As banks start to accept applications for Paycheck Protection Program (PPP) loan forgiveness, there are several key factors that government contractors should consider prior to determining whether forgiveness is right for them.
Impact on Indirect Cost Rates
The Office of Management and Budget has indicated that the government should receive a credit or reduction in billing for costs paid with forgiven PPP dollars. The credit would be required for contracts subject to Federal Acquisition Regulation (FAR) Part 31 (flexibly priced contracts and those in which certified cost and pricing data is required). As a result, issuance of credits in accordance with FAR 31.201-5 would result in a reduction in cost pools and bases that must be carefully reviewed.
For example, let’s look at the impact of PPP loan forgiveness on a cost-plus government contractor with a PPP loan for $760,417 that was used in totality to pay labor costs. Changes in indirect cost rates based on a three-tier, total cost input, indirect cost rate calculation are as follows:
As you can see, the reduction in claimed costs paid with forgiven PPP loan dollars results in an increase in indirect cost rates. The increase in rates is caused by a reduction in claimed labor costs for credits to reduce claimed costs for amounts paid with forgiven PPP dollars. On the surface, the reduction in claimed costs appears to be in the contractor’s favor given the increase in the billable rate per dollar of direct labor from $1.54 to $1.65. To accurately evaluate the impact of PPP loan forgiveness on cashflow, contractors need to consider the impact of changes in rates on contract billings.
Impact on Contract Billing
Continuing the example, let’s assume the contractor has $3,000,000 of direct labor which is reduced by credits of $670,956 for the portion of PPP loan forgiveness related to direct labor costs, no rate caps and available contract funding. The impact on billing is as follows:
From this analysis, we should note that while the billable rate for every dollar of direct labor increased from $1.54 to $1.65 due to PPP loan forgiveness, the contractor experienced a reduction of $806,110 in billings. This result is due to the reduction in billable labor costs by amounts paid with forgiven PPP dollars.
In this analysis, the reduction in contract billings exceeds the total amount of PPP loan forgiveness of $760,417. Given the impact of PPP loan forgiveness on billings, this contractor may initially determine that applying for PPP loan forgiveness is not right for them. Prior to making a decision, additional analysis to review loan forgiveness impact on taxable income and cashflow is necessary.
Impact on Deductibility of Business Expenses and Taxable Income
The CARES Act states that proceeds from PPP loans are not included in the borrower’s gross income but there is no guidance in the Act regarding whether borrowers can claim business expense deductions for expenditures paid with forgiven PPP dollars.
Uncertainty exists on how Section 162 of the Internal Revenue Code will apply to costs paid with forgiven PPP dollars. Under Section 162 of the Internal Revenue Code, deductions are not allowed for an otherwise allowable deduction that was paid with tax-exempt income. Given the uncertainty, the guidance suggests that costs paid with forgiven PPP dollars are nondeductible. As a result, contractors will lose deductions for deductible costs paid with forgiven PPP dollars.
Using the same contractor, the income tax effect of PPP loan forgiveness is as follows (assuming a blended passthrough income tax rate of 35%):
In this example, the reduction in contract billings of $806,110 is greater than the loss of tax deductions of $760,417 resulting in a lower taxable income upon forgiveness of the PPP loan. This outcome is entirely dependent upon the current IRS position that deductions will not be allowed for deductible costs that are paid with tax-exempt income. A change in the allowability of deductions for costs paid with forgiven PPP dollars will significantly impact this analysis and should be considered. The reduction in taxable income results in a lower tax liability but a full analysis of the impact of PPP loan forgiveness requires an examination of cash flow.
Impact on Cash Flow
The impact of PPP loan forgiveness on cash flow can vary significantly depending on the unique circumstances of each contractor. Government contractors should complete a detailed cash flow analysis to compare cash needed to pay income tax obligations, cash from contract billings at adjusted indirect rates (with and without indirect rate caps) and cash to repay the PPP loan if not forgiven.
Net cash flow in this example is as follows:
This simple example highlights that net cash flow with and without PPP loan forgiveness is generally comparable for a government contractor that does not have indirect cost rate caps. Had the same contractor had a cap on their indirect cost rates, the impact of PPP loan forgiveness on cashflow would be significant, as shown below.
Given the impact that changes in indirect cost rates have on billings and net income, contractors must perform a detailed review their contracts and determine whether adjusted indirect cost rates can be billed prior to applying for PPP loan forgiveness. A comparison of cashflow with and without PPP loan forgiveness that does not incorporate the impact of changes in indirect cost rates would be misleading.
Additional Thoughts - Timing Challenges
The timeline between applying for PPP forgiveness and legal release from the loan obligation adds an additional layer of complexity. Essentially, credits for costs paid with PPP dollars are not due to the government until forgiveness occurs. This creates a situation where credits will be issued in a year in which the costs were not incurred, impacting indirect cost rates and contract billings.
Further complicating matters is the lack of guidance on how to accurately report business expenses for income tax purposes. It is currently not known whether taxpayers should deduct business expenses as incurred and adjust deductions in a subsequent year when the PPP loan is forgiven. Many questions also remain unanswered regarding the impact of potential changes in tax rates and income from operations when forgiveness occurs in a year that is not the same as when the costs were incurred.
As noted in the examples above, a surface level analysis may indicate that PPP loan forgiveness is in the contractor’s favor. Generally, contractors with contracts subject to FAR Part 31 can expect net cash flow without PPP loan forgiveness to be greater than the net cash flow with PPP loan forgiveness. However, rate caps and available funding could change this analysis.
As shown in the example above, changes in indirect cost rates can have a significant impact on billings and net cash flow. Contractors should carefully evaluate whether changes in indirect cost rates are billable under applicable contracts, changes in tax law and their portfolio of contracts by type to properly evaluate the impact of PPP loan forgiveness and make the right decision for your business.
The advisory team at Wall, Einhorn & Chernitzer continues to monitor legislative changes and updates related to COVID-19. The overview included in this article is based upon guidance available as of the date of publication. For questions or clarification on any of the items covered in this article, contact WEC’s Government Contracting Advisory Team.