Originally published on Forbes.com Apr 16th, 2013
The Vancouver Clinic, Inc wanted to figure out a way to motivate newly recruited physicians to stay on at least five years. Somebody came up with a clever idea. Give them a loan of between $12,000 and $35,000 depending on specialty. If they stay five years forgive the loan. Send them a 1099, for the loan forgiveness in five years. Great idea. On top of the motivation to stay, it saves payroll taxes. Too bad it did not work – the tax part anyway.
From 2007 to 2009 the clinic made over $1,500,000 in signing bonus/advances/ loans or whatever you want to call them. The IRS thought the payments should be treated as wages:
On or about January 10, 2011, the United States, through the Internal Revenue Service, assessed against the Clinic withholding and FICA taxes (Form 941 taxes), together with interest, in the total amount of $626,745. On or about January 25, 2011, the Clinic paid the withholding and FICA tax assessments (Form 941 taxes) together with the interest attributable thereto, for each of the Tax Periods, in the total amount of $626,745. On or about June 15, 2011, Plaintiff filed with the Internal Revenue Service claims for refund of the tax paid by it, in the amount of $593,398. On November 16, 2011, the United States, through the Director of the Ogden, Utah Service Center of the Internal Revenue Service, mailed to Plaintiff Notices of Disallowance of each of its Claims for Refund of tax for each of the Tax Periods.
Next step is for the clinic to sue for refund. That suit did not go well.
The reasoning was pretty simple:
The law has developed one principle for determining whether a transaction is a loan for tax purposes. For a transaction to constitute a bona fide loan, there must be an unconditional promise to repay at the time the funds are advanced.
As far as the Court was concerned, that was not what was going on here. Neither party wanted the arrangement to end with the loan being repaid.
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 upfront 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. Employee retention was what the Clinic wanted to achieve through the Agreement: the Clinic wanted to reap the benefits of the productive years of the physician’s tenure in years three, four, and five, while at the same time giving the physicians much-needed funds in the early years of employment when they were not as valuable to the Clinic. If the physicians did not stay, then the Clinic wanted to get that money back.
The other thing that makes me less than enthusiastic about plans like this, besides them not actually working, is that you end up with somebody having phantom income hanging over his or her head. Presumably in year five when they have to pay the piper, they are a little more settled. Still it would kind of drive me crazy.
You can follow me on twitter @peterreillycpa.