How banks that make SBA loans are taxed on their fees

Editor: Howard Wagner, CPA

The Paycheck Protection Program (PPP) generated a significant amount of guidance from the IRS (as well as many states) with respect to the tax treatment of the loan forgiveness amount and related eligible expenses for borrowers. However, little has been written about the taxation of PPP loan fees from the lending bank’s perspective. In addition, with the large number of banks that participated in the PPP, there appears to be a renewed interest in the U.S. Small Business Administration’s (SBA’s) other loan programs, including the Section 7(a) program, which has historically been one of the SBA’s most popular loan programs, providing financial assistance to small businesses. This item discusses some of the federal tax issues that arise for banks with respect to loan fees earned through both the PPP and 7(a) program.

PPP loan fees

The PPP was enacted as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, and was expanded under the Paycheck Protection Program and Health Care Enhancement Act, P.L. 116-139; the Paycheck Protection Program Flexibility Act of 2020, P.L. 116-142; and the Consolidated Appropriations Act, 2021, P.L. 116-260. The PPP was created to provide low-interest, small business loans to cover payroll and other costs incurred by small businesses that were facing economic disruption during the COVID-19 pandemic, which would then be forgiven if the borrower used the loan proceeds for a qualified purpose within a predetermined time period.

PPP loans are issued by lenders — primarily banks — and are 100% guaranteed by the SBA. Although the PPP did not provide specific tax benefits to the lending banks, it has had a significant impact on the banking industry. As an incentive to lenders, the SBA pays a substantial “processing fee” for originating loans under the program. The fee is calculated as a percentage of the amount borrowed and is between 1% and 5%, depending on the loan’s size. The processing fee associated with these loans has generated uncertainty as to the tax treatment and timing of taxability of the fees.

One of the questions asked is whether the tax treatment will conform to GAAP. The AICPA addressed certain accounting matters surrounding the book treatment of the loan origination fees in Technical Questions and Answers, Section 2130.44, which states:

Upon funding of the loan, the fee should be accounted for as a nonrefundable loan origination fee under FASB ASC 310-20, Receivables — Nonrefundable Fees and Other Costs. As a result, it should be offset against loan origination costs and deferred in accordance with FASB ASC 310-20-25-2 and amortized over the life of the loan.

Therefore, the income will be recognized either over the life of the loan or through the date the loan is forgiven. Although there is consensus on the book treatment, there is more uncertainty surrounding the tax treatment.

There are two opposing arguments on the timing of when the income should be recognized for tax purposes. Each argument depends on whether the loan origination fee represents a fee paid for a service to compensate the lender and cover the cost of the loan processing or, alternatively, whether it should be considered part of the overall yield on the loan and therefore represents original issue discount (OID).

On the one hand, the SBA refers to the PPP loan fees as “processing fees” to reimburse banks for their costs to process the loan. As such, based on the description and terms of the SBA PPP loan fee agreements, these fees are considered to be for services rather than for the use or forbearance of money, and they are not included in the loan principal. Accordingly, these fees would not represent yield on the overall loan that can be deferred as OID. The taxpayer would therefore recognize the income in the year of receipt in accordance with Sec. 451.

On the other hand, while the PPP loan agreements indicate that the fee is paid to the lender in order to cover the cost of processing the loan, one can argue the fee paid by the SBA would exceed the bank’s internal loan processing costs and therefore represent yield on the overall loan. Regs. Sec. 1.1273-2(g)(2) provides that, in a lending transaction, a payment from the borrower to the lender (other than a payment for property or for services provided by the lender, such as commitment fees or loan processing costs) reduces the issue price of the debt instrument evidencing the loan. Regs. Sec. 1.1273-2(g)(4) further states:

If, as part of a lending transaction, a party other than the borrower (the third party) makes a payment to the lender, that payment is treated in appropriate circumstances as made from the third party to the borrower followed by a payment in the same amount from the borrower to the lender and governed by the provisions of paragraph (g)(2) of this section.

Thus, given that the PPP loan fee may exceed the lender’s cost to process the loan application, an argument can be made that the fee represents an enhancement to the interest yield on the loan and thus should be treated as OID.

Further supporting this argument, in Capital One Financial Corp., 133 T.C. 136 (2009), the U.S. Tax Court noted that:

Courts, including this Court, have held that fees earned by a lender relating to the lending of money are properly treated as interest unless the fee is for a specific service. Although courts look to all the facts and circumstances to determine whether an item of income is a service fee or interest, the primary inquiry is whether the charge compensates the lender for specifically stated services it provided to and for the benefit of the borrower beyond the lending of money.

