An increasingly popular vehicle when trying to lure prospective employees is the offer of a forgivable loan, issued at the inception of employment. The concept is for the employee to receive an upfront payment of cash, similar to a sign-on bonus, where the related income arising from the forgiveness of such debt is recognized over the life of the obligation provided in the agreement.
Example: Company C and employee E enter into an agreement whereby C loans E $1 million on day 1 of employment with the company. C will forgive the $1 million (plus accrued interest) over a five-year period, provided E remains at the company. E will recognize 20% of the total proceeds received (one-fifth) into gross income in each of the five years as that portion of the debt is forgiven.
Careful attention must be paid during the planning process and when drafting the loan agreement not to create a situation where the treatment of the loan is considered as compensation instead of bona fide debt, causing the loan proceeds to be taxable by the recipient in the year received.
The primary issues for consideration are whether the receipt of proceeds from a forgivable loan constitutes gross income and whether the provisions contained in a loan agreement would provide enough substance for the loan to be considered bona fide debt. Sec. 61 provides that gross income includes all income unless otherwise specifically excluded either directly in other sections of the Code or under judicial precedents. The statutory definition merely defines gross income as income from whatever source derived, and it does not contain any mechanical tests that can be applied to specific situations.
The courts have developed a concept that treats as gross income all items that clearly demonstrate an accession to wealth. The Supreme Court has stated in a gross income case that income is realized whenever there are “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion” ( Glenshaw Glass Co ., 348 U.S. 426, 431 (1955)). However, the Supreme Court has also held that gross income does not include the receipt of loan proceeds ( James , 366 U.S. 213 (1961)). The concept behind this position is that since the borrower has the obligation to repay the loan, the borrower has no accession to wealth. Nevertheless, the taxpayer cannot exclude amounts from gross income as loan proceeds if there is no loan or if the loan is not bona fide. Advances made to the taxpayer where the taxpayer has unrestricted control of the amounts advanced do not constitute a loan and will be includible in gross income if the advance lacks the characteristics of a genuine loan.
Characteristics of bona fide debt must be present to receive favorable tax treatment. Characteristics of bona fide debt should include, but are not limited to, document terms that should be evidenced by a promissory note (or similar agreement), a forgiveness/repayment schedule, arm’s- length interest charges, analysis of events triggering the forgiveness of the loan, and terms discussing what would occur if the employee were to default. Practically speaking, an agreement that the parties intend to establish bona fide debt should resemble conventional debt instruments, where the parties involved are clear as to the fact that they are entering into a debt agreement. For example, when a homeowner enters into a loan agreement (mortgage) with a bank, he or she receives a loan amortization schedule that stipulates the total payment each month and provides a breakdown between principal and interest. The homeowner will also receive documentation explaining default provisions, penalty amounts for late payments, and many other details related to the mortgage.
The existence of an agreement between both parties is a good way of documenting that the parties have entered into a bona fide loan. In many circumstances, the agreement is in the form of a promissory note signed by both parties. It is well established that in the case of a loan, the debtor must satisfy the repayment obligation by making a monetary or cash payment under the agreement ( Beaver , 55 T.C. 85 (1970)). Such payments should include not only the principal but also a compounding interest component similar to a mortgage or other agreement where money is being loaned or repaid.
Clearly stated within the agreement should be the terms that would trigger the forgiveness of the loan. An example of this could be that 20% of the loan is forgiven on each of the first five one-year anniversary dates following the inception of the agreement. Default provisions should also be present within the agreement. Such default provisions could summarize the actions taken by the employer to retrieve the outstanding loan balance in the case where the employee is no longer employed—for example, the outstanding loan balance is due within 10 days of termination. If the employee pledges collateral, a default provision might state that if the employee does not make a loan repayment within 10 days of termination, the employer could take action against the collateral. An employer might also state that it will charge additional interest and penalties upon default.
In addition to covering all bases in establishing a genuine loan between an employee and an employer, the parties should also exclude certain terms from the agreement. When referring to the forgivable loan, using such phrases as “award,” “retention bonus,” or “compensation” could jeopardize the attempt to constitute bona fide debt. There should be no mention in the agreement regarding U.S. and/or state withholding taxes because the amount will be includible in gross income only if the terms of the agreement are held and the loan or portion of the loan is actually forgiven. Reference to compensation synonyms and withholding taxes asserts the idea that the employee has dominion and control of the amounts loaned and thus would have compensation with required withholding in the year of receipt.
Technical Advice Memorandum (TAM) 200040004 discusses the idea that guaranteed bonus payments paid to an employee as a mechanism to aid the employee in making the loan repayments (as opposed to the loan being forgiven) could prevent its treatment as bona fide debt, so all the proceeds received would be deemed to be compensation in the year of receipt. In the case discussed in the TAM, the employee never had dominion and control over the bonus payments because the amounts were used directly to pay down the loan balance. Thus, the employee never had an accession to wealth because the loan repayment negated the bonus. Since the bonus payments were not includible in gross income, the initial receipt of the loan proceeds was deemed to be the only taxable event, and the proceeds were taxable in the year received.
Receipt of proceeds from a forgivable loan can create a favorable outcome with regard to the deferral of income taxes. Careful planning must precede the employee and his or her tax professional entering into an agreement to ensure that proper language is used in the establishment of bona fide debt.
Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or awong@hrrllp.com.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.