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On October 26th the SBA sought formal approval from the Office of Management and Budget to make use of two new forms, SBA Form 3509 and 3510, to request that PPP borrowers who received a loan of $2,000,000 or more must answer a series of questions that will be used by the SBA to determine whether the current economic conditions made the loan “necessary… to support the ongoing operations of the [business].” The Form states that it will be due to the lender servicing the PPP loan within ten business days of receipt from the lender, which does not give borrowers much time to compile documentation or to review answers with their advisors.
This “necessity requirement” is discussed at length in our blog post entitled Was Your PPP Loan ‘Necessary’? If Not, There Could Be Horrific Repercussions, and will fortunately not apply to the vast majority of borrowers who received loans that were less than $2,000,000.
The $2,000,000 limit is based upon aggregating all loans received by affiliated entities. The SBA uses four tests to determine if affiliation exists which are as follows:
- Affiliation based on ownership – Affiliation exists based on ownership of, or the power to control, more than 50 percent of voting equity.
- Affiliation arising under stock options, convertible securities, and agreements to merge – The SBA treats options, convertible securities, and agreements as though the rights granted have been exercised in determining if affiliation exists.
- Affiliation based on management – Affiliation can exist when officers, members, or partners control the management of one or more other business concerns.
- Affiliation based on identity of interest – Affiliation can exist where there is an identity of interest between close relatives such as where the close relatives operate concerns in the same or similar industry in the same geographic area).
By way of review, the above-referenced “necessity language” was included in the original CARES Act, but generally ignored by borrowers who had great concern that the economic downturn would negatively impact their operations and eliminate profitability.
Many PPP borrowers viewed the program to be a governmental relief act that all similarly situated businesses and/or charities should be entitled to, notwithstanding whether the business or charity had significant negative reaction to the COVID-19 crisis, and also notwithstanding whether the business was well funded. This was until SBA issued FAQ 31 which stated that Borrowers must take “into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business.”
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As an example, two almost identical pizza restaurants that could be profitable on take out and delivery services could have had the same exact payroll, overhead, personnel, and challenges, while one restaurant company happened to have $2,000,000 in its bank account because its owners ran it conservatively, while another might have had only $100,000 in its bank account.
The restaurant company with $2,000,000 in its bank account would have certainly felt “entitled” to receive the same forgivable loan as was received by its competitor with $100,000 in its bank account, and even $2,000,000 may not have seemed like enough money to keep the restaurant going, given the profound challenges that could have been experienced if there had been a long term shut down.
Assuming that both restaurants received a $2,000,000 PPP loan, should the restaurant that was already well-funded have returned the loan? Maybe, but given the uncertainty that existed at the time of the application, and the fact that we are now eight to nine months into this crisis with no clear end in sight, requesting a PPP loan to support operations while maintaining reasonable cash reserves in the business to be used after the 2 1/2 months of support provided by the PPP loan would certainly seem like a prudent and reasonable business decision.
Now both restaurants will be filling out the questionnaires, which can be viewed by clicking [HERE].
The questions asked on both the for-profit and non-profit versions of the questionnaire indicate that the SBA is going to take a hard look at the legitimacy of the loans, and try to ensure that SBA loan benefits are available to those who need them most. Some of those questions include the following:
- During the loan forgiveness covered period of the PPP loan, were any of Borrower’s owners who work at Borrower compensated by Borrower in an amount that exceeds $250,000 on an annualized basis?
- Has Borrower paid any dividends or other capital distributions (other than for pass-through estimated tax payments) to its owners?
- Between March 13, 2020 and the end of the loan forgiveness covered period of the PPP loan, has Borrower prepaid any outstanding debt (i.e., paid before contractually due)?
- Did Borrower directly receive any funds from any CARES Act program other than PPP, excluding tax benefits?
- What was the Borrower’s gross revenue in the second calendar quarter of 2019 and 2020?
- Was the Borrower subject to a shutdown order?
- As of the last day of the calendar quarter immediately before the date of the Borrower’s PPP loan application, how much did Borrower own in cash and cash equivalents?
The SBA’s FAQ 46 indicated that it would not challenge the necessity of loans under $2,000,000. Though this means that borrowers who receive less than $2,000,000 in loans will not be asked to fill out such questionnaires, that does not necessarily mean that such loans may not be challenged by other governmental agencies, whistleblowers, or even the general public.
Time will tell what occurs with respect to the above $2,000,000 loan borrowers, but hopefully the resilience of the economy and smart business adaptation will permit them to repay whatever portion of the loan will be necessary to settle with the SBA in situations where the necessity issue comes up.
It seems certain that the SBA will not be able to live up to the time table that was published by the SBA on June 26, 2020, which gives banks only sixty (60) days from the receipt of a forgiveness application to review and forward it to the SBA, and gives the SBA only ninety (90) days to then review and approve forgiveness.
Quite likely it will be many years before a good number of PPP loans are forgiven, based upon the issue of necessity.
This will cause even more uncertainty on the tax end – – the IRS has announced that PPP monies used to pay expenses that result in forgiveness are not tax deductible, therefore making PPP loans taxable to the extent of forgiveness.
PPP Borrowers who believe that the necessity of the loan will be challenged have to decide whether to take the tax deduction for the expenses paid in 2020, which may be viewed as evidence that they believed that their loan would not be forgiven.
Borrowers should remember that there is no CPA-client privilege under the federal evidence laws. Borrowers who believe that there may be issues relating to their loans should hire a lawyer under the attorney-client privilege, who may in turn hire an accounting firm or other financial professionals to assist in the determination of what portion of the loan was necessary, and what portion, if any, should be returned. Using the CPA firm that issues financial statements and tax returns for the Borrower may be risky, even if they are hired by a law firm for this purpose, since the attorney-client privilege would not apply for work or communications not directly associated with the subject matter of the legal representation.
I will keep you posted as further guidance is provided.