Dealmakers loathe uncertainty. In addition to the challenges of analyzing impacts of COVID-19 on a business and on closing transactions generally, they must navigate myriad issues arising from use of government stimulus loans, grants and other programs – in many cases without clear answers. We have discussed the recently released rules from the Small Business Administration (SBA) for acquiring control of a business that received a loan under one of the most popular stimulus programs, the Paycheck Protection Program (PPP). But as businesses were able to avail themselves of more than one program to weather the economic effects of COVID-19, dealmakers still grapple with doing deals with businesses that have participated in additional stimulus programs, such as the employee retention credit (ERC), without taking on undue risk associated with or adversely affecting the continued participation in these programs.
In order to further help dealmakers understand the rules of engagement for businesses that have used the ERC, the Internal Revenue Service (IRS) recently updated its COVID-19 Frequently Asked Questions (FAQs) regarding the interaction of PPP loans and the ERC in connection with M&A transactions. The IRS guidance adds FAQs 81a and 81b and addresses whether the ERC is affected when an acquiring company (Acquiring Employer) that has claimed the ERC acquires the equity (FAQ 81a) or the assets (FAQ 81b) of the target company (Target Employer) that has a PPP loan.
Under the CARES Act an employer can either obtain a PPP loan or claim the ERC, but not both. The ERC uses an aggregation rule to treat affiliated entities as one employer in order to prevent one affiliate in a group from obtaining a PPP loan and another affiliate in the same group from claiming the ERC. Prior to the updated IRS guidance, it was not clear how the aggregation rules would apply in an M&A context, e.g., whether the ERC of the Acquiring Employer would be subject to recapture if the Target Employer has a PPP loan. The new IRS guidance addresses this issue for equity and asset transactions as summarized below.
In the case of an equity transaction where the Target Employer would be treated post-closing as a member of the Acquiring Employer’s affiliated group under the aggregation rules, FAQ 81a provides three alternative methods that permit the transaction to proceed without affecting or recapturing the Acquiring Employer’s ERC:
- PPP Loan Satisfaction. The IRS guidance states that if the Target Employer fully satisfies the PPP loan prior to the transaction closing date in accordance with paragraph 1 of the October 2, 2020 notice issued by the Small Business Administration (SBA October 2 Notice), the ERC of the Acquiring Employer is not affected and it is not subject to recapture under Section 2301(l)(3) of the CARES Act. The IRS guidance also states that the ERC can be claimed for qualified wages paid on or after the closing date to employees of the Target Employer.
It is not clear why the PPP loan needs to be satisfied “prior to the transaction closing date” as opposed to at the closing, but the Acquiring Employer and the Target Employer should be able to work around this requirement.
- PPP Loan Escrow. The IRS guidance anticipates that a PPP loan may be forgiven (and in the transactions that White and Williams has completed to date where a PPP loan was involved, this is what we have advised), so the guidance permits another alternative where the Target Employer has, prior to the transaction closing date, submitted a forgiveness application to the PPP lender and established an interest-bearing escrow account in accordance with paragraph 2a of the SBA October 2 Notice. In this case, the ERC of the Acquiring Employer is not affected and it is not subject to recapture under Section 2301(l)(3) of the CARES Act. As in the case of the PPP loan satisfaction, the IRS guidance states that the ERC can be claimed for qualified wages paid on or after the closing date to employees of the Target Employer.
- PPP Loan Continuance Post-Closing. The IRS guidance also anticipates the possibility that the Target Employer’s PPP loan will continue post-closing. This scenario would seem to apply if the Target Employer intends to repay the PPP loan without going through the PPP loan forgiveness and escrow process (or some of the proceeds were used for permitted purposes that were not eligible for forgiveness). In this case, the ERC of the Acquiring Employer is not affected and it is not subject to recapture under Section 2301(l)(3) of the CARES Act.
Under this exception, the IRS guidance is allowing the pre-closing PPP loan of the Target Employer to continue, even though the Acquiring Employer has claimed the ERC, by foregoing application of the aggregation rules to the acquisition of the Target Employer. However, unlike the PPP loan satisfaction and escrow exceptions, the wages paid to employees of the Target Employer either before or after the closing date are not eligible for the ERC.
In the case of asset acquisitions, the IRS guidance addresses how the Acquired Employer’s ERC may be affected when the Target Employer’s PPP loan is assumed and when such PPP loan is not assumed:
- No PPP Loan Assumption. The IRS guidance states that the ERC of the Acquiring Employer is not affected and it is not subject to recapture under Section 2301(l)(3) of the CARES Act if the Target Employer’s PPP loan is not assumed in an asset acquisition. This result makes sense because in an asset acquisition the aggregation rules technically do not apply and presumably the post-closing wages of employees of the business being acquired are eligible for the ERC of the Acquiring Employer.
- PPP Loan Assumption. In the case of an asset acquisition where the Acquiring Employer assumes the PPP loan of the Target Employer, the ERC of the Acquiring Employer is not affected and it is not subject to recapture under Section 2301(l)(3) of the CARES Act provided that the Acquiring Employer does not claim the ERC after the closing date for any employee who was employed by the Target Employer on the closing date. This rule seems to apply when the PPP loan is assumed and paid, as well as when the assumed PPP loan is forgiven.
It is clear that the IRS guidance provides a high degree of flexibility in structuring acquisitions without triggering the loss of the ERC by the Acquiring Employer. Tax advisors will also need to work through how these rules apply in the context of “hybrid” transactions that are structured as a sale of equity, but are classified for income tax purposes as an asset sale, such as in the case of a Code Section 338(h)(10) or a Rev. Rul. 99-6 transaction since the FAQs do not specifically reference hybrid transactions. Nonetheless, this guidance is very welcome and it should allow transactions to proceed that were on hold due to uncertainty about the application of the aggregation rules to the ERC in the M&A context.