Guide to Payroll Loans

As of May 28, 2021, the Paycheck Protection Program has run out of funding. You can learn more about the PPP with our COVID-19 resource hub.

Fluctuations in revenue are a challenge for any business but, for a small business that needs to fund a payroll, they can threaten the survival of the business.  Business can be slow, customers can be late to pay, or both.  During these times of unreliable cash flow, payroll business loans can provide a solution.

Small business payroll loans are short-term loans or advances that allow businesses owners to cover unexpected shortages in cash flow and pay employees. This can be especially true of businesses with many hourly employees that have an inconsistent payroll week-to-week.  Many business owners caught in this situation prefer a short-term advance to cover the gap, and then quickly repay it.  Funding for these loans is typically available within one business day.

But while business loans for payroll may be quick and convenient, they aren’t necessarily inexpensive.  And even though a business owner may want to pay off the debt quickly, the time frame for repayment can be demanding.

As an aside, it’s important to note that payroll loans for small business are not the same as payday loans, which are short-term consumer loans.  Payday loans charge borrowers an average interest rate of 400 percent, and are illegal in some states.  But small business loans to cover payroll are recognized as a method to help small businesses cover payroll expenses.

Payroll Funding Options

While payroll loans are not an ideal solution, they can prevent the calamity of missing payroll.  An agitated and unmotivated workforce, a bad reputation and expensive legal troubles headline the fallout for those wondering what happens if they can’t make payroll.  Fortunately, there a variety of ways to finance payroll for businesses that find themselves with no money to pay their employees.  These include:

  • Business lines of credit.  Revolving credit and flexibility make business lines of credit the preferred option for payroll financing.  The use of the line of credit isn’t limited to payroll financing, and can be used to smooth out the cash flow of a business for other purposes, too.  Small business lines of credit can be unsecured up to a certain amount, which means that no collateral is needed.  Business owners can tap into funds as needed, and only pay interest on the funds that are used.
  • Short-term business loans.  Short-term loans are an option for small business owners who need access to a small amount of money the next business day after approval.  They feature lump-sum financing and are designed for quick repayment.  In some instances, lenders even ask borrowers for a post-dated check for the full amount in advance to guarantee repayment in full. If the loan is not repaid on the specified due date, the lender is legally entitled to redeem the check.  The borrower is then held responsible for the amount of the check and any additional fees that may be incurred if the check bounces.

Online lenders can process these loans in one business day.  But, to qualify, borrowers need a personal credit score of at least 600, proof of business income and must have been in business for at least a year.  Interest rates for short-term loans can range from 15 to 30 percent for a single loan.  Lenders can also charge higher interest rates or additional fees for delinquent loans.

  • Invoice Financing.  Invoice financing is a way for businesses to improve cash flow – and to potentially finance payroll — by borrowing funds against the money their customers owe.  It creates a line of credit based on the value of those invoices.   Lenders can give a business a portion of its unpaid invoices up front in the form of a line or credit.  This portion is normally ranges from 80 to 90 percent.

Once the customer pays an invoice, the business then pays back the amount loaned – plus fees and interest — to the lender.  Under the terms of invoice financing, the business is still responsible for collecting the amount of the invoice.  This is the primary difference between invoice financing and invoice factoring.  Given the fact that 60 percent of invoices are paid late, and 20 percent are more than two weeks late, the flexibility of invoice financing makes it a preferred choice of small businesses.

  • Invoice Factoring.  Small business owners can borrow against their unpaid invoices through invoice factoring, which is different than invoice financing.  Invoice factoring allows business owners to sell open accounts receivable to a factoring company.  While this method of financing is not a loan, it’s preferred by businesses with substantial outstanding invoices to fund large amounts.  It allows business owners to receive an advance of up to 85 percent of the total amount of an unpaid invoice.

Once the invoice is paid, the factoring company will forward the balance of the invoice to the business owner minus a factoring fee of between one and three percent.  This interest typically begins to accrue once the invoice is paid in full rather than when it’s purchased by the factoring company.

