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Tax Court: Interest on forgiven loan taxable

by | Jul 4, 2018 | Valuations

Some employers who are seeking to snare top talent offer deferred signing bonuses – often in the form of loans – to key employees.

The loans are scheduled to be forgiven later, after the employees prove their commitment to the new organization.

cf0312cA recent Tax Court case (Robert J. Brooks, et ux. v. Commissioner, TC Memo 2012-25, Jan. 26, 2012) deals with just such a loan and serves as a reminder that employer loans that are later forgiven usually result in taxable income to the employee.

In this case, Robert Brooks received a loan of more than $500,000 from his employer. The employer promised to forgive the entire loan – including interest – if Brooks stayed employed for the full five-year loan term. He stayed and the employer forgave the loan.

Brooks included the forgiven loan principal and accrued interest as income on his tax return. But later, Brooks had second thoughts and claimed that, although the forgiven principal was income, the forgiven interest was not. The entire amount forgiven was $650,342, including $506,300 of principal and $144,042 of accrued interest.

The tax law generally treats the discharge, or forgiveness, of debt as income, but there are exceptions. One is that a debtor does not realize income from forgiveness of debt to the extent that payment of the liability would have provided a deduction. Under this rule, a cash-method taxpayer will not realize income upon the cancellation of the accrued interest that would have been deductible if it had been paid.

Brooks argued that the interest his employer forgave would have been deductible under Code Section 212, which allows individuals to deduct all the ordinary and necessary expenses paid or incurred for the production of income. Brooks said the loan’s purpose was to give him a stake to showcase his skills as a stockbroker to produce income for himself and his wife.

The Tax Court acknowledged that Brooks engaged in a large number of stock trades, which Brooks pointed to as proof that he used the loan to buy a portfolio of stocks. He argued that his actions proved that the forgiven interest would have been deductible as an expense for the production of income.

The IRS countered that Brooks did not trace the flow of money from the loan to his investments. Without evidence showing use of the loan proceeds to buy stocks or securities, the IRS contended that Brooks didn’t prove he would have been entitled to a deduction.

The Tax Court agreed with the IRS. Interest expense generally is allocated to the associated debt. The court said it had to look at how Brooks used the loan proceeds to determine whether the interest related to the debt would have been deductible.

Brooks did not give the court enough information to make the determination.