax Deferral following the forgiveness of a PPP loan.
In light of these programs, acquiring companies should make it part of their standard diligence process to determine whether the target company or its affiliates have availed themselves of CARES Act relief programs and confirm their eligibility for such relief. Purchase agreements should include representations regarding any PPP loans, any ERTCs received by the target company and any Payroll Tax Deferral under the CARES Act and the target’s eligibility for such relief. Additionally, the purchase agreement should state which party is responsible for any recapture of pre-acquisition target ERTCs or the denial of forgiveness of a PPP loan. Furthermore, the purchase agreement should state which party is responsible for any recapture of pre-acquisition target ERTCs as well as provide that any deferred payroll taxes are treated as pre-closing taxes accrued for in debt or working capital, as the case may be, to ensure that such are the responsibility of the seller, notwithstanding the fact that they will be paid post-closing.
This is of particular importance for potential buyers that have claimed the ERTC or those with outstanding PPP loans because current IRS guidance on the CARES Act does not address the issue of how to apply the above rules where a company that has claimed the ERTC (or an affiliate of such company) acquires, or is acquired by, a company that has received a PPP loan. It is possible that the IRS will look to the fact that the entities were distinct and unrelated at the time at which both applied for the CARES Act benefits. Alternatively, it is possible that the IRS will deny eligibility for the ERTC benefits or require the recapture of prior ERTCs, despite the fact that each entity was previously individually eligible. It is also unclear whether asset acquisitions (or stock purchases treated as asset purchases as a result of an election under Section 338(h)(10) of the Code) could avoid the disallowance of eligibility for one or both of the benefits in instances in which such a transaction would not trigger entity-level taxes (such as where the target is a member of a consolidated group, a partnership or an S corporation). Guidance from the IRS would be welcome to increase certainty in this area.