PPP Loan Forgiveness: The 25% Reduction Rule Explained
If your small business received a PPP loan, understanding the forgiveness requirements can feel like navigating a maze of rules and exceptions. One of the most critical—and often misunderstood—provisions is the 25% reduction rule. Getting this wrong could mean losing thousands of dollars in forgiveness or facing serious compliance issues.
Here's what you need to know about the 25% reduction rule, how it affects your forgiveness amount, and what steps you can take to protect your business.
What Is the 25% Reduction Rule?
The 25% reduction rule actually refers to two separate but related requirements in the PPP loan forgiveness calculation:
1. The 25% Wage Reduction Rule: If you reduced any employee's wages by more than 25% during your covered period compared to the first quarter of 2020, your loan forgiveness amount gets reduced by the excess amount.
2. The 25% Revenue Reduction Requirement: This applies specifically to second-draw PPP loans and requires businesses to demonstrate a 25% or greater reduction in gross receipts to qualify for the second loan.
Let's break down each of these requirements in detail.
Understanding the 25% Wage Reduction Rule
This rule protects employees from significant pay cuts during the covered period. Here's how it works:
Who It Applies To
The wage reduction rule applies to employees who:
- Earned an annualized salary of $100,000 or less in 2019
- Were not employed by you in 2019 (new hires)
Highly compensated employees (those earning over $100,000 annually) are exempt from this protection.
How the Calculation Works
You compare each qualifying employee's average pay during your covered period (either 8 or 24 weeks) to their average pay during the reference quarter (typically January 1 to March 31, 2020).
If their pay dropped by more than 25%, your forgiveness gets reduced dollar-for-dollar by the excess reduction amount. For example:
- Employee earned $4,000/month in Q1 2020
- During your covered period, they earned $2,500/month
- 75% of $4,000 = $3,000 (the minimum allowed)
- $3,000 - $2,500 = $500/month reduction
- If your covered period is 24 weeks (roughly 6 months), you'd lose $3,000 in forgiveness for that employee
The Safe Harbor Exception
Here's the good news: you can avoid this reduction if you restore wages by a specific deadline. The wage reduction safe harbor applies if:
The employee's annual salary or hourly wage as of December 31, 2020 (or earlier, if you applied for forgiveness before then) equals or exceeds their wage as of February 15, 2020.
This gives businesses a chance to fix temporary wage reductions and preserve full forgiveness.
The 25% Revenue Reduction Requirement (Second-Draw Loans)
If you applied for a second PPP loan, you needed to prove a 25% reduction in gross receipts. This is a different requirement altogether.
Qualification Standards
To qualify for a second-draw PPP loan, you must:
- Have exhausted your first PPP loan funds
- Employ fewer than 300 employees
- Demonstrate a 25% or greater reduction in gross receipts
Two Ways to Calculate
The SBA allows two approved methods:
Annual Comparison Method:
- Compare your 2020 tax return gross receipts to your 2019 tax return
- If 2020 was at least 25% lower, you qualify
Quarterly Comparison Method:
- Compare any quarter in 2020 to the same quarter in 2019
- If any single quarter shows a 25% or greater drop, you qualify
For businesses that started in 2020, Q1 2020 serves as your baseline, and you can use Q2, Q3, or Q4 2020 for comparison.
What Counts as Gross Receipts?
This is crucial: "gross receipts" has a specific definition for PPP purposes:
- Includes: All revenue from your tax returns or income statements
- Excludes: Any COVID-19 relief funds received in 2020 (including your first PPP loan, EIDL grants, etc.)
Using the wrong figure could disqualify you or trigger repayment requirements.
Documentation Requirements: What You Need to Prove
The documentation timeline matters significantly:
At Application (Loans Under $150,000)
Initially, you only need to provide a good-faith certification that you meet the 25% reduction requirement. No supporting documents are required upfront.
At Forgiveness Stage
This is when documentation becomes mandatory. You must provide:
For Annual Method:
- Complete 2019 tax return
- Complete 2020 tax return
- Financial statements if your business structure doesn't file traditional tax returns
For Quarterly Method:
- Financial statements covering the relevant quarters
- Bank statements supporting the claimed revenue reduction
- Profit and loss statements for both comparison periods
Missing or incomplete documentation is one of the top reasons forgiveness applications get delayed or reduced.
FTE Reduction: The Related Workforce Rule
While we're discussing the 25% rules, it's worth understanding the FTE (full-time equivalent) reduction rule, which works alongside the wage reduction requirement.
