Often, when there is a shortage of employees with specific skills, medical practices may assist employees or potential employees in furthering their education. The practice may also seek to attach ‘strings’ to the educational benefit in order to provide an incentive for the newly trained employees to remain in their employ.
In order to accomplish this goal at a minimum current tax cost to the employee, the educational benefit may be structured as a loan, with the loan forgiven if the employee remains employed for a certain period of time. As this article will explain, the proper structuring of this loan is extremely critical to obtain this current tax deferral for the employee.
A true loan is neither taxable by the debtor nor deductible by the lender. But if the loan is forgiven, there is a taxable event. If the loan is satisfied through services rendered by an employee, the amount forgiven is taxable as wages at the time forgiven.
Payments labeled as ‘loans’ are sometimes held by the IRS to be advance payment for services. In that case, they are taxable as wages subject to payroll taxes at the time of the advance.
The Tax Court summarized the differences this way: “If the advances were loans, it is obvious that they did not constitute taxable income. On the other hand, if the advances were compensation for services, even though those services were to be performed in the future, they constituted taxable income in the years received.”
In either case, the recipient of the funds incurs an obligation, which requires satisfaction at some point in the future. 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 a debtor-creditor relationship arise, requiring satisfaction by monetary repayment.
Whether an advance is a loan or advance payment of wages is a factual determination. A debtor/creditor relationship must exist at the time of the advance to constitute a loan. Intent is key. The courts look at (a) whether there is a written note or loan agreement, (b) if interest is charged, (c) if there is a fixed repayment schedule, (d) if collateral was provided, (e) if repayments were made, (f) if the borrower had the ability to repay the loan, and (g) if the parties conducted themselves as if the transaction was a loan, reflected in books, records, etc.
The subject of a 2004 letter ruling was a program initiated by a hospital, in conjunction with a nursing school, in order to provide an adequate supply of nurses to meet the demands of patient care. Under the program, the hospital would agree to advance loans on behalf of a student for tuition. The student could either repay the loans in cash or seek loan forgiveness by making a commitment to work at the hospital as a registered nurse for a period of two years after graduating. Each tuition payment was evidenced by a Student Loan Nurse Agreement, which provided for an interest rate equal to or greater than the applicable federal rate set by the IRS. If the student successfully completed two years of employment by the hospital as a registered nurse, all principal and interest was to be forgiven.
The IRS found that the program and the notes legally obligated the student to repay the amount of tuition advanced by the hospital on the student’s behalf, whether in cash or through the performance of services as a registered nurse for a period of two years. The notes also evidenced the hospital’s intent to seek repayment in the event of default. The IRS ruled that the tuition amounts constituted loans includible in the student’s gross income at the time the loans are forgiven. The ruling also pointed out that there was no employment relationship until the student accepted employment with the hospital. The forgiveness constituted wages for purposes of employment at the time of forgiveness.
On the other hand, in Vancouver Clinic Inc., a U.S. District Court held that advances were compensation for services. A medical clinic entered into agreements with newly hired physicians, titled ‘associate physician loan agreements.’ The purpose of the agreements was to facilitate physician recruitment and retention. The agreements provided that the physicians would have to repay the advances only if they broke their contract to remain employed for five years. The agreements provided for accruals of interest at prime, but as long as the physicians worked for the five years, no payments were due at all.
Compounding the problem, when the amounts were forgiven, the clinic reported the forgiveness on a Form 1099-MISC rather than as wages. With interest, the IRS assessed more than $600,000.
In ascertaining the intent of the parties by examining the facts and circumstances, the court said: “In this case, the performance between the parties and the agreement on its terms strongly suggest that the parties did not actually intend repayment. The physicians expected to fulfill their promise to work at the clinic for five years, and, as a result, the advances would be forgiven. The name the parties gave the agreement is not persuasive, nor is it dispositive. The agreement provided physicians with up-front advances as an inducement to get the physicians to remain working for five years. The agreement penalized physicians who departed early by making them repay under a provision that functioned like a liquidated-damages clause for the physician’s breach of his or her promise to remain employed.”
The expectation of the parties at the time they entered into the agreement was that the physicians would serve their time for five years at a minimum. They would not repay any loan because they would fulfill their obligation for five years. And it is only in the exceptional case that anyone would repay the advances. That has to be the controlling expectation, or the agreement would look totally different than the deal consummated by the parties. The parties’ expectation, their intent, was that the loan would be forgiven, and there was no fixed schedule for repayment at the time that the agreement was signed. Moreover, the ‘borrower’ did not have a reasonable prospect of repaying in the vast majority of those circumstances.
The cases cited above compel just one conclusion: advances under the agreement were compensation for services. The primary purpose of the agreement was to offer an incentive for physicians to remain with the clinic for five years. The clinic adopted a common-sense solution to a common problem. Examined under a microscope, it both appears and is a part of the clinic’s compensation package. The advances were wages for services, required to be recognized as compensation. As a result, the clinic was required to withhold the appropriate employment and income taxes from the advances and report the advances to the physicians on a Form W-2 in the tax period in which the payments were made.
Given the risk, as demonstrated by Vancouver, it is important to classify the educational assistance correctly at the time of the advance. If it cannot be demonstrated that the advance is truly a loan that anticipates repayment, it may be prudent to treat the payment as an advance payment of compensation. If the parties intend a loan, then dot the i’s and cross the t’s.
To do so, consult with knowledgeable tax and legal advisers. Be sure to document with a legally enforceable note. Provide for interest and a repayment schedule. Record the agreement as a loan on your books. Finally, don’t forget to report amounts forgiven as wages when forgiven.