Always Consider the Tax Aspects of Employer-Employee Loans
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 a transaction intended by the parties to constitute a true loan to instead trigger taxable income to the employee as disguised compensation.
Companies often include employee loans in their executive compensation packages. (Since the advent of Sarbanes-Oxley, public companies have been precluded from entering into loan transactions with their executive officers and directors.) 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.
The interest rate under the loan, the loan documentation, the means by which the loan principal is to be repaid, the collateral for the loan, the potential or contractual forgiveness of the loan, and even the specific use of the loaned funds can each play a pivotal role in the success or failure of the contemplated loan transaction for tax purposes. When an employer loans funds to an employee using appropriate loan documents that provide for "monetary repayment" of the loan (as contrasted to repayment via the provision of services), a sufficient rate of interest, and that have the characteristics of an arm's-length loan, the transaction should be respected as a loan by the IRS.
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.
Where the interest rate under the loan is less than the required AFR (commonly referred to as a "below-market loan"), 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. If the loan is a term loan, the amount of the foregone interest is considered to be transferred to the employee as of the date of the loan, with the result that the employee's taxable compensation would increase as of the date on which the loan is made. Where the loan is a demand loan, the foregone interest is calculated separately for each year, and each year's taxable compensation amount increases as of December 31.
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 - While an employer loan is generally intended to provide financial assistance to the employee, forgivable loans are often used as a compensation technique to provide an employee 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 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.
The above-referred true loans differ from employer-employee "loans" where the repayment obligation is contingent rather than unconditional. Under such an arrangement (e.g., where a five-year loan will, by its terms, be forgiven at the end of the employee's completion of five years of employment with the lending employer, and must be repaid only if the employee resigns or is terminated for cause during that five years), on the theory that, rather than to provide its employee with financial assistance, the employer has entered into the arrangement primarily to incent the employee to provide services for the duration of the five-year period. Given this, the receipt by the employee of the "loan" proceeds may constitute taxable compensation income.
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. 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.
What Does CohnReznick Think?
Considering the inherent tax risks, failing to use a sufficient interest rate for an employer-employee loan of greater than $10,000 in the current low-rate interest environment simply makes no sense. (The current short-term AFR is only slightly higher than 1% (1.11%), and both the mid-term and long-term AFRs are between 2% and3%). In particular, forgivable loans should be carefully considered and, whenever possible, the characteristics of a bona fide loan should be present and well-documented. Finally, an employer-employee loan to purchase shares of the employer's stock should be made on at least a partially recourse basis. We often see loans, including demand loans, between S Corporations and their shareholders and partnerships and their partners. These loans also need to be appropriately structured and documented to achieve the desired tax result.
Dana Fried, National Tax Managing Director
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
Tax Reform: The Tax Cuts and Jobs Act –
What you need to know, now
InsightAccounting for NFT and cryptocurrency donations: Not-for-profits should develop policies nowJohn Alfonso, Mindy NgWhat are NFTs, and how should not-for-profit organizations prepare to accept and account for these digital gifts? Read our overview.
InsightHow to assess your incentive stock option (ISO) strategyShaune ScutellaroRead 5 key points to consider when working through these complex equity compensation plans, related to tax, timing, and more.
InsightNew York State issues pass-through entity tax guidance: Making an election, estimated payments, and moreArvinder Kaur, Corey L. RosenthalTechnical Memorandum TSB-M-21(1)C, (1)I addresses issues such as, how does an entity make an election, or pay an estimated payment? Read more.
Press ReleaseSolarz joins CohnReznick as National Tax Managing DirectorCohnReznick LLP, one of the leading advisory, assurance, and tax firms in the United States, today announced that Alan H. Solarz, JD, CPA, has joined the firm as Managing Director in its rapidly growing National Tax practice. Based in New York, Solarz has more than 35 years of experience as a transactional tax lawyer and tax advisor.
InsightDeferred compensation for tax-exempt organizations: Tax and 990 reporting issues to considerLori Rothe Yokobosky, Laura KielczewskiLearn about common tax and Form 990 reporting issues associated with nonqualified deferred compensation arrangements.