June 2, 2020
The Small Business Administrator Jovita Carranza and U.S. Treasury Secretary Steven Mnuchin recently announced that recipients of Paycheck Protection Program (PPP) loans of $2 million or more should expect an audit if they apply for loan forgiveness. Here are some tips to position your small business or not-for-profit organization to receive the maximum allowable forgiveness, as well as to prepare for the subsequent government audit.
Important: The Small Business Administration (SBA) has created an audit safe harbor for any PPP loan borrower that, together with its affiliates, received PPP loans with an original amount of less than $2 million. That safe harbor will protect a small borrower from a PPP audit based on its good faith certification. However, the government may still decide to audit a PPP loan for other purposes, such as possible misuse of PPP funds.
The Coronavirus Aid, Relief and Economic Security (CARES) Act created the PPP to help distressed small businesses and not-for-profit organizations during the novel coronavirus (COVID-19) pandemic. PPP loans may be subject to 100% forgiveness if certain criteria are met, and the amounts forgiven are excluded from the borrower’s gross income. This is notable because forgiven debt generally is taxed as cancellation of debt income.
Under current rules, PPP loans may be used to cover the following expenses for eight weeks after receipt of funds:
- Certain employee health care benefits,
- Mortgage interest,
- Utilities, and
- Interest on any other existing debt.
Forgiveness is available for payments for payroll, mortgage interest, rent and utilities. Current guidelines also stipulate that at least 75% of the funds must be spent on payroll and employee benefits. Additionally, loan recipients must also maintain employee and compensation levels during that time period.
Under IRS Notice 2020-32, no deduction is allowed for an expense that’s otherwise deductible if the payment of the expense results in forgiveness of a PPP loan. It explains that, to prevent a double tax benefit, the tax code disallows a deduction for any amount otherwise allowable as a deduction that’s allocable to tax-exempt income (other than interest). The IRS asserts that forgiven PPP funds constitute such tax-exempt income.
Important: Congress is currently considering legislation that would change the rules for PPP loans and possibly expand funding for the program. Contact your tax advisor for the latest developments on this issue.
Track Your Expenses
The purpose of a PPP audit is to ensure that your organization is following the SBA and tax rules for this pandemic-relief loan program. During a PPP audit, you’ll need to provide government auditors with the appropriate documentation and analysis related to the loan and its usage. Don’t wait until you receive notice of the government’s intention to audit your business. As soon as you receive PPP funds, put policies and procedures in place to identify and segregate the documents needed to report how the funds were used.
If possible, one easy solution is to open a new bank account to use exclusively for PPP loan proceeds. Pay only qualifying expenses from this account. That way, all the transactions will be in one place — and government auditors won’t need to access all your organization’s books and records.
Investing the time, effort and expense to segregate data now will help you comply with the auditor’s requests. This will make the audit faster and less burdensome, because you’ll already have the relevant data captured in real-time — rather than having to retroactively recreate the paper trail. This approach also signals your commitment to ensuring compliance with the program’s requirements.
Prepare for Certification
Companies that receive a PPP loan must certify that the funds allowed the business to support its ongoing operations and that the amount forgiven was used to pay employees and for other qualifying expenses. Your organization should have documents and analysis on hand to support this certification.
To demonstrate why a loan is essential to supporting your ongoing operations, create detailed forecasts of your organization’s financial position prior to receiving the loan. This should include a forecast income statement, balance sheet and statement of cash flows. Consider every source and use of funds and base your forecasts on credible, defensible assumptions. Once completed, compare the forecast cash shortfall against the amount received from the PPP.
Consider a Trial Run
Will your PPP practices withstand a government audit? If you’re unsure, consider hiring a qualified external auditor to conduct a test audit. They’ll submit requests designed to mimic the actions of government auditors. They’ll also document where your company’s compliance efforts excel — and which aspects may need to be improved or revised. Contact your CPA firm for more information.