Member Article

On April 3, 2020, small business owners started applying for forgivable loans under the Paycheck Protection Program (PPP) to help keep their workforce employed during the COVID-19 pandemic. As the program got underway, the Small Business Administration (SBA) rolled out important new guidance for small businesses, including an updated loan application form and comprehensive guidance on PPP requirements for borrowers and lenders.

The SBA also clarified the scope of what are known as “affiliation rules” for borrowers seeking to obtain PPP loans (the Affiliation Rule). As discussed in our April 3, 2020 article, “Can Qualified Small Businesses Get a PPP Loan under the CARES Act?,” the affiliation rules are critical because only businesses with less than 500 employees can qualify for PPP loans. As straightforward as that sounds, it isn’t: the employee threshold isn’t limited to one company’s headcount; it is calculated based on who owns the company and whether that owner has controlling stakes in other businesses. If so, the employee count is the total of all workers of that owner’s portfolio of companies.

Fortunately, the SBA Affiliation Rule released on April 3 solves some of the puzzle: Significantly, it clarifies the affiliation rule to suggest that many startups and other small businesses that might otherwise be excluded from seeking PPP loans qualify for assistance. The second piece, although far less far-reaching, is notable: it makes clear that faith-based organizations are not subject to affiliation rules when applying for PPP loans.

Majority Control vs. Plurality Control

We will start with the first piece of the puzzle and its implications for small businesses.

The guidance clarifies which of two SBA tests for affiliation will apply in determining “control” of a particular entity. As such, the Affiliation Rule, as well as a contemporaneously published Summary of the Affiliation Rules for the PPP, make clear that affiliation between multiple entities generally applies only where a single person or entity controls more than 50% of entities' voting equity.

Barring majority equity ownership, the board of directors or CEO is considered to control a company. Where a single entity or individual controls the board of directors, affiliation may need to be tested. Finally, if the company's bylaws or shareholders' agreement allows a minority shareholder to block action of the board of directors or other shareholders, that individual will be deemed to control the entity and affiliation may need to be tested.

When the CARES Act was originally released, it was unclear whether affiliation would be tested under the SBA's majority equity control standard (at 13 CFR section 121.301) or a separate more onerous SBA rule (at 13 CFR section 121.103). Under that standard, affiliation would have been imposed where two or more individuals or entities controlled less than 50% of a business's voting equity, but the aggregate of these minority holdings was large as compared to other stock holding.

The higher control threshold has important implications for startups. Under the PPP loan program, a startup is generally subject to affiliation testing only where a single investor owns more than 50% of the voting stock of the startup (and no individual controls the board of directors). In such a case, the startup must aggregate its employees with the employees of the investor (as well as any other company in which the investor also owns 50% of the voting stock).

In contrast, had the SBA's other affiliation rules applied, minority ownership could have created affiliation. For example, if a startup had two VC investors which each owned 30% of the shares (the other 40% owned by the founders), that startup arguably would have to test for its 500 employees by aggregating its employees with the two VC investors (and other employees of companies controlled by those two VCs). Luckily, the Affiliation Rules make clear that only majority control of a company creates affiliation testing.

Thus, startups should feel relatively confident that they are likely not subject to the affiliation rules provided no single shareholder holds more than 50% of the voting equity of the company and no single individual or entity controls of the company’s board of directors. If a startup does have a majority owner, then that startup must aggregate its employees with the employees of that majority owner (and the other businesses controlled by the majority owner) when testing to determine if it has 500 or fewer employees for PPP loan qualification.

Faith-Based Organizations

As mentioned above, the Affiliation Rule also provides special dispensation for faith-based organizations. There is no affiliation testing between any church, association of churches, or other faith-based organization or entity and any other person, group, organization, or entity that is based on a sincere religious teaching or belief or otherwise constitutes a part of the exercise of religion. Regardless of control, each faith-based organization is eligible for a PPP loan provided it has 500 or fewer employees.

While these two affiliation questions have now been addressed, we understand that members of Congress continue to push for more exclusions to general SBA affiliation standards, particularly for startups. We will provide guidance as any new rules are announced.

Individuals and small businesses with questions about PPP loans or the CARES Act generally can contact Christopher Karachale or the Hanson Bridgett Tax Group.