This article is reprinted with permission from the
March 21, 2001
edition of
New York Law Journal.
2001 NLP IP Company.


Tax Treatment of Loans to Executives

By Joseph E. Bachelder

MANY EMPLOYERS make loans to their executives. The purpose of such a loan may be to assist the executive in the purchase of a home or in the purchase of employer stock. Sometimes the loan is in the form of a cash advance (e.g., as part of a sign-on arrangement with a new executive).

Frequently, the loan is forgivable over a period of time provided the executive remains employed. Sometimes such forgiveness does not appear in the note or loan agreement but is provided in the form of future guaranteed bonuses that can be applied to satisfy the debt. The loan also may be forgivable if the executive's employment terminates for specified reasons (e.g., death, disability or termination by the employer without cause).

Loan Is Compensation

In Technical Advice Memorandum 200040004 (Oct, 6, 2000) (TAM), the Internal Revenue Service concludes that a loan by an employer to an employee evidenced by a promissory note, under the circumstances addressed by the TAM, represented compensation, not a loan, for tax purposes.

The ruling was requested by the employer, not the executive. It directly concerns the deductibility of the payment made by the employer and the timing of that deductibility. The TAM states explicitly, however, that the position it is taking regarding treatment of the payment as compensation affects not only the issue of treatment by the employer but also treatment in the hands of the executive.

In this case, an employer conducting a stock brokerage business entered into "sign-on" arrangements with its new brokers. As described in the TAM:

[at] the time the up-front payments are made Taxpayer and the participating employee simultaneously enter into two contracts. The first document is entitled "Bonus Agreement," the second is entitled "Promissory Notes and Pledge Agreement."

As part of these arrangements, the brokerage advanced cash to the new brokers. The advances were evidenced by the promissory notes. The notes were payable in five annual installments, with interest. The bonus agreement provided for annual bonuses equal to the amount of principal and interest coming due each year. Thus, if a broker remained employed for the full five years, the bonus amounts, in the aggregate, would equal the total amount due on the note. In the event a broker terminated employment due to death, disability or a termination by the employer other than for cause, the outstanding amount under the note, including interest, was forgiven. In the event of any other termination (e.g., a voluntary termination or a termination by the employer for cause), the broker was required to pay the balance due on the loan.

The bonus agreement provided that all bonus payments under it were to be applied to payment of amounts due under the promissory note until it was paid in full. It also provided that the bonus payments were not to be recognized as compensation under the employee benefit plans such as the employee stock ownership trust and the profit-sharing plans.

The IRS held that the "purported loan lacks the indicia of bona fide indebtedness."

Before discussing the reasoning of the TAM, please note the following:

   1. The employer in this case consistently treated the advances as loans and was seeking the ruling to confirm that treatment.
   2. On the other hand, by tying the amount and timing of the bonus payments to the amount and timing of the installments becoming due on the promissory note, the employer opened the door for the IRS to question the true nature of the transaction.
   3. The problem with the ruling is not so much that the IRS decided as it did in the case before it but rather with the reasoning underlying its decision, as discussed below.
   4. In any event, the position taken by the IRS in TAM 200040004 and the reasoning underlying that position are a warning to tax planners to give careful attention to the structuring of loans by employers to executives.
    5. The latter part of the column suggests ways in which employers and executives might enter into forgivable loan arrangements designed to reduce the risk of challenge by the IRS under TAM 200040004.

Reasoning Behind the TAM

The IRS gives two reasons for its conclusion that the arrangements between the brokerage firm and certain of its brokers did not constitute loans, but represented compensation:

First, it states that

[a] loan from an employer to an employee is bona fide if there is an unconditional and personal obligation on the part of the employee to repay the loan.

The IRS concludes that

[in] the present case, unconditional and personal obligations to repay the loans are not present because the loans will be repaid with guaranteed "bonus payments" to be made by Taxpayer which precisely match the payments due under the loans. The employee will be required to repay a portion of the up-front payment only if the employee leaves Taxpayer's employ before the end of the required period of service.

