Forgivable loans in employment agreements.

• Author: Wong, Alan

An increasingly popular vehicle when trying to lure prospective employees is the offer of a forgivable loan, issued at the inception of employment. The concept is for the employee to receive an upfront payment of cash, similar to a sign-on bonus, where the related income arising from the forgiveness of such debt is recognized over the life of the obligation provided in the agreement.

Example: Company C and employee E enter into an agreement whereby C loans E $1 million on day 1 of employment with the company. C will forgive the $1 million (plus accrued interest) over a five-year period, provided E remains at the company. E will recognize 20% of the total proceeds received (one-fifth) into gross income in each of the five years as that portion of the debt is forgiven. careful attention must De paici during the planning process and when drafting the loan agreement not to create a situation where the treatment of the loan is considered as compensation instead of bona fide debt, causing the loan proceeds to be taxable by the recipient in the year received.

The primary issues for consideration are whether the receipt of proceeds from a forgivable loan constitutes gross income and whether the provisions contained in a loan agreement would provide enough substance for the loan to be considered bona fide debt. Sec. 61 provides that gross income includes all income unless otherwise specifically excluded either directly in other sections of the Code or under judicial precedents. The statutory definition merely defines gross income as income from whatever source derived, and it does not contain any mechanical tests that can be applied to specific situations.

The courts have developed a concept that treats as gross income all items that clearly demonstrate an accession to wealth. The Supreme Court has stated in a gross income case that income is realized whenever there are "instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion" (Glenshaw Glass Co., 348 U.S. 426, 431 (1955)). However, the Supreme Court has also held that gross income does not include the receipt of loan proceeds (James, 366 U.S. 213 (1961)). The concept behind this position is that since the borrower has the obligation to repay the loan, the borrower has no accession to wealth. Nevertheless, the taxpayer cannot exclude amounts from gross income as loan proceeds if there is no loan or if the loan is not bona fide. Advances...