A Borrower and a Lender Be
Everyone recognizes the importance of debt financing to a business. The business needs liquidity to purchase or improve assets, or to pay expenses. It borrows the necessary funds from an institutional lender that requires their repayment a fixed date or according to a fixed schedule. In order to compensate the lender for the use of the funds, the business promises to pay interest; depending upon various factors, the lender may insist that the loan be secured by some form of collateral.
For years now, many businesses have, themselves, become lenders – as opposed to borrowers – in order to acquire and retain talented employees. Specifically, employers have made a variety of different loans to employees; for example, some are traditional loans calling for a market rate of interest with periodic repayments, others provide for below-market rates of interest, some are made to assist the employee in moving to the employer’s community, and others are made to assist the employee in acquiring life insurance for the benefit of his family (as in the case of split-dollar insurance).
A “Real” Loan?
Although the employer-lender and the employee-borrower are usually not related to one another, the terms of the loan are often closely scrutinized by the IRS to ensure that the income tax treatment of the arrangement, as reported on the parties’ tax returns, is consistent with its economic reality.
In general, the parties intend that the amounts transferred to the employee-borrower represent a true loan, with a genuine and realistic expectation of repayment. In that case, the employee’s receipt of the funds is not treated as an income-realization event because there has been no accretion in value to the employee. If the employer subsequently forgives any of the amounts owing, then those amounts would be taxable to the employee as compensation at that time.
In many cases, unfortunately, the employer and the employee fail to structure their arrangement in a way that achieves the intended result. The “loan” may not be evidenced by a promissory note, it may have not a maturity date, interest may not be paid, events of default may be ignored, etc. Consequently, the IRS will find that the so-called “loan” was, in fact, compensation that should have been taxed to the employee upon receipt.
In a recent decision of the U.S. Tax Court, however, it was the employee, rather than the IRS, who argued that the arrangement was compensation, and not a loan.
Taxpayer Joins a Practice
In 2009, Taxpayer agreed to join LLC’s medical practice as an independent contractor. In connection therewith, LLC agreed to advance $XYZ to Taxpayer as a guarantee of compensation (the “Guaranty Amount”). This loan was evidenced by a promissory note and was advanced to Taxpayer in installments over a period of six months (the “Guaranty Period”). The Guarantee Amount was limited to an amount of salary which the parties agreed represented no more than fair market value for Taxpayer’s services. Taxpayer was obligated to repay to LLC the $XYZ that LLC loaned to him.
Taxpayer and LLC also entered into a so-called “compensation guarantee with forgiveness agreement,” into which the note was incorporated by reference. Together, Taxpayer’s agreements with LLC (the “Agreement”) provided that Taxpayer was to work for LLC on a full-time basis for at least thirty-six months (the “Commitment Period”), and that LLC was to report any compensation paid Taxpayer on IRS Form 1099-MISC, regardless of whether Taxpayer received the compensation in the form of cash, or as a “forgiveness of amounts owed” by Taxpayer to LLC.
Among other things, Taxpayer agreed to actively engage in the full-time practice of medicine in the geographic area served by LLC (the “Community”), to bill all patients and third-party payors promptly for all services rendered, and to use his best efforts to collect all patient accounts.
At the end of the Guarantee Period, the sum of all payments made by LLC to Taxpayer during such period, and not otherwise repaid (the “Loan Repayment Amount”), would become payable by Taxpayer in accordance with the note executed by Taxpayer. Interest on the Loan Repayment Amount (based on the prime rate reported in the WSJ) would begin to accrue at the end of the Guarantee Period. However, in an effort to encourage prompt payment, interest would be forgiven on any principal amounts repaid within six months of the end of the Guarantee Period. Amounts so forgiven, if any, were to be reported on IRS Form 1099.
Notwithstanding the foregoing, and to encourage Taxpayer to remain in the Community beyond the six month Guarantee Period, LLC agreed to forgive one-thirtieth of Taxpayer’s Loan Repayment Amount (corresponding to one-thirtieth of the remaining thirty month period of the thirty-six month Commitment Period) for each calendar month after the end of the Guarantee Period that Taxpayer remained in the full-time private practice of medicine in the Community, and maintained medical staff privileges at LLC. Any amounts forgiven would be reported on IRS Form 1099.
Thus, although Taxpayer had an unconditional obligation to repay the $XYZ that LLC had transferred to him, that obligation was subject to a condition subsequent. Amounts outstanding under the note were subject to forgiveness, but would become due and payable if Taxpayer failed at any time during the Commitment Period to fulfill his obligations under the Agreement regarding his full-time practice in the Community. In the event that Taxpayer defaulted on his obligations, LLC could accelerate repayment of any outstanding debt, plus interest, owed by Taxpayer. Taxpayer could prepay all or any part of the note at any time. As security for the payment of principal and interest on the note, Taxpayer granted LLC a security interest in, and irrevocably assigned to LLC, all accounts receivable of Taxpayer’s private practice of medicine, whether now existing or hereafter arising. Taxpayer also agreed to permit LLC to make regular audits of Taxpayer’s accounts receivable balances, and further agreed that LLC could perfect its security interest in Taxpayer’s accounts receivable.
Reporting the Advance
Taxpayer did not include in his 2009 gross income the $XYZ advanced to him by LLC during that year.
During 2009, LLC paid Taxpayer total nonemployee compensation of $ABC and reported that compensation on the Form 1099-MISC that it issued to him for that year. LLC did not include the $XYZ loan on the Form 1099-MISC or in another information return that it issued to Taxpayer for the 2009 tax year.
During 2010, LLC paid Taxpayer total nonemployee compensation of $DEF and reported that compensation on the Form 1099-MISC that it issued to him for that year.
