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8.26.20 – SSI –  Mitch Reitman 

Dealers and integrators that received EIDL loans may already be in default or have inadvertently broken the law in applying for and receiving them.

Two components of the spring stimulus package were the Paycheck Protection Program (PPP) loans and the Economic Injury Disaster Loan (EIDL) program.

While the PPP was a very generous and hastily designed benefit, the EIDL program was conceived years ago to provide loans to businesses that have suffered from major storms, droughts and other federally-declared disasters.

The Small Business Administration (SBA) has already advanced over $150 billion in EIDL money to borrowers who have verified that they have suffered “substantial economic injury” due to the ongoing coronavirus pandemic.

The maximum EIDL loan amount is $2 million, and the deadline to apply for these loans is Dec. 31. Applicants previously could accept an “advance” of up to $10,000 that is considered a “grant” and does not need to be repaid. However, on July 11 the SBA announced the EIDL advance program has been discontinued and the website provides the following:

All available funds for the EIDL Advance program have been allocated. By law, SBA is not able to issue EIDL Advances once program funding has been obligated and is no longer available. EIDL loan applications will still be processed even though the Advance is no longer available.

EIDL loans bear interest at 3.75% and come with significant loan program requirements that very few borrowers are aware of or have thought about. Many security, fire/life-safety and systems integration companies that received these loans may already be in default or have inadvertently broken the law in applying for and receiving them. This will become more evident in months to come.

While the PPP loans were made by banks — and many of the early loans were made to known, trusted customers — other lenders entered the market and may have originated PPP loans that will not qualify for forgiveness. If there is an issue with a borrower’s PPP loan status, the SBA may start digging into the company’s operations. Whistleblowing employees and others may receive bounties for turning in unassuming employer borrowers who might not even be aware of the issues at hand.

While a great many borrowers consider it to be a duty or an entitlement to borrow under the EIDL program, the standard of need is much higher than the necessity standard that applied for PPP loans. And while an EIDL loan is outstanding there can be no dividends or personal expenses paid by the business entity for its owners, as discussed below.

EIDL Loan Brass Tacks

EIDL loan proceeds cannot be spent on any expenses that were already funded and paid for by PPP loan proceeds or medical practice relief loan payments, and must be spent only on the following:

  • Payroll costs during business disruptions or substantial slowdowns
  • Providing paid sick leave to employees unable to work due to the direct effect of COVID-19
  • Mortgage payments
  • Rent
  • Meeting increased costs to obtain materials unavailable from the applicant’s original source due to interrupted supply chains
  • Repaying obligations other than those listed above that cannot be met due to revenue losses

Further, SBA already considered the following uses EIDL loan money to be ineligible:

  • Payment of any dividends or bonuses
  • Disbursements to owners, partners, officers, directors, or stockholders, except when directly related to performance of services for the benefit of the applicant
  • Repayment of Stockholder (or LLC Member) loans, except when the funds were injected on an interim basis as a result of the disaster and non-repayment would cause undue hardship to the stockholder/Member
  • Expansion of facilities or acquisition of fixed assets
  • Repair or replacement of physical damages
  • Refinancing long term debt
  • Paying down (including regular installment payments) or paying off loans provided, or owned by another federal agency (including SBA)
  • Payment of any part of a direct federal debt, (including SBA loans) except IRS obligations
  • Payment of any penalty resulting from noncompliance with a law, regulation or order of a federal, state, regional, or local agency
  • Contractor malfeasance
  • Relocation

In summary, a very high percentage of EIDL borrowers are in violation of civil and criminal statutes and loan provisions because of one or more of the following:

  • They did not have the degree of Substantial Injury as the law requires when they applied and received the loans
  • They have spent loan monies on prohibited expenses
  • They have paid dividends or personal expenses for their owners

Borrowers often do not realize that the law and the loan agreement prevents them from taking dividends out of their company until the entirety of the loan is paid back. EIDL loans are 30-year loans with an interest rate of 3.75%. This means that theoretically, businesses will not be able to take out dividends for over 30 years if they received an EIDL loan and do not repay it in full.

Most security, fire/life-safety and systems integration companies have elected to be taxed as S corporations (a very good idea). These businesses must pay reasonable wages to their owners and they are required to pay employment taxes. While S corporation owners pay federal income tax on the net income of the business, they are not required to pay employment taxes on these.

It is a typical practice for many small businesses to make distributions to the owners to enable them to pay the taxes, but this is now illegal for those who have received EIDL loans.