Businesses with bad or no credit can qualify for invoice factoring because funding decisions are based on the credit rating of their customers.  There are no up-front fees.  Approval can take three-to-five business days and, in some cases, a businesses can receive initial funding within 24 hours of setting up an account.   Many larger companies, which have in-house debt collection, favor invoice factoring.

  • Merchant Cash Advances.  These are considered a last-resort option for business owners with poor personal credit, lack of documentation and immediate payroll funding needs. Merchant cash advances involve a business selling some of its future credit card sales in exchange for an immediate lump sum.  In exchange, the business is expected to repay the advance within a specified time period through either daily or weekly withdrawals from its bank account.  Credit card sales are the only criteria necessary for approval.

These advances are more expensive than loans but, since they don’t depend on good credit scores, they can be easier to qualify for.  Cash advance amounts range from $2,500 to $250,000.  Borrowers typically must be in operation for 18 to 24 months with annual revenues greater than $150,000.

Merchant cash advances can also provide funding within a day.  But the cost is steep.  The funding comes from non-bank, tech savvy lenders, and comes with high interest rates.  These rates can vary wildly, from 16 to 100 percent.  Such rates, combined with the quicker repayment terms – typically four months to two years – make merchant cash advances the last resort for business owners.

Each of these options has pros and cons, depending on what’s accessible and affordable for a given business (check out these top payroll funding options for 2020).  Interest rates on a business payroll loan can be as high as 30 percent.  Such debt can easily sink a business, especially one that’s still trying to establish itself.  As a result, all business payroll loans should not be looked upon as a consistent, long-term solution.

Longer-term funding solutions – such as business lines of credit — can help pre-empt future payroll issues.  Studies have shown that 82 percent of small businesses fail due to poor cash flow.  A business loan that’s used to finance payroll should have flexible funding, renewable funding and repayment terms that are good fit for the cash flow of a given business.

Banks offer business loans and lines of credit that can finance the payroll of a small business.  But while bank loans come with attractive rates and extended terms, bank financing can be difficult to qualify for.  While specifics vary according to banks, approval for a business loan from a bank normally requires a minimum of:

  • A credit score above 620;
  • A business to be in operation for at least two years;
  • And strong monthly and annual cash flows.

For businesses that do qualify, rates can range from four to 10 percent.  Repayment terms can stretch from one to five years.

The approval time can also be lengthy, which can negate the purpose of applying for a loan to meet payroll.  The SBA Express loan program can help hasten the process.  Through this program, the SBA can approve payroll loans within 36 hours.  This faster turnaround comes at a price.  Rates for SBA payroll loans are typically six percent with repayment required in between three and seven years.

Faster approval for business payroll loans can also be available through alternative online lenders, which also feature a quick and simple application process. Alternative lenders require minimal documentation to for approval.  Funding can be available within days of application.

Despite the onerous interest rates attached to payroll financing, there are several situations where a business payroll loan can make sense.

  • Cash Flow Problems.  Emergencies and slow-to-pay customers can create cash-flow problems in the short term.
  • Seasonal Surges.  Hiring additional employees may be necessary due to seasonal fluctuations in business.  These employees may have to be paid before the additional revenue hits the books.
  • Lack of Options.  A business payroll loan may be the only choice of a small business if it can’t get approval from other lenders.

Business Loans for Payroll Tax

Another potential use for a business loan for payroll is to pay the employer portion of payroll taxes.  The employer’s payroll tax expense includes 6.2 percent for Social Security tax withholding and 1.45 percent for Medicare tax withholding.  Employers are also responsible for paying Federal and state unemployment taxes.

These taxes are due on a regular basis.  If the payroll tax of a business is $1,000 or less for the quarter, quarterly payment is required.  A business with payroll taxes of $50,000 or less for the prior year must deposit payroll taxes monthly.  Business must deposit their payroll taxes semi-monthly if they paid more than $50,000 for the prior year.