How FTE Reduction Affects Forgiveness
If you reduced your workforce count during the covered period compared to your reference period, your forgiveness amount gets reduced proportionally.
The calculation:
- Average FTE during covered period ÷ Average FTE during reference period = FTE ratio
- Your maximum forgiveness × FTE ratio = Adjusted forgiveness amount
For example, if you went from 10 FTEs to 7.5 FTEs, your ratio is 0.75, and your forgiveness gets reduced by 25%.
The FTE Reduction Safe Harbor
Similar to the wage reduction safe harbor, you can avoid FTE penalties if:
- You reduced FTE levels between February 15, 2020 and April 26, 2020, AND
- You restored FTE levels by December 31, 2020 (or your forgiveness application date, whichever is earlier) to match or exceed your FTE count as of February 15, 2020
If you qualify for safe harbor, you skip the FTE reduction calculation entirely and preserve full forgiveness.
Common Mistakes to Avoid
After reviewing hundreds of forgiveness applications, these errors appear most frequently:
1. Miscalculating the Reference Period
Many businesses use the wrong dates for their baseline comparison. The reference quarter is typically Q1 2020 (January 1 to March 31, 2020) for wage reductions, but your specific situation might require a different period.
2. Including Relief Funds in Gross Receipts
When calculating the 25% revenue reduction, accidentally including PPP funds, EIDL grants, or other relief money inflates your 2020 receipts and could disqualify you from a second draw.
3. Missing the Restoration Deadline
Some businesses assume they can restore wages or FTE counts after December 31, 2020, and still qualify for safe harbor. The deadline is firm—unless you applied for forgiveness earlier, in which case that earlier date becomes your deadline.
4. Inadequate Documentation
Relying on incomplete bank statements or informal bookkeeping records instead of proper financial statements causes application delays and potential denials.
5. Ignoring Part-Time and Seasonal Workers
The FTE calculation includes part-time employees (counted as fractional FTEs) and has special rules for seasonal workers. Missing these nuances leads to incorrect calculations.
What Happens If You Don't Meet the Requirements?
The consequences of misrepresenting your eligibility are serious:
For Revenue Reduction Misstatements
If the SBA determines you didn't actually meet the 25% revenue reduction requirement for a second-draw loan:
- You must repay the full loan amount
- You won't be eligible for forgiveness
- Knowing misstatement can result in fines and potential criminal charges
For Wage or FTE Reductions
If you failed to meet safe harbor requirements or didn't properly calculate reductions:
- Your forgiveness amount will be reduced accordingly
- You'll owe the difference to your lender
- In cases of fraud or misrepresentation, penalties may apply
Steps to Protect Your Forgiveness
Here's a practical action plan to ensure you maximize forgiveness while staying compliant:
Step 1: Audit Your Payroll Records
Review each employee who earned $100,000 or less in 2019:
- Calculate their average pay in Q1 2020
- Calculate their average pay during your covered period
- Identify any reductions exceeding 25%
- Determine if you restored wages by the safe harbor deadline
Step 2: Verify Your FTE Calculations
- Determine your reference period FTE count
- Calculate your covered period FTE count
- Check if you qualify for FTE safe harbor
- Document any reductions and restorations
Step 3: Gather Complete Documentation
Assemble all required documents before starting your forgiveness application:
- Payroll reports for all relevant periods
- Tax returns (if using annual method for second draw)
- Quarterly financial statements (if using quarterly method)
- Bank statements supporting revenue claims
- Documentation of any wage or FTE restorations
Step 4: Consider Professional Help
PPP forgiveness rules are complex and the stakes are high. Consider consulting with:
- A CPA familiar with PPP requirements
- A bookkeeper who can verify your calculations
- Your lender's PPP forgiveness specialists
The cost of professional help is usually far less than the cost of a reduced forgiveness amount or compliance issues.
Step 5: Apply Before Documentation Expires
Don't wait too long to apply. While most documentation requirements remain the same, key records like bank statements and payroll reports become harder to reconstruct as time passes.
Looking Ahead: Record Retention Requirements
Even after your forgiveness is approved, your obligations continue:
You must retain all PPP-related records for six years after the date your loan is forgiven or repaid in full. This includes:
- Loan application and forgiveness application documents
- Payroll tax filings and payment receipts
- Cancelled checks, payment receipts, and account statements
- Documentation supporting your revenue reduction claim
The SBA can audit your loan at any time during this six-year period, so maintain organized, complete records.
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