Second, the IRS states that 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.

The IRS found repayment in the form of services rather than in cash.

Reasoning of the TAM Is Flawed

The reasoning of the IRS on both these points is subject to question.

Requirement of an unconditional obligation. Debt can exist even if there are future circumstances that may modify or eliminate it. The IRS seems to have confused requirements for a negotiable promissory note with requirements for general contractual indebtedness.

It is true that a negotiable instrument must contain an unconditional promise to pay. 1 However, a debt may be evidenced by an instrument other than a negotiable instrument, such as a contract or an account, and, under commercial law, an enforceable debt can be represented by a conditional promise to pay. 2 Payment can be conditioned, among other things, on the prior payment of another debt. 3 Two tax cases recognize debts as bona fide loans for federal income tax purposes when payment has been conditioned on a future event. In one case, payment on certain "water contracts" was limited to future revenues from a water system. 4 In another case, payment was limited to future revenues earned by an agent in a life insurance business. 5

The TAM cites several tax cases in support of its position on the issue of unconditionality. Each of these cases involved advances to employees or agents of companies in the insurance business. The future earnings of the employees or agents (e.g., commissions) were to be applied against the advances. In two of the cases, if the commissions were not earned, the loan would not have to be repaid. 6 In the third case, the Tax Court held that the arrangement did constitute a loan and the IRS subsequently acquiesced in the decision. 7

Payment by Cash

Requirement that repayment be made by cash. If a debt is to be evidenced by a negotiable promissory note, then it also must be payable only in cash. 8 There is no requirement, however, that a debt evidenced by a nonnegotiable promissory note or by a contract be payable only in cash. 9 Today, many commercial loans are noteless -- evidenced solely by a contract between the lender and the debtor. 10 As a contract debt, a loan can be discharged in any way contemplated by the contract, whether it be cash, property or services. 11

The IRS also recognizes that a debt, such as an advance by an employer to an employee against future earnings, representing a legal obligation of the employee to repay the debt, can be discharged through the performance of services. 12 Tax cases support the same proposition. 13

In support of its position in the TAM that an obligation denominated as indebtedness is not necessarily indebtedness for tax purposes, the IRS cites only one case, Beaver v. Commissioner, 55 T.C. 85 (1970). In that case, the petitioner had been serving as vice president in charge of finance and comptroller of a manufacturing company starting in April 1958. The taxpayer was advanced salary. This practice continued for several years. The understanding was that the amounts advanced would be paid out of future salary.

On its books, the employer treated the advances as part of payroll. It withheld federal income taxes and FICA taxes from the advances. The taxpayer apparently did not object to the withholding. The taxpayer did not execute any note in favor of the employer and, according to the court, "the record does not indicate that any provision was made for the payment of interest with respect to the advances."

Under these circumstances it is not surprising that the court found that the payments to the taxpayer were taxable compensation in the form of salary advances rather than a loan. (In fact, the taxpayer failed to file tax returns for the years 1958 through 1962 and later entered a plea of guilty to a criminal charge for failure to file a tax return.)

In this context, the court said:

In the case of a loan, satisfaction is to be made by making monetary repayment pursuant to the parties' agreement. In such case a debtor-creditor relationship is established at the outset. In the case of compensation for future services, satisfaction is to be made by actually performing such services. Only when such services are not rendered does there arise a debtor-creditor relationship requiring satisfaction by monetary repayment.

It also said:

An essential element is the intent of the recipient to make monetary repayment of the amount of the advance and the intent of the person advancing the funds to enforce such repayment.

A distinction should be made between (a) an advance of salary to be satisfied out of future performance of services and not represented by a written evidence of indebtedness and (b) a loan made by an employer to an executive for a specified amount, which bears interest, is due by a fixed date (or is payable in fixed installments) and is represented by a written evidence of indebtedness, such as a loan agreement or a promissory note (whether or not negotiable), and which may be satisfied out of future services, not just cash. Clearly the Beaver case does not support the position that an arrangement described in clause (b) cannot be recognized as a loan for tax purposes.

