Was an Employee "Loan" Really a Taxable Cash Advance?

A sign-on bonus can be an effective recruiting tool, but employers often seek to structure it so that the bonus is recoverable if the employee does not stay on board for a sufficient time. Two approaches that accomplish this business objective may not achieve the desired tax treatment. One method involves an initial sign-on payment in the form of a "loan" repaid over time from guaranteed bonuses. Another method provides a schedule to forgive the debt as the loan payments become due. Loan treatment is desirable for tax purposes, because amounts loaned to an individual are not income.

One issue that arises under these approaches is whether the purported loan is really a cash advance. Determining whether a bona fide loan exists for tax purposes is a factual issue that depends on the circumstances of the particular transaction. The more characteristics of a loan that are present, the greater the likelihood that a transaction will be treated as a loan for tax purposes.

Several indicators of a bona fide loan include the existence of a note, a repayment agreement, a stated interest rate and collateral. The absence of one of these indicators might not, in itself, be conclusive evidence that there is not a bona fide loan. At the same time, the presence of all the indicators may not be conclusive that a loan does indeed exist. The parties' intent for the loan to be repaid in cash weighs heavily in the IRS's evaluation. A mere contingent obligation to repay in cash may not be sufficient to sway the Service from its conclusion that there was no intent to repay and thus no loan.

Guaranteed Payments

In Letter Ruling (TAM) 200040004, the IRS concluded that the unconditional and personal obligation to repay loans was not present, because the loans were to be repaid with guaranteed bonus payments that precisely matched the payments due under the loans. According to the Service, the employee's obligation, in substance, was to be satisfied by the performance of future services rather than by a cash payment.

In the TAM, repayment contingencies provided that, in the case of the employee's voluntary termination or termination for cause, the employee would be required to repay the loans without the benefit of the bonus payment. (Termination by a company for cause generally is considered so remote that it may not affect the tax analysis.) The IRS found that the repayment obligation triggered by voluntary separation appeared to be more akin to a payment for breach of employment contract, rather than a payment of principal and interest; see Rev. Rul. 67-48.

Given these facts, according to the TAM, the promissory note and bonus agreement did not give rise to a bona fide loan, even though evidence of loan characteristics were present on the grounds that:

• The "loan" would be repaid with guaranteed "bonus payments," and the employee did not have an unconditional and personal liability to repay the debt (unless a specified condition was met);
• The repayment was intended to be satisfied by the employee's rendering of future services, not by actual cash payment;
• The circular flow of the funds lacked both a business purpose and economic substance; and
• The cash repayment that might occur if the employee voluntarily separated from service appeared to be more like liquidated damages for breach of an employment contract than the payment of debt.

An arrangement involving the scheduled forgiveness of debt as payments become due does not seem distinguishable from the bonus addressed in TAM 200040004. Accordingly, the Service could be expected to take the same position for predetermined loan cancellations.

Tax Treatment

Timing is important. A tax-timing problem arises from a disconnection between when an employee includes the "loan" amount in income and when the employer takes the corresponding deduction. According to the TAM, the loans were includible in the employee's income when made; the amounts were not deductible by the employer until the years when the bonuses were paid. This timing results from the application of Sec. 461(h), which requires determination of economic performance before amounts can be deducted. If, as in the TAM, the "vesting" of a front-end payment is conditioned on the performance of future services, economic performance will not occur until the employee has rendered the required services.

Whether a reasonable tax position can be taken for loan treatment in a particular factual situation should be evaluated carefully in light of the IRS's conclusions in TAM 200040004. The form of the transaction and inclusion of all evidence of a bona fide loan might not result in loan treatment if the employer guarantees that the employee will not be out-of-pocket for the loan repayment while employed. Although TAMs are not authoritative guidance, this ruling provides a strong indication of the Service's likely rejection of loan treatment for many employee advances and signing bonuses structured to recruit key employees.

From Joan Vines, CPA, Washington, DC