Some small businesses that have an annual tax liability of $1,000 or less for the entire calendar year may ask for permission to file an annual payroll tax return (Form 944 Employer’s Annual Tax Return) and remit payroll taxes for the entire year with that return.  For small businesses that can qualify, filing this annual return can be the most preferred option for paying payroll taxes.

For larger businesses that get caught in a cash-flow crunch, a business loan to provide financing for payroll taxes can be acceptable solution.  If the payment of payroll taxes is between one and five days late, the IRS charges a penalty of two percent of the unpaid tax.  Deposits made six to 15 days late are charged a five-percent penalty.   If payment is 16 or more days late, the IRS will assess a penalty of 10 percent.

Being delinquent in paying payroll taxes – or income taxes – can also undermine attempts by a business to secure additional funding for other purposes.  Banks and other traditional SBA lenders typically don’t approve funding for SBA loans to business owners who are in debt to the IRS.  Some alternative SBA lenders, however, offer  funding programs to reconcile tax liens and judgements and to secure SBA loans to address other business needs.

In extreme cases, should the IRS decide that the failure of a business to pay taxes is tax evasion, the owner of the business may face criminal charges.  Tax evasion penalties can bring a maximum fine of $500,000 and up to five years in prison.  In addition, the business owner will still be responsible for the unpaid tax.  Given the severity of potential punishments, the high interest rate of a business payroll loan can be a relatively small price to pay.

Cost of Hiring Employees

One way for small business owners to avoid getting caught short when it comes to payroll is to know the exact cost of hiring an employee.  In addition to salary or hourly wage, business owners need to know how much does it cost to hire an employee before taking on additional payroll.

After taking into consideration salary, taxes and benefits, it’s been estimated that the actual cost of an employee is typically 1.24 to 1.4 times its base salary.  This means that an employee with an annual salary of $30,000 is actually between $37,500 and $42,000.  Benefits can include items such as health and dental insurance, worker’s comp insurance, long-term disability insurance, 401(k) contributions and equipment such as cell phones and laptop computers.

The actual cost of an employee who makes $70,000 per year would fall between $85,000 and $87,500.  The benefits for this higher-salaried employee cost less percentage than the $30,000 employee, because many benefits are not calculated on a pure percentage basis.

Understanding these costs and appropriately budgeting for them are critical to properly calculate the cost of an employee.  Doing so can help small business owners smooth out their cash flow without the aid of payroll loans for business.

Payroll Loans and the CARES Act

Earlier this year, Congress enacted the CARES Act, which is the largest government stimulus program in the history of United States in response to the COVID-19 pandemic.  The purpose of the act is to strengthen the nation’s economy during the pandemic and help citizens and businesses alike.

The CARES Act established the Paycheck Protection Program (PPP) designed to help small businesses cover ongoing operating expenses in the short-term and to encourage the retention of employees.  The PPP is a loan program run through the SBA.  These loans are backed by a 100% government guarantee.  By contrast, SBA 7(a) loans, which are the typical small business loans offered through the SBA, are guaranteed up to 75%.

Among the goals of the PPP are to ensure that workers continue to be paid during the pandemic and in doing so, reduce the need for workers to apply for unemployment insurance.  This will, in turn, reduce the financial stress on companies that are earning less revenue.  It will also help ensure businesses are adequately staffed so they can effectively reopen when government-mandated lockdowns are called off.

In addition, PPP loans forgiven if businesses spend the funds that come from them on government-approved expenses, such as payroll costs.

Other small business expenses that PPP loans can be used for are group healthcare benefits, health insurance premiums, paid sick or medical leave, interest on mortgage obligations and other debt obligations incurred before Feb. 15, 2020, rent obligations and utility payments.

The maximum loan amount available for a business is the lesser amount of either:

  • Two and a half times the monthly payroll costs of a small business plus the outstanding total of certain SBA loans that were taken out between Jan. 31, 2020 and the date of the new PPP loan, or $10 million.

No collateral is required for these loans, small businesses must prove they were in operation on February 15, 2020, to qualify.

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