The Circumstances of the TAM are Special. The fact pattern that TAM 200040004 addresses is unique:

   1. As noted above, the amount due on an installment basis and the guaranteed bonus payments (five payments over the five-year period) were exactly the same as the timing and amount of the bonus amounts under the bonus agreement.
   2. The bonus payments were not received by the broker but were applied directly to pay off the debt.
   3. The note on its face was forgiven upon termination of employment except in two circumstances: voluntary termination by the broker and termination of the broker by the employer for cause.

Thus, while a ruling like TAM 200040004 raises a red flag for employers and employees wishing to enter into loan arrangements with forgiveness features, the circumstances giving rise to it were unusual and the result in TAM 200040004 might have been avoided if the employer had documented the arrangements differently.

Avoiding the TAM

Designing Loan Arrangements to Avoid the TAM. There are several things that an employer might do to mitigate the problems raised by TAM 200040004.

   1. Do not include a forgiveness provision in the promissory note or other loan document.
   2. Do not schedule bonus payments under a separate agreement to be made at the same time and in the same amounts as installments becoming due under the promissory note or other loan document.
   3. Provide that bonus amounts are to be paid to the executive and not applied directly against the debt. In order to give reasonable assurance of payment by the executive, the promissory note or other loan document can provide that failure to make payment of principal and interest when due will result in accelerated maturity of the debt.
   4. In lieu of forgiveness of the debt upon certain terminations of employment, include in severance payments amounts that approximate (but are not exactly the same) as the amounts due under the note or other loan document.


FOOTNOTES:

1 N.Y.U.C.C. @ 3-104(1)(b); Model U.C.C. @ 3-104(a)(1990).
2 Richman v. Kauffman, 369 N.Y.S.2d 565 (App. Div. 1975).
3 Id. at 567.
4 Wilson v. Commissioner, 51 T.C. 723 (1969), acq., 1976-2 C.B. 3.
5 Latendresse v. Commissioner, 26 T.C. 318, 321, 328 (1956), acq. in result, 1957-2 C.B. 5, aff'd, 243 F.2d 577, 580 (7th Cir.), cert. denied, 355 U.S. 830 (1957).

6 Kinzy v. United States, 1987 U.S. Dist. LEXIS 14769, 1987-2 U.S.T.C. (CCH) P9520 (N.D. Ga. 1987); George Blood Enterprises, Inc. v. Commissioner, T.C. Memo 1976-102, 35 T.C.M. (CCH) 436 (1976).
7 Gales v. Commissioner, T.C. Memo 1999-27, 77 T.C.M. (CCH) 1316 (1999), acq., 2000-52 I.R.B. 605.
8 N.Y.U.C.C. @ 3-104(1)(b); Model U.C.C. @ 3-104(a)(1990).
9 80 N.Y. Jur. 2d, Negotiable Instruments and Other Commercial Paper @ 104 (1989); 10 C.J.S. Bills and Notes @ 236.
10 One tax case has recognized an advance evidenced only by entries in a corporation's books as a bona fide loan. See Werner v. Commissioner, T.C. Memo 1962-269, 21 T.C.M. (CCH) 1434 (1962).
11 Sherman v. Matthieu, 94 N.Y.S. 565 (App. Div. 1905) (mortgage satisfied through performance of services); See also In re Estate of Nowicki, 351 N.Y.S.2d 40 (Sur. Ct. 1973) (discussing what constitutes payment).

12 Rev. Rul. 68-337, 1968-1 C.B. 417 (advances repayable out of future earnings for services); Rev. Rul. 69-465, 1969-2 C.B. 27 (advances repayable out of future commissions of insurance salesmen).
13 Lehew v. Commissioner, T.C. Memo 1987-389, 54 T.C.M. (CCH) 81 (1987) (advances repayable out of future commissions); McIsaac v. Commissioner, T.C. Memo 1989-307, 57 T.C.M. (CCH) 793 (1989) (same).