S corporation shareholders will be unable to make distributions, either directly or indirectly, to themselves or others without written consent from the SBA. The agreement also broadly defines what is considered a “distribution,” including any advances, loans or bonuses, but remains vague in describing how this consent is to be obtained.

Because of the volume of loans and processing issues, the SBA is almost unreachable by phone, meaning that this consent requirement for any and all distributions is likely to be broken by many without intention.

Even more confusing is the situation of an LLC that is taxed as a partnership or sole proprietorship (default status). The IRS code does not allow owners of a sole proprietorship or partnership to take a salary. They must report and pay taxes on the net income of the entity.  Owners who are active in their businesses typically take distributions, but these may not be allowable under the terms of the EIDL Loan agreement (exclusion number 2 may allow it but this has yet to be clarified by the SBA).

If an EIDL borrower is in default, even a technical default, and has conventional loans, this may be a violation of their loan covenants, possibly placing the associated loans in default and causing much larger issues.

The agreement also requires that any borrower may not relocate his or her business without prior written permission from the SBA and if the borrower receives any funds from non-EIDL sources to help with Coronavirus-related injuries then those funds must be turned over to the SBA. These sources include but are not limited to insurance proceeds, claims for civil liabilities, and grants from other governmental agencies or private entities.

Record Retention Requirements

The SBA requires businesses to keep records of how the EIDL loan proceeds are spent, and provide the SBA with this information by 90 days after the loan is repaid. This means that for businesses that repay the loan on time, they will have to keep financial statements for over 30 years.

What is “Substantial Economic Injury” for purposes of EIDL Qualification?

This is probably the biggest criminal exposure for EIDL borrowers. When applying for an EIDL loan, borrowers had to state the reason the loan was needed was due to a “substantial economic injury.” SBA regulations have long maintained, and the EIDL application reiterates:

“Substantial economic injury generally means a decrease in income from operations or working capital with the result that the business is unable to meet its obligations and pay ordinary and necessary operating expenses in the normal course of business.”

Substantial economic injury is also defined in the U.S. Code of Federal Regulations at Book 13, Code of Federal Regulations, Section 123.300, which states the following:

  1. Substantial economic injury is such that a business concern is unable to meet its obligations as they mature or to pay its ordinary and necessary operating expenses. 
  2. Loss of anticipated profits or a drop in sales is not considered substantial economic injury for this purpose. 

The entire United States has been declared a disaster area because of COVID-19, but proving that the business suffered “substantial economic injury” to the point of being “unable to meet its obligations, or pay its ordinary and necessary operating expenses” may be hard to do for many businesses that have cash on hand from PPP loans that will be forgiven, as well as from other sources.

This is why it is important for businesses to consult with an attorney to better understand if their loan meets the guidelines, and, if not, to repay the loan as soon as possible.

The Trump administration has stated that borrowers are “in big trouble” if they did not satisfy the economic necessity requirements for PPP loans, while nothing seems to have been said about the much higher EIDL loan hurdle. Many EIDL loan borrowers will be well advised to return their EIDL loans, with interest at 3.75%, before whistleblowers become active or governmental agents come knocking.

Collateral Requirements for EIDL Loans

Many EIDL borrowers forgot or were unaware that there was a collateral agreement in the application for loan amounts greater than $25,000. This differs from PPP loans that have no collateral requirements.

The collateral agreement for an EIDL loan is vigorous and will generally prevent the borrower from pledging collateral to any other lender, and may cause existing lenders to declare their loans to be in default if provisions of the existing loans prevent given collateral status to any other lender.

The collateral includes all “tangible and intangible personal property that Borrower now owns or shall acquire or create immediately upon the acquisition or creation thereof.”

The collateral section of the loan agreement also indicates that a borrower will not sell or transfer any of the collateral without written consent from the SBA, unless the collateral is inventory sold in the normal course of business. Additionally, borrowers may not seek any advances on superior liens on the EIDL loan collateral without the written consent of the SBA. This means that if you also have a line of credit, you may not be able to use it to run your business..

Borrowers who received an EIDL payment should be well aware of the rules and regulations related to them. For answers to specific questions, borrowers should speak with a qualified CPA and attorney to best understand the short and long-term requirements for receiving these loans, and may want to start with an attorney who can hire the CPA to keep communications under the attorney client privilege.

The best path forward for many EIDL borrowers will be to pre-pay the loan once it is clear that it is probably not needed, to allow the business to “meet its obligations as they mature, or to pay its ordinary and necessary operating expenses.”

Mitch Reitman is Managing Principal of Reitman Consulting Group, a member of the SSI Editorial Advisory Board and an SSI Industry Hall of Fame inductee.  He can be reached at MReitman@Reitman.US.