Was an employee "loan" really a taxable cash advance?

• Author: Zarzar, Robert
• Position: Sign-on bonuses

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...