The Tax Impact Of Employer Loans To Employees
By: Randall A. Denha, JD., LL.M.
Many companies understand the importance of finding and retaining top talent. To recruit and preserve such valuable resources, many companies have turned to offering traditional and compensation-related employee loans. Whether such loans are constructed for retention or to administer employee aid, their tax treatment should be closely considered. Companies intending to provide financial assistance to their employees through employer loans must carefully navigate and structure these loans in compliance with the applicable tax requirements. The failure to comply with the relevant tax rules may cause the loan to instead be treated as taxable income to the employee as disguised compensation.
Companies often include employee loans in their executive compensation packages. A private company considering a loan to its employee should carefully consider the various tax requirements and consequences in structuring the arrangement. Under certain circumstances, the IRS may view a purported employer-employee loan transaction as a taxable compensatory advance or as providing taxable deferred compensation. Therefore, it is critical to take all steps possible to preclude the loan from appearing to be compensatory. Also worth noting is that the Sarbanes-Oxley Act of 2002 (SOX) imposed restrictions on loans to certain employees. SOX made it unlawful for an issuer to extend or maintain credit in the form of a personal loan to a director or executive officer. Therefore, public companies subject to SOX should avoid offering employee loans to directors or executive officers; however, employee loans can still be offered to other rank and file employees. Non-public companies not subject to SOX can extend employee loans to employees of all levels.
Before a loan is made to an employee, certain factors must be considered. Here are some factors to consider for various types of employer loans:
Interest Rate – Appropriate interest must be charged to the employee under an employer-employee loan. With limited exceptions for certain employee residential and relocation-related loans, and for loans of $10,000 or less under which tax avoidance is not a principal purpose, the minimum interest rate to be charged under an employer-employee loan must be at least equal to the Applicable Federal Rate (the “AFR”) for the month in which the loan takes place. Different AFRs apply (posted monthly by the IRS) to short-term loans (3 years or less), mid-term loans (greater than 3 years but less than 9 years), long-term loans (greater than 9 years), and demand loans.
Below-Market Loans are loans where the interest rate under the loan is less than the required AFR and the difference between the interest that would have been paid using the applicable AFR and the interest at the rate actually used will constitute taxable compensation income to the employee. Below-market loans are provided to employees at a lower interest rate then they could otherwise receive in the market. Below-market loans can be offered at either a reduced interest rate (below the AFR) or completely interest free, as an original issue discount. The spread between the reduced interest rate and the market rate of interest (the AFR) is recognized as compensation to the employee and deducted as compensation expense by the employer. The timing of the recognition of compensation depends on whether the loan is a demand loan or a term loan.
Demand Loans are payable on demand of the lender. For a demand loan, the amount of forgone interest is recognized as taxable compensation to the employee and as a compensation expense deduction to the employer on the last day of the calendar year.
Term Loans are traditional loans with a set repayment schedule and maturity date that cannot be altered at the demand of the lender. If a term loan is provided to an employee who leaves the company prior to repaying the loan, the employee must continue to make repayments of the loan, even after he or she is no longer employed, according to the original repayment schedule. For a term loan, the amount of forgone interest is transferred at the time the loan is made and is equal to the excess of the amount loaned over the present value of all payments that are required to be made under the terms of the loan agreement. Therefore, term loans are treated as original issue discount loans. The employee will recognize taxable compensation and the employer will recognize compensation expense on the date the loan is made.
Bona Fide Loans – Properly documenting the factors identified by the IRS as indicative of a true loan is perhaps the most critical aspect of structuring a tax-effective employer-employee loan transaction. In this regard, the IRS takes the position that the following factors are indicative of a bona fide loan:
- The employee enters into a formal and valid loan agreement with the employer and both parties execute a valid promissory note
- The employee is required by the terms of the loan agreement and the promissory note to make “monetary” repayments pursuant to a specified repayment schedule
- Both the employee and the employer intend that all interest and principal payments required under the loan documents will be made, and on a timely basis
- Interest accrues on the unpaid loan balance at a stated rate (which, as explained above, should be at a rate of not less than the applicable AFR)
- The employee provides adequate security for the loan
- There is an unconditional and personal obligation on the part of the employee to repay the loan in full
Forgivable Loans – A popular tool used to attract top talent is the employee forgivable loan. Employers often issue these loans as sign-on or retention bonuses to retain and attract top executives. Think of these loans as providing top talent with upfront cash. Depending upon the existence (or lack) of the bona fide loan factors, forgivable loans may or may not be recognized as true loans for tax purposes.
