When to Report a Forgivable Loan?

[ETax847]

A client received a loan from his employer upon accepting his offer that would be forgiven after 3 years, as long as he remained employed with the firm for that length of time.  Should the full amount received be treated as taxable income at the time it is received, or at the end of the 3 year period when the loan is forgiven?

All bases were covered to ensure the arrangement is a true loan as seen in the loan documents

 

[Medlin Software, Dennis]

Complicated. For accounting/tax, at date of loan becoming junk (uncollectable) may be proper.

Your post stating it was an agreed time frame means the amount should likely cause recalculation of wages for RROP (Regular Rate of Pay) purposes to make sure OT and PTO were paid using the correct (RROP) rate, and any difference made up (as well as adding the forgiven amount as current wages). Same as if it were a retention/hire bonus paid 3 years later.

[BulldogTom]

It would be a whole lot easier if the client swapped checks with the employer in 3 years and "paid off" the loan and the employer "bonused" the employee the same day for the same amount (less PR taxes).   Not as tax efficient but cleaner.

I assume the desire of both parties is to get this through without PR tax being paid by either party.   Just an assumption.   If I am right, then the IRS ***could*** reclassify as wages and apply penalties and interest by contending that it is nothing but payment for services rendered by the employee.

I wonder what the interest rate is and if the employee is paying interest at a market rate and on a schedule?  If so, that makes it more palatable as a real loan.

Tom
Longview, TX

[Medlin Software, Dennis]

Tom is right on point. If the interest does not meet "reasonable" tests, it is taxable as wages/income when given (as advances are). There is zero chance this is not "but for employment" and taxable as wages at some point. If it is done correctly, the tax hit can be deferred until forgiven (the only possible benefit I can see).

The IRS does not ultimately care about services performed; they use the "but for employment" test. An example is giving money to an employee for some sort of family expense. "But for employment" there would have been no relationship, and it would be unlikely the employer would have paid the family expense.

BUT, the OP states both parties know it will be forgiven, some will find it tough to not handle as taxable wages on date of the not really a loan was funded.

[Lee B]

Actually the big problem here is that you and your client will have to respond to what his employer does or doesn't do.

As both Tom and Dennis have pointed out, the proceeds are more than likely W-2 wages which would be the IRS position in this situation.

Will his employer at some point issue a W-2 or a 1099 or even issue anything is the big question?

 

[jklcpa]

Seriously, don't guess at this or make assumptions as to how this works. This is a recruiting incentive structured as a loan where it is written off at the end of a designed period if the employee stays with the company.

It's an issue that the IRS has challenged because it believes that the "loan" is taxable when given as a compensatory cash advance, and the employer would get the deduction in the year the period ends (in this case, year 3). The complication is exactly how the transaction is set up that will govern when the income is reported. There is case law on this issue also, iirc one of the more recent ones being Morgan Stanley.

Here is an older article from The Tax Advisor that discusses the issue and does reference a TAM, but there is more recent case law on this too: https://www.thetaxadviser.com/issues/2011/oct/clinic-story-09.html

Here's a blog type article that also describes it and includes some of the advantages and disadvantages of using these employment incentives. https://keepfinancial.com/blog/employee-forgivable-loans-can-be-unforgiving-users-beware

The OP should do more research and case law to understand the issue better and not rely on simple, basic answers here as to when it becomes taxable.

 

[jklcpa]

Here's another good one: https://www.alvarezandmarsal.com/insights/warning-employee-loans-could-have-adverse-tax-consequences#:~:text=In Technical Advice Memorandum (TAM,the loan%2C for tax purposes.

[Medlin Software, Dennis]

Another important factor is the amount of the "loan". If it is more than say 35% of the employee's average paycheck, if the employee walks before the 3-year period, the employer may not be able to recapture via payroll and would be wanting to make it wages - at least for "punishment" purposes. (A daily issue on payroll chat groups, how to recoup advances, sign on, moving, etc.)

If the OP is from the perspective of a preparer handling a question from a client (the employee), I would not (as preparer) step in the steaming pile. Let the employer handle it, correctly or incorrectly, and go from there. The employee reporting it as wages, when the employer has not, could result in the end of the employment. If the employee wants to work for someone who may be shady, so be it.

The main issue is it is taxable period. Trying to make it not is a problem, as it trying to tax shift (if the forgiveness is a wink and nod deal instead of documented).

[jiji778]

On 10/23/2024 at 4:42 PM, Medlin Software, Dennis said:

Another important factor is the amount of the "loan". If it is more than say 35% of the employee's average paycheck, if the employee walks before the 3-year period, the employer may not be able to recapture via payroll and would be wanting to make it wages - at least for "punishment" purposes. (A daily issue on payroll chat groups, how to recoup advances, sign on, moving, etc.)

If the OP is from the perspective of a preparer handling a question from a client (the employee), I would not (as preparer) step in the steaming pile. Let the employer handle it, correctly or incorrectly, and go from there. The employee reporting it as wages, when the employer has not, could result in the end of the employment. If the employee wants to work for someone who may be shady, so be it.

The main issue is it is taxable period. Trying to make it not is a problem, as it trying to tax shift (if the forgiveness is a wink and nod deal instead of documented).

Frankly, I would let the employer dictate this one; if they go ahead to report it as wages later should it be forgiven, then again, issue at hand solved, but if not, a complete no-go area. If they do not declare it as income it may create a lot of problems to the client, they may be sacked should they declare it themselves. It is usually safer to stand still and let the employer take the blame or not, whichever way it is.

[ETax847]

Thanks to all for taking the time to respond! This was super helpful.

[Corduroy Frog]

On 10/25/2024 at 12:53 AM, jiji778 said:

Frankly, I would let the employer dictate this one;

I believe there is ample evidence that the amount of loan forgiveness should be added to his W-2 as taxable income, as well as taxable under social security.

Not exactly the same as the exercise of a stock option, but if there are no code/regs stipulated, the impact should be the same.  Stock options 100s at a strike prce of $10 versus market price of $100.  Benefit $90 per share for exercising options on 100 shares.  $9000 gets added to his W-2 taxable income and social security income if not over the limit.  Employee basis in stock is $100 per share.

Employer dictating this?  Only to the extent that the employer set up this arrangement from the beginning.