The Tax Court went on to explain that the mere fact that the fees, charged as a percentage of the loan, are designated as such in the agreements is not enough to support the fact that these are fees for services, unless it can be shown that the funds were used for that specific purpose.

Both positions — that the fees are for services or, alternatively, that they represent OID — have merit. Each bank will have to look at its individual situation and make a determination. Keep in mind that regardless of the side of the argument a bank adopts, the approach must be applied consistently in all years until the loans are fully paid off or forgiven. Additionally, consideration should also be given to sourcing for state tax purposes. Given that these are fees paid by a third party (i.e., the SBA), and not paid directly by the business receiving the PPP funding,Regs. Sec. 1.1273-2(g)(4) applies, as discussed previously. Thus, the fees would be considered as if paid directly by the borrower and should be sourced accordingly, based on individual state sourcing rules, which are beyond the scope of this discussion.

7(a) loan program

Similar to the PPP, the 7(a) loan program is designed to provide loans to small businessesthat might not otherwise qualify for financing through conventional lenders. The loan program’s name refers to Section 7(a) of the Small Business Act of 1953, P.L. 83-163.

While PPP loans are 100% guaranteed by the federal government, only a portion of the 7(a) loans are guaranteed, depending on the loan size. Often, the lender will sell the guaranteed portion of such loans (75% to 85%), retaining the unguaranteed portion and simultaneously entering into a contract with the buyer to retain the servicing rights on the guaranteed portion. The typical sale structure provides for the lender to retain a portion of the cash flow from the interest payments as compensation for servicing the loan. Careful consideration needs to be given as to whether the retained servicing rights, also referred to as “servicing spread,” constitute excess servicing.

Excess servicing is defined in Rev. Rul. 91-46 as the portion of the servicing spread that exceeds the normal servicing and therefore represents a continuing investment in the interest component. The typical servicing fee retained by the lender on 7(a) loans is 100 basis points. In comparison, Rev. Proc. 91-50 provides safe harbors for what constitutes normal servicing, which are generally between 25 and 44 basis points, depending on the size and the type of the loan. In other words, the typical servicing fee on 7(a) loans is much higher than these safe harbors. It is important to note, however, that Rev. Proc. 91-50 only applies to one- to four-unit residential loans, not to business loans. No specific safe-harbor percentage exists for 7(a) loans, but it may be reasonable to consider Rev. Proc. 91-50 as a reference point in determining that a portion of the servicing spread would result in excess servicing.

Given, as discussed above, that the servicing spread on 7(a) loans likely exceeds reasonable compensation, and the bank simultaneously enters into the mortgage servicing contract at the time of sale, the 7(a) loan would be considered a “stripped bond” within the meaning of Sec. 1286(d)(2). This follows from Rev. Rul. 91-46, which provides that: (1) if a taxpayer sells mortgages and at the same time enters into a contract to service the mortgages for amounts received from interest payments on the mortgages, and (2) if the contract entitles the taxpayer to receive amounts that exceed reasonable compensation for the services to be performed, the mortgages are “stripped bonds” within the meaning of Sec. 1286(d)(2). In addition, the taxpayer’s rights to receive amounts under the contract are “stripped coupons” within the meaning of Sec. 1286(d)(3), to the extent they are rights to receive mortgage interest other than as reasonable compensation for the services to be performed.

Accordingly, the basis allocation provisions under Sec. 1286(b)(3) would apply in determining any gain or loss on the sale of the loan, as illustrated in the following example:

Example: A bank originates a 7(a) loan, and the guaranteed portion of the loan is $980,000 of loan principal. The bank sells the guaranteed portion of the loan into the secondary market for $1 million. The bank simultaneously enters into an agreement with the buyer to retain the servicing rights on the guaranteed portion of the loan. The taxable gain on the sale of the 7(a) loan will be $25,845, based on the assumptions shown in the table, “Assumptions in the Example,” (below).

Final note

With the current political environment and discussion of corporate tax rate increases, careful consideration should be given to the timing of, and planning around, the taxability of fees under both the PPP and the 7(a) loan program. Banks will have to evaluate their individual, and potentially unique, tax situations and internal lending department structures to determine which positions are most appropriate for them.

EditorNotes

Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowe.com.

Contributors are members of or associated with Crowe LLP.