According to the Service, a loan scheduled to be forgiven over a particular period as long as the employee remains employed by the lender is an advance payment of compensation, not bona fide debt; see, e.g., Beaver, 55 TC 85 (1970). Many employers try to avoid this issue by not scheduling a cancellation of debt based on an individual's continued employment; instead, employers will agree to a guaranteed cash bonus arrangement that provides an employee with money to pay the loan.
However, in Letter Ruling (TAM) 200040004, the IRS ruled that a cash loan/bonus arrangement still resulted in immediate income to the employee for the amount of the purported loan. In addition, the employer was not allowed a compensation deduction until the employee actually provided services.
An employer made a cash payment to an employee and entered into two separate contracts with him. The first contract was a promissory note agreement and the second contract was a bonus agreement. The note contract provided that the cash payment was proceeds on a promissory note. The note required repayment in five annual payments with interest. The employer would forgive the note on the employee's death, disability or termination without cause. Otherwise, the note was unconditionally payable by the employee. The employee granted the employer a security interest in his company common stock. The employer was authorized to offset other payments due the employee https://www.suntrust.com/loans for amounts due and unpaid on the note.
The second contract (the bonus agreement) guaranteed that the employer would pay the employee five annual fixed bonus payments. The bonus payments corresponded in amount and timing to the required note payments. The bonus agreement provided that all bonus payments would be retained by the employer as an offset to (and in payment of) the promissory note. The employee did not have any rights to the guaranteed bonus payments, because the payments would automatically apply to the note balance. Thus, in effect, the employee would neither make future note payments nor receive bonus payments in cash, as both would simply offset each other.
Loans to Employees Were Not Bona Fide Debt
For the Service to find immediate taxable income, the cash received by the employee could not be a loan. A loan, of course, is not considered income; see James, 366 US 213 (1961). If an arrangement does not constitute a bona fide loan, the cash is considered compensation income when received.
In determining whether or not the arrangement was a loan, the IRS admitted that the loan appeared to be bona fide in form, based on factors indicative of debt:
1. The employee's signature on a promissory note;
2. The employee is required to make cash payments;
3. The employee is charged interest; and
4. The employee's pledge of stock as security for the loan.
However, the Service viewed the purported loan as not "an unconditional and personal liability on the part of the `debtors.'" Because the loan payments would be made with guaranteed bonus payments, which corresponded with the loan payments in both amount and timing, the IRS concluded that the loan, in effect, would be paid back with the employee's future services.
The Service distinguished this arrangement from a similar one in Gales, TC Memo 1999-27. In Gales, a commissioned insurance agent obtained advances (i.e., loans) from his employer. The advances accrued interest and were paid directly back with future commissions earned by the agent. The Tax Court held that, because the employee earned commission income, there was uncertainty about whether future compensation would be sufficient to cover the loan payments. Therefore, the Tax Court ruled that the advances were not taxable income in the year received.
In the TAM, the bonus payments were fixed and corresponded with the loan payments in timing and amount; the loan payments were effectively guaranteed as long as the employee provided the services required under the employment contract. Therefore, there was no unconditional promise to repay the loans in cash. The IRS dismissed the fact that the employee could terminate employment before five years and had to repay the loan without benefit of the bonus payments, as that situation would, in effect, also exist if the arrangement was a loan with scheduled forgiveness and an employee left his employment. In both situations, there was no actual monetary liability unless the employee quit before the scheduled repayments or bonuses.
The Service cited Beaver for the proposition that a bona fide loan requires the borrower to make monetary payments to satisfy the loan. Under this arrangement, the loan and bonus payments corresponded in amount and timing such that both offset each other. However, according to the TAM, even if the bonus and loan payments are actual separate payments, the circular flow of checks was a meaningless gesture. Under the arrangement, no real future payments would be made; the guaranteed bonus payments completely offset the required loan payments, and bonus payments would not actually be made to the employee but remain with the employer as an offset on the loan. Therefore, the IRS concluded, the loan proceeds were a payment for future services.
In the TAM, the bonus payments were not income to the employee. Because the employee would never be entitled to them, as they were merely offsets to the loan payments, he did not have "dominion and control" over any bonus payments. Thus, the Service disregarded the bonus payments as income; instead, it found the loan proceeds to be a cash advance to the employee.
Finally, if the employee terminated employment before the five-year period, the loan payments would be fees paid for termination of an employment contract. In the year a "termination fee" is paid, an employee may claim the payment as a right deduction under Sec. 1341. The IRS could argue, however, that the payment is an unreimbursed employee business expense subject to the miscellaneous itemized deduction 2%-of-adjusted-gross-income floor.
Timing of the Employer's Compensation Deduction
On the employer side, the IRS concluded that the employer's corresponding compensation deduction was not allowed until the employee performed the services. Because the arrangement involved cash compensation to the employee, the matching of income and deduction under Sec. 83 did not apply. Instead, the deductibility of the arrangement was determined under the all-events and economic-performance tests of Sec. 461 and the regulations thereunder. Under Regs. Sec. 1.461-1 (a)(2), the all-events test is satisfied when an arrangement is made, because the liability for payment of bonuses is established in fact and amount at that time. But the economic performance rules of Sec. 461(h)(2)(A)(i) provide that a deduction for performance of services occurs as the services are provided. Therefore, unless both the all-events and economic-performance tests are satisfied, the employer cannot deduct the advance compensation when paid.
FROM GARY T. WEAVER, CPA, AND ED SAIR, J.D., MLT, CPA, WASHINGTON, DC