Loan/bonus arrangement results in immediate income to employee.

• Author: Sair, Edward A.

Employee loans are generally subject to special scrutiny in an IRS examination. In addition to the issue of sufficient interest for Sec. 7872 purposes, controversy often ensues over whether the loan is bona fide debt or merely an advance payment of compensation.

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.

Facts

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 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...