[From IRS Audit Publication re Reasonable Compensation, 10/29/2014.] #7. LOANS – NO INTEREST, LOW INTEREST, DISGUISED COMPENSATION Loans made by entities to its employees may be at no interest or at low interest and the terms may be such that the loan is, in fact, disguised compensation. Loans to individuals exerting control in an entity should be scrutinized to determine if the loan terms are reasonable and are similar to what would be offered by unrelated third parties in the regular course of business. Some factors that are indicative of a bona fide loan include: the existence of a promissory note, cash payments required according to a specified repayment schedule, interest being charged, and security required for the loan in case of default. Beyond the existence of these factors a Valuation Analyst should determine if the loan provisions are indeed being followed and enforced. A Valuation Analyst should also look for loan forgiveness provisions for all or part of the loan. If a Valuation Analyst determines that a loan is a part of the employee’s compensation, the amount of the loan must be included in the Reasonable Compensation analysis.
IRS Audit Techniques Guide -- The following discussion is copied from the IRS audit guideline that appears under the heading "Loans":
Loans - No Cost/Low Cost/ Disguised Compensation - A number of companies have made loans or extended credit to their executives. These loans have either been at no cost or low cost. In some instances, the terms have been such that the loan is really disguised compensation. Factors that are indicative of a bona fide loan are 1) existence of a promissory note, 2) cash payments according to a specified repayment schedule, 3) interest is charged, and 4) there is security for the loan.
Loans to executives should be reviewed to determine if they are bona fide and to determine if the terms are being followed. Is there a written document detailing the terms of the loan, payment over a certain number of years or is payment on demand; is the interest rate at market or at a below market rate of interest; is the loan listed on the company’s balance sheet as a receivable? Are the terms of the loan being followed – payments are to be made monthly and the executive is not making payments, etc. The loan terms could include forgiveness of part or the entire loan if the executive remains with the company for a certain number of years, etc.
I.R.C. §7872 deals with the treatment of loans with below market interest rates; it specifically applies to what it terms compensation-related loans, which include belowmarket loans directly or indirectly between an employer and an employee. In general, § 7872 operates to impute interest on below market loans. In the case of employer/employee loans, the employer is treated as transferring the foregone interest to the employee as additional compensation and the employee is treated as paying interest back to the employer. Different rules apply depending on whether a loan is a demand loan (7827(a)) or a term loan (7872(b)). A demand loan is a below market loan if it does not provide for an interest rate at least equal to the applicable federal rate. A term loan is a below-market loan if the present value of all amounts due on the loan is less than the amount of the loan (i.e., the yield to maturity is lower than the applicable federal rate). With respect to demand loans, the imputed interest payments and deemed transfer of additional compensation are treated as being made annually. With respect to term loans, the lender is treated at the time of the loans as transferring the difference between the loan amount and the present value of all the future payments under the loan as additional compensation. The term loan is then treated as having original issue discount equal to the amount of the deemed transfer of additional compensation and, thus, subject to the original issue discount provisions of § 1272 et. Seq. There is a de minimis exception from the application of the § 7872 imputation rules if loans between the parties in aggregate do not exceed $10,000. (7872(d)(3)). The de minimis exception does not apply if one of the principal purposes of the loan is tax avoidance.
Personal loans to officers and directors of public companies are banned by the enactment of the Sarbanes-Oxley Act of 2002, which became effective on July 30, 2002. Personal loans outstanding on the date of enactment are not prohibited, provided there is no material modification or renewal of the loan on or after the date of enactment. Neither loans nor an extension of credit can be renewed after the date of enactment of Sarbanes-Oxley. This law does not apply to private companies. Some loans to executives are essentially disguised compensation based on the terms of the loan. Sections 61(a)(1) and 61(a)(12) define gross income to include compensation for services and income from discharge of indebtedness. Reg. §1.61-12(a) provides that if an individual performs services for a creditor, who in consideration for the services, cancels the debt, the debtor realizes income in the amount of the debt as compensation for services. Discharge of indebtedness income by an employee from an employer under these circumstances is payment in the nature of compensation, and thus is includible in gross income and wages for employment tax purposes.
Issues have been raised regarding loan forgiveness (remain in the employ of the corporation for a period of four years), unusual repayment methods (stock in lieu of cash), and extreme repayment dates (repayment by the executive’s trust upon the death of the executive and his spouse). Loans are often used to disguise compensation; therefore, the underlying intent must be examined and addressed.