In early 2011, Taxpayer terminated his employment with LLC. During 2011, LLC did not pay Taxpayer any nonemployee compensation, and did not issue any Form 1099-MISC to Taxpayer for that year.
Pursuant to the Agreement, during 2012 Taxpayer made payments to LLC totaling $MNO in repayment of the remaining balance of the $XYZ that LLC had loaned to him in 2009. LLC did not issue any Form 1099 to Taxpayer for 2012.
Taxpayer filed Schedule C, Profit or Loss From Business, with his tax return for the 2012 tax year, on which he claimed his repayment of $MNO as “Other expenses.”
Taxpayer: “Not a Loan”
The IRS examined Taxpayer’s 2012 tax return and disallowed the repayment expense of $MNO claimed by Taxpayer on his Schedule C because the repayment of a loan, the IRS explained, was not a deductible expense. Taxpayer disputed the IRS’s position, and argued that the $XYZ transferred to him in 2009 did not constitute a loan. (Although it is not discussed in the opinion, query whether the assessment limitations period for 2009 had expired by the time Taxpayer filed his 2012 return.)
In considering whether Taxpayer was entitled to the claimed repayment expense, the Tax Court had to determine whether the $XYZ that LLC transferred to Taxpayer during 2009 pursuant to the Agreement constituted a loan. If the Court found that it constituted a loan, Taxpayer would not be entitled to the repayment expense claimed in 2012.
What is a Loan?
The determination of whether a transfer of funds constitutes a loan is a question of fact. In order for a transfer of funds to constitute a loan, at the time the funds are transferred there must be an unconditional obligation (i.e., an obligation that is not subject to a condition precedent) on the part of the transferee to repay, and an unconditional intention on the part of the transferor to secure repayment of, the funds.
Whether a transfer of funds constitutes a loan may be inferred from factors surrounding the transfer, including the existence of a debt instrument, the existence of a written loan agreement, the provision of collateral securing the purported loan, the accrual of interest on the purported loan, the solvency of the purported borrower at the time of the purported loan, the treatment of the transferred funds as a loan by the purported lender and the purported borrower, a demand for repayment of the transferred funds, and the repayment of the transferred funds.
The Court’s Analysis
According to the Court, various factors surrounding LLC’s transfer of $XYZ to Taxpayer during 2009 indicated that the transfer of those funds constituted a loan, including the following: Taxpayer executed a promissory note in which he agreed to repay to LLC all amounts that LLC transferred to him; there was a loan agreement with respect to LLC’s transfer to Taxpayer of the $XYZ; Taxpayer agreed to pay interest on the $XYZ that he received from LLC at the rate specified in the note; Taxpayer agreed to secure the repayment of the $XYZ loan and the interest thereon by granting LLC a security interest in all accounts receivable of his private practice of medicine; Taxpayer had the ability to repay the $XYZ that LLC transferred to him; and Taxpayer and LLC treated the $XYZ that LLC transferred to Taxpayer as a loan in that LLC did not include the $XYZ loan in Form 1099-MISC or in any other information return that it issued to Taxpayer for the 2009 tax year, and Taxpayer did not include the $XYZ in gross income for that year.
In the face of these factors, which indicated that the $XYZ transferred to Taxpayer in 2009 by LLC constituted a loan, Taxpayer nonetheless took the position that the transfer should be considered an advance payment by LLC of Taxpayer’s salary, not a loan.
In support of his position, Taxpayer contended that there was no unconditional obligation imposed on him to repay the $XYZ. According to Taxpayer, any repayments would only become due if he materially breached the Agreement. In other words, Taxpayer’s obligation to repay the $XYZ that LLC transferred to him was subject to a condition precedent and, consequently, his obligation to repay that amount to LLC was not unconditional.
According to Taxpayer, it was only when he terminated his employment with LLC that any unearned portion of the $XYZ advanced to him became due to LLC.
The Court rejected Taxpayer’s argument, pointing out that it ignored the provisions of the Agreement regarding the $XYZ transfer and was inconsistent with the facts.
The Court found that pursuant to the agreement with respect to the $XYZ transfer to Taxpayer, Taxpayer had an unconditional obligation to repay to LLC the $XYZ that it transferred to him. That obligation of Taxpayer was subject to a condition subsequent. That is to say, if Taxpayer worked in LLC’s medical practice for at least six months, LLC agreed to forgive and cancel one- thirtieth of Taxpayer’s Loan Repayment Amount for each calendar month after the end of the Guarantee Period that Taxpayer remained with LLC.
Because Taxpayer failed to establish that the $XYZ transferred to him during 2009 was not a loan, he was not be entitled to claim the 2012 Schedule C repayment expenses of $MNO.
Employee Forgivable Loans
Employer advances to employees represent an important tool in attracting and retaining qualified individuals. In order to be effective, the amounts advanced have to represent a bona fide loan to the employee, and the recognition by the employee of any portion thereof as income has to be deferred until such time as such amount is forgiven by the employer.
In order to attain this result, and to avoid the immediate taxation upon receipt of the advance as compensation, it is imperative that the arrangement be structured, documented, and implemented as an arm’s-length loan, and that any forgiveness thereof be tied to the employer’s continued service with the employer.
By way of analogy, and as additional guidance, the employer’s adviser review the rules applicable to the transfer of restricted property. Under these rules, the employee to whom an employer transfers property is not “vested” in, and taxed on the value of, such property until the property is no longer subject to “substantial risk of forfeiture;” i.e., the employee has satisfied certain employment-related requirements (for example, a specified number of years of service). As in the case of a forgivable loan, the employee who fails to satisfy these requirements will have to forfeit (repay) the property to the employer.
As always, it will behoove the parties to a forgivable loan arrangement to consult their tax advisers in advance, to familiarize themselves with the tax consequences, and to ensure their consistent treatment of the amounts advanced.