Up-Front Payments to New Stockbrokers Were Compensation, Even If Required to Be Repaid

Corporation T engages in the securities business and uses the accrual method for purposes of computing its income for Federal income tax purposes. As a means of recruiting new stockbrokers, T offers an arrangement under which a new employee receives certain "up-front" payments. When these payments are made, T and the participating employee simultaneously enter into two contracts--a bonus agreement and a promissory note agreement.

Although these notes' specific dollar amounts and interest rates vary from participating employee to participating employee, the overall structure of the transaction is the same. The employee receives an up-front payment, repayable with interest in five annual installments due on the last day of August each year. T will forgive the entire remaining unpaid principal and accrued interest on a participating employee's death or disability while employed by T or on termination of employment with T (other than for cause). At T's option, any unpaid principal and interest becomes immediately due and payable if a participating employee defaults on an installment payment when due. If any such default is not cured within five days, T has the right to withhold from any amounts payable (as compensation or otherwise) to a participating employee the amount of any payments due under the note, and to apply the withheld amounts to the remaining amounts due. T takes a security interest in all T common stock owned or acquired by a participating employee during the note's term.

Under the bonus agreement, T agrees to pay annual bonuses (plus interest) to a participating employee in five annual installments on the last day of August each year. The bonus agreement provides that a participating employee acknowledges the contemporaneous execution of a note payable to T, and that all bonus payments made pursuant to this agreement apply to the payment of the note until paid in full. The agreement states that the participating employee understands that bonuses paid under this agreement are not considered "recognized compensation" and are disregarded for purposes of T's employee benefit plans, including (but not limited to) the T employee stock ownership trust and profit-sharing plans.

Analysis

The issue is whether the up-front payments from T to participating employees are compensation or loan proceeds. T asserts that these amounts are the proceeds of bona fide loans, while the IRS argues that they are compensation to the participating employees.

In form, the transactions appear to be bona fide loans: (1) the employee signs a promissory note; (2) the employee must make cash payments according to a specified repayment schedule; (3) interest is charged; and (4) there is security for the loan (T stock held by the employee). However, we conclude that, in substance, the up-front payments constitute compensation includible in gross income on receipt.

The purported loan lacks the indicia of bona fide indebtedness. First, there is no unconditional and personal liability on the part of the "debtors" (i.e., the participating employees). A loan from an employer to an employee is bona fide if there is an unconditional and personal obligation on the employee's part to repay the loan. In the present case, unconditional and personal obligations to repay the loans are not present; the loans will be repaid with guaranteed "bonus payments" to be made by T that precisely match the payments due under the loans. An employee will be required to repay a portion of the up-front payment only if he leaves T's employ before the end of the required period of service. Provided the employee provides all of the contracted services, he will not be required to repay any portion of the up-front payment.

Second, the purported loan does not require cash payments in accordance with a specific repayment schedule. 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 pursuant to the agreement. In the present case, despite the form of the transaction, an employee's obligation is satisfied in substance by the performance of services over five years, rather than by a cash payment. For each year he performs services, T forgives one-fifth of the debt. Thus, there is a forgiveness of the debt, rather than a payment of the debt by cash.

T argues that participating employees make cash payments of the loan by applying the bonus payments toward the debt. This argument presupposes that (1) the bonus payments constitute gross income at the time the bonuses are "paid" and (2) the application of the bonus payments toward the debt involves an actual payment (cash expenditure) for which an interest deduction would be allowed (assuming that deduction of interest would otherwise be proper).

Based on a thorough examination of the facts and circumstances, only the up-front payment has any tax effect; by contrast, the bonus payments should not be treated as compensatory payments made to employees. Accordingly, we must reject T's contention that annual offset of the "bonuses" against a portion of a "loan" represents an employee's periodic receipt of income and the simultaneous repayment of loan principal and (potentially) deductible interest. Instead, the up-front payment is in fact the only relevant compensatory payment made by T, with T's deductibility of that compensation determined under Secs. 162 and 461.

First, periodic bonus payments do not constitute gross income for T's employees. Receipt of the bonus payments does not create any accession to wealth over which an employee has dominion and control. Under the bonus agreement, bonus payments must be immediately applied toward repayment of the loan. Further, each loan payment and corresponding bonus payment match both as to amount and timing.

In addition, repayment of the purported loans would not give rise to interest deductions because, in substance, there are no payments (cash expenditures) by employees. A cash expenditure is not present because the "lender" (T) provides the funds with which the "borrowers" make an immediate repayment on the loans.

As stated, an employee receives a bonus payment and must immediately use this money to make payment on the loan. This may be accomplished either by an actual exchange of checks or (without a check swap) by offsetting the employee's obligation to T against T's obligation to the employee. This circular flow of funds between the parties should be disregarded for tax purposes; it lacks a business purpose and economic substance, and appears to be motivated solely by tax avoidance considerations, rather than by any independent nontax purpose.

If an employee leaves before the end of the required service period, he generally will be required to pay the loan's balance. This repayment obligation appears to be more in the nature of liquidated damages for breach of an employment contract, rather than a payment of principal and interest. This obligation is a conditional obligation that arises only on the occurrence of an event subsequent to the receipt of the up-front payment. Such a conditional obligation is not sufficient to characterize the transaction as a loan.

IRS Letter Ruling (TAM) 200040004 (10/10/00)

REFLECTIONS. Also at issue was the timing of the deduction for these up-front payments. Because the participating employees have not provided all the services required in the year of payment, under the economic performance rules of Sec. 461(h), the full amounts of the payments are not currently deductible in the first year. Rather, T incurs the amounts as participating employees perform services over the first five-year term and may currently deduct the amount incurred in each year