To stand out from the competition and attract and retain top talent for the long-term, some employers rely on some very creative compensation tactics.
One of those tactics is a forgivable loan. Under this type of arrangement, employers offer an employee a loan that will be forgiven if that worker is able to meet certain terms. Generally, at least one of those terms is that the employee stays at the company for a certain length of time. But employers can also work performance standards into the terms of the loan as well.
Here’s an example of how this type of structure works, courtesy of The Emplawyerologist: Say an employer offers one employee a $50,000 forgivable loan because it wants to retain that worker for at least five years.
Under the terms, every year that employee stays with the company $10,000 of the loan is forgiven until the five years are up and the loan is completely forgiven. So if the employee leaves after one year, she is only on the hook for $40,000 of the $50K loan (plus interest). The $50,000 is offered up front as a tax-deferred lump sum and the employee can use it in any way she sees fit.
Forgivable loans do include certain tax implications employers need to be aware of. According to the IRS, the loan amount doesn’t count as compensation as long as it represents a true debt agreement between the employer and the employee with the proper corresponding documentation.
This documentation should include:
- A promissory note or some type of a legally binding agreement between the employer and the employee receiving the loan
- a forgiveness/repayment schedule, and
- clear terms for the forgiveness, repayment, default and interest (based on market rates) of the loan.
This documentation should never include any wording that refers to the loan as a bonus, award or compensation or the loan could become taxable compensation by the IRS.
The loan amount, however, is taxable as income to the employee over the life of the loan, e.g., as the loan is repaid or forgiven over time.
In other words, in the $50,000 loan example above, only $10,000 will be taxable as income each year for the life of the loan.