Forgivable loan arrangements typically provide for the employee’s repayment obligation to be contingent upon his or her continued employment with the employer. The intent is for the employee to have no tax consequences upon receipt of the loan proceeds, and subsequently to realize taxable compensation income only as and to the extent the loan is forgiven. The income recognition from the employer’s forgiveness of the underlying principal and interest payments is generally intended to be tax deferred to the employee and recognized over the life of the loan.
The most common structure is for the employer to forgive a uniform percentage of the loan amount on an annual basis (e.g., 20% per year for a five-year loan), resulting in some taxable compensation each year. If the above bona fide loan factors are present and adequately documented, a forgivable loan should be treated as a loan for tax purposes. In Technical Advice Memorandum (TAM) 200040004, the IRS concluded that a loan by an employer to an employee evidenced by a note agreement represented compensation, at the time of the loan, for tax purposes. The recognition of compensation requires the employee to include the lump-sum payment as income in the year it is received instead of deferring recognition of the income over the service period. Although TAMs are not authoritative guidance, the IRS has informally indicated that the conclusion reached in this TAM reflects its current position on employee forgivable loans. Therefore, the IRS would conclude that a loan scheduled to be forgiven based on continued employment is actually a salary advance taxable to the employee upon receipt.
Bonus Arrangements-Another approach often used is where, despite bona fide loan formalities being in place, the employer and the employee also enter into a bonus arrangement at the time of the loan. Under this scenario, the employee will earn annual bonuses for the period the loan is in effect, with each annual bonus equal in amount to the employee’s annual loan repayment obligation. The parties agree that, rather than paying the bonus amounts to the employee, the employer will use those amounts to satisfy the employee’s repayment obligations under the loan. Thus, the employee would only be required to make “monetary” repayment of the loan if his or her employment is terminated under certain circumstances. Beware: The IRS has challenged these types of arrangements and treated the loan proceeds as compensatory cash advances. In these cases, the IRS has argued that the income stream created by the bonus results in the employee not having the required personal liability to repay the loan, the circular flow of funds between the parties lacks a business purpose and economic substance, the agreement is motivated solely by tax avoidance considerations and because “monetary” repayment of the loan is only required upon termination of employment, the loan agreement operates more as contractual liquidated damages than as a feature of a bona fide loan repayment.
Non-Recourse Loans to Purchase Employer Stock – An employer may offer an employee the opportunity to purchase shares of the employer’s stock and lend the purchase price for the shares to the employee in return for the employee’s promise of repayment, with interest, over a specified time. Dramatically different tax consequences will result if, under the terms of the loan, the employee has no personal liability and, instead, repayment of the loan is secured solely by the employee’s pledge of the shares being purchased.
Where there is sufficient personal liability for the repayment of the loan, i.e., a “recourse” loan, assuming that the loan is otherwise valid, it should be respected as such for tax purposes. However, if the loan is made on a “non-recourse” basis, a very different result may occur for tax purposes. Considering that, if the value of the shares were to drop below the outstanding loan repayment amount, the employee could simply walk away from the loan and forfeit the pledged shares, the employee would have little incentive to repay.
Consequently, a non-recourse loan arrangement may be taxed differently as it may be treated as the employer’s grant of a compensatory option to purchase the employer’s stock. In this case, the result could be the conversion of potential lower-rate capital gain on the shares into higher-rate ordinary compensation income.
Documentation is essential to ensure that loans to employees are treated as such for tax purposes. An arrangement may appear to be an employee loan, but if it does not look like one or sound like one on paper, it will not receive favorable tax treatment from the IRS. The best way to structure an employee loan is to satisfy all the formal requirements as though the company were loaning money to a third party.
The following factors indicate the existence of a bona fide loan arrangement:
- A promissory note signed by both parties;
- The receipt of cash payments according to a specified repayment schedule;
- Interest charged at a stated interest rate; and
- Security for the loan.
If these stipulations are not satisfied, you run the risk that the IRS may treat employee loans as advance payments that must be included as taxable compensation to the employee.
