Tax Consequences of a Non-Recourse Employee Advance Agreement
Providing financial assistance to an employee through an employee advance agreement is a perfectly viable option. But it only works well for all the parties involved if they recognize the potential tax consequences of such a loan.
Since the lines are blurry as to whether or not these loans are considered income, it’s important to understand the tax consequences they carry.
What is an Employee Advance Agreement
Employee advance agreements can be either recourse or non-recourse loans. This means that the person who accepts the loan is either liable or not liable in paying the loan off.
These loans are usually reserved for executives, affiliates, or investors in public companies. To the IRS, they may appear as stock options or compensatory devices.
Companies issue these loans to their employees who want to buy stock, ut don’t have the funds. I.e. (x) company wants to give (y) investor stock, but (y) investor doesn’t quite have the funds to pay for the stock.
These loans incentivize internal investment and build security in a company’s stock. But there are tax implications that (x) company and (y) investor need to account for.
Employee Compensation Issue
Because companies often include these loans on their executive compensation packages, the IRS may consider them as taxable compensatory advances. Therefore, it’s important to take all steps possible to ensure the loan doesn’t appear as compensatory.
Possible Contributing Factors
The following is a list of factors that determine whether the IRS deems a loan as compensatory
- Interest Rate
- Loan Documentation
- Means of principal repayment
- Contractual Forgiveness
- Specific Use
In order for an employer to avoid a loan being viewed as compensatory, there must be a substantial interest rate. The minimum interest rate for employee advance agreements is equal to the Applicable Federal Rate (AFR) for that month.
In other words, the interest rate must be at or above market value. If the interest rate falls below the AFR, the difference must be deducted from the employee’s income as taxable income.
If the loan is a term loan, the amount of the foregone interest is considered transferred to the employee as of the date of the loan. This results in an increase in the employee’s taxable compensation.
If the loan is a demand loan, the IRS calculates the foregone interest separately for each year, and each year’s taxable compensation amount increases as of December 31.
Bona Fide Loans
Perhaps the most important factor on this list is properly documenting loans so they are considered actual loans.
Factors such as there being an unconditional and personal obligation to repay the loan in full on behalf of the employee ensure the IRS recognizes the legitimacy of the loan.
Nonrecourse loans have a dramatic effect on the employee’s tax code. Since legally, the receiver of the loan doesn’t own the stock, he/she is treated for tax purposes as though they have a stock option. Because of this, the taxation event doesn’t occur on the date of the loan, but rather when the stock option is deemed exercised.
Because of this, nonrecourse loans can result in unexpected taxable income at a later date.
As opposed to employer loans, which are used as financial assistance for the employee, forgivable loans are often used as compensation techniques to provide employees with upfront cash. For tax purposes, if forgivable loans lack the conditions of a bona fide loan, they may not be recognized as true loans.
Understand What You’re Getting Into
Employee advance agreements can have tricky tax consequences. What interest rate is used, how you file them, and who is liable all affect how the IRS looks at these loans. So do your due diligence!