The potential for loan forgiveness is a pillar of the Paycheck Protection Program (PPP), and the high demand for PPP loans has been primarily driven by small businesses expecting a zero-dollar balance at the end of the term. As loans begin to fund, the eight-week “covered period” is beginning for many small businesses. It is imperative that these businesses clearly understand the loan forgiveness requirements of the PPP, as well as the restrictions on a borrower’s use of proceeds.

We expect the SBA to publish additional guidance on loan forgiveness, and this article will be updated when that guidance is issued.  For now, this article summarizes the current loan forgiveness requirements and provides a hypothetical example to help illustrate how they could work in practice.

Use of PPP Loan Proceeds

Under the CARES Act, borrowers may use PPP loan proceeds to pay any of the following:

• “Payroll costs,” a defined term that includes all of the following:
  • salaries and wages (capped at $100,000 on an annualized basis for each employee);
  • payments for vacation, parental, family, medical or sick leave;
  • severance payments;
  • payments required for the provision of group health care benefits, including insurance premiums;
  • retirement benefits; and
  • state and local taxes assessed on the compensation of employees.
• Interest (but not principal) on any debt or mortgage obligations that existed prior to Feb. 15, 2020.
• Rent arising under a lease agreement in force before Feb. 15, 2020. (In the absence of specific guidance or restriction, we presume this applies to both real property and personal property leases.)
• Utility payments (including electricity, gas, water, transportation, telephone or internet access) for which service began before Feb. 15, 2020.

The statute itself does not require any specific allocation of proceeds. However, the SBA’s Interim Rule (and all subsequent SBA guidance) requires borrowers to spend at least 75% of the loan proceeds on “payroll costs,” as defined above. The borrower is responsible for documenting use of proceeds for payroll costs in order to determine the amount of forgiveness. If a borrower uses loan proceeds for unauthorized purposes, the borrower will be required to repay those amounts and could be subject to additional charges from the SBA for knowing violations or misappropriations. If a shareholder, member or partner uses PPP funds for unauthorized purposes, the SBA may have direct recourse against such shareholder, member or partner for the unauthorized use.

Loan Forgiveness, Generally

A borrower may seek loan forgiveness by submitting a request to its lender. The request must include documents that verify their number of full-time equivalent employees and pay rates, as well as the payments on eligible mortgage, lease and utility obligations. To assess eligibility, the lender will evaluate the borrower’s use of proceeds during the eight-week period following the loan’s origination. This eight-week period is also known as the “covered period.” A borrower is eligible for loan forgiveness if it has used at least 75% of the loan proceeds for payroll costs, with any balance going towards covered mortgage interest payments, covered lease payments or covered utilities.

Decrease Based Upon Reduction in Full-Time Equivalent Employees

The amount of loan forgiveness may be reduced if there has been a reduction in full-time equivalent employees. This reduction in loan forgiveness (if any) is calculated by multiplying the amount of loan forgiveness by a fraction. The numerator of the fraction is the average number of full-time equivalent employees of the borrower during the eight-week covered period. The denominator of the fraction is either:

• (a) the average number of full-time equivalent employees of the borrower between Feb. 15, 2019 and June 20, 2019 
  OR
• (b) the average number of full-time equivalent employees of the borrower between Jan. 1, 2020 and Feb. 29, 2020

If the borrower is deemed a “seasonal employer” by the SBA, then the borrower must use subsection (a) above as the denominator. Otherwise, the borrower can choose between (a) and (b) (presumably, whichever is lower).

Decrease Based Upon Salary Reduction

The amount of loan forgiveness is further reduced if employees who made less than $100,000 in annualized wages in 2019 receive a reduction in pay of more than 25% during the covered period. The SBA will be issuing additional guidance on the loan forgiveness element of the PPP, and specific guidance on this provision is warranted to determine how this dollar-for-dollar calculation will work in practice.

Rehiring Employees or Restoring Wages

Reductions in employment or salary that occur between Feb. 15, 2020 and April 26, 2020 can be “cured” and will not reduce the amount of loan forgiveness if, by June 30, 2020, the borrower eliminates the reduction in employees or the reduction in wages, as applicable. There is no requirement that the borrower rehire the same employees; restoring the number of full-time equivalent employees is sufficient.

UPDATE:  In new guidance dated May 3, 2020, the SBA clarified that if a terminated employee rejects a good faith, written offer from the borrower to re-hire the employee at the same salary and for the same number of hours, loan forgiveness will not be reduced with respect to that employee, provided that the borrower has documented the offer and the employee’s rejection of the offer. 

How Does This Work in Practice?

To illustrate how the loan forgiveness works in practice, let’s use a hypothetical example.

Company A is a non-seasonal employer whose business is significantly affected by COVID-19. As a result, Company A terminates the employment of 50 full-time equivalent employees on March 1, 2020. Later, Company A borrows $1 million through the PPP on May 1, 2020. Company A spends all of the loan proceeds on payroll costs, so the full amount is eligible for forgiveness. Company A has an average of 150 full-time equivalent employees between May 1 and June 27 (i.e., the eight-week “covered period”), as compared to (a) the average of 250 full-time equivalent employees it had between Feb. 15, 2019 and June 20, 2019 and (b) the average of 200 full-employees it had between Jan. 1, 2020 and Feb. 29, 2020. For now, assume that Company A did not reduce the pay of any of its employees.

In this hypothetical (and all other things being equal), Company A is eligible for loan forgiveness in the amount of $750,000. Company A would elect option (b) as its “denominator,” and the $1 million would be multiplied by a fraction of 150/200 (i.e., 75%). The remaining $250,000 must be paid back by Company A under the terms of the loan (i.e., at 1% interest over a two-year term).

Now, adjust the hypothetical to assume that on March 1, 2020, Company A also reduced the total salaries of its remaining workers, all of which earned an annualized salary of less than $100,000 in 2019. If the salary reductions during the covered period were more than a 25% reduction from the employee salaries during the most recently completed calendar quarter, the amount of loan forgiveness would be further reduced dollar-for-dollar by the amount of that decrease. The CARES Act isn’t entirely clear on how this amount will be calculated, and it is expected that the SBA will issue further guidance on the issue. But in implementing the salary reductions, Company A should be prepared to repay a portion of the loan proceeds under the terms of the loan.

Finally, assume that on June 1, Company A elects to rehire all the full-time equivalent employees it terminated on March 1, and the company rescinds the salary reductions referenced above. All other things equal, as a result of the action taken by Company A on June 1, the entire $1,000,000 loan is eligible for loan forgiveness.

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