According to a 2017 study by CareerBuilder, they determined that 78% of US workers live paycheck-to-paycheck and 75% of workers were in debt. With those statistics, many employers find it common to be approached by an employee for a loan or advance. While it may be seen as a way to improve employee morale, productivity, and employee loyalty, there are many other factors to take into consideration to avoid a detrimental impact. In this article, I will cover some of the little known aspects of employee loans and advances.
First off is whether or not the loan is going to be a taxable transaction. If the loan amount is greater than $10,000 and there is no interest charged, or it is lower than the applicable federal rate (AFR), then the IRS considers this a taxable benefit. The amount of interest between the AFR rate and the actual rate of interest on the loan is considered compensation and is taxable for Social Security, Medicare, and FUTA tax, but not federal income tax. The IRS publishes the AFR on the following website; https://apps.irs.gov/app/picklist/list/federalRates.html. You will find rates are updated every month, and the rate used is determined by the month the loan is issued. The timing of the recognition of compensation depends on whether the loan is a demand loan or a term loan. Consult with your tax accountant for computation of the taxable amount of interest.
The IRS would also consider this rule of taxable fringe benefit for loan amounts less than $10,000 if the principal purpose of the loan is to avoid paying taxes. For example, if the loan is made with little or no intention of repayment, repayment is very infrequent, or maybe there is just an endless renewal of the loan once it is repaid.
Documentation is key, which brings up the next concern. Employee loans need to be documented in a formal manner and should contain the following points;
- agreement is signed by both the employee and the employer
- employee is required to make payments pursuant to a specified repayment schedule
- interest and principal payments will be made on a timely basis
- interest accrues on the unpaid loan balance at a stated rate
- unconditional and personal obligation on the part of the employee to repay the loan in full
Documentation should also include having formal policy, even making it part of the employee handbook. Having a policy would minimize a claim of discrimination. Sure, having a formal policy may ‘advertise’ to the employees that a loan is available and open one up to a flood of requests, but not having a policy could be much worse leading to a possible civil lawsuit.
Non-profit organizations have an additional layer of concern. In order to be recognized as a 501(c)(3) by the IRS, “No part of the net earnings of the corporation shall inure to the benefit of, or be distributable to its members, trustees, officers, or other private persons, except that the corporation shall be authorized and empowered to pay reasonable compensation for services rendered.” This may very well translate to employee loans not being allowed, as that is to the benefit of a private person. Here is the IRS Compliance Guide on activities that may jeopardize a charity’s exempt status. Some states, such as Vermont, flat out prohibit non-profits from loaning money to board members. Violating the state or federal regulations could jeopardize a non-profit status.
If you are a public company, then the Sarbanes-Oxley Act of 2002 (SOX) made it unlawful to extend or maintain credit in the form of a personal loan to a director or executive officer. Non-public companies not subject to SOX can extend employee loans to employees of all levels.
Lastly, is what to do in the event of default. With a properly documented loan agreement, an employee who separates employment would still be bound to repayment terms, but in the event of default, the forgiven balance is reported as income. While most cancelled debt is reported on a 1099-C form, for employees or former employees who were issued the loan while employed, their cancelled debt is reported just as if it were wages on a W-2 form.
In summary, as they say dot your i’s and cross your t’s when it comes to employee loans. Do not take them lightly by simply writing the employee a check hoping repayment, and follow a procedure to keep your business in compliance.
While I make every attempt to ensure the accuracy and reliability of the information provided in this article, the information is provided “as-is” without warranty of any kind. PayMaster, Inc or Romeo Chicco does not accept any responsibility or liability for the accuracy, content, completeness, legality, or reliability of the information contained. Consult with your CPA, Attorney, and/or HR Professional as federal, state, and local laws change frequently.