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It is not uncommon for sought-after job seekers to receive what appears to be an offer that is too good to be true: in addition to a good compensation and benefits package, the employer proposes to make a loan to the applicant, and to forgive the entire amount if the person stays employed for a particular term—such as five years. Sometimes the game plan is not in writing, and is left to “wink wink, nudge nudge” in terms of the likelihood that the loan will be forgiven if the person stays employed that length of time.
These arrangements are not in any way “illegal,” but as Robert and Elizabeth Brooks learned in the United States Tax Court this year, in TC Memo 2012-25, there are some significant tax problems that could arise from this arrangement.
At the outset, there is a question about whether the arrangement is really a “loan” when there is an intent to forgive in the first place. A loan is a transaction where one person borrows money from the other, with the agreement that it will be repaid, and the lender expects repayment. They are easily reduced to writing, bear interest, and are treated as loans by both parties. Those facts alone, however, will not necessarily make the transaction a loan.
As Judge Mark Holmes pointed out in the Brooks case, such advances have in various contexts been treated as income at the outset because the Court concluded that the intent of the transaction was not a loan, but rather an attempt to induce the person to provide personal services, and the obligation to repay was conditional—only if the applicant quits or was fired for cause within five years. In that situation, the “loan” could be treated as income in the year it is advanced.
In the case of Mr. and Mrs. Brooks, the Court was confronted with the tax year in which the loan was actually forgiven, and Judge Holmes noted that the Internal Revenue Code normally treats forgiveness of debt as income, since the borrower who does not have to pay it back has received an economic benefit. This discharge of indebtedness income includes both the forgiven loan principal and the accrued interest.
In these situations, the old adage that “If it looks too good to be true, it probably is,” isn’t necessarily the point. Rather, before one enters into a transaction like this, it is critical that the prospective employee pin down as closely as possible what the real intentions are, and then review them with a tax adviser. A lot of trouble can be avoided if these steps are taken at the outset, rather than after the IRS comes in and questions the transaction.
George Connelly is recognized as one of the leading federal tax litigators in the United States. His practice focuses on IRS audit, collection and criminal matters including civil and criminal tax litigation matters, for clients ...