Last week we looked at deferred compensation as a way to induce employees to refrain from competing with former employers. Click here if you missed that post. You may have another option that may ensure employee staying power — and maybe also non-competition. It’s known as a forgivable loan. What is it, how does it work and is it something that might make sense for you? The EmpLAWyerologist will look into these questions –after the jump…First things first: What’s a forgivable loan? Essentially it’s a loan offered to an employee, that can be forgiven — if the employee meets the terms. As many of my faithful readers know, the devil is in the details. What are the terms? Typically, the terms will include a certain amount of time the employee must stay with the company. For example, you hire Wanda Worker and you want her to stay with you at least 5 years. You give her a forgivable loan of $50,000. For each year that Wanda stays (up to five years) $10,000 of that loan is forgivable. So, if Wanda leaves after 1 year, she must pay back $40,000 of the $50,000 plus interest. If she leaves after 2 years, s/he owes $30,000 plus interest, after 3 years s/he owes $20,000 plus interest–and so forth. If Wanda stays for 5 or more years she owes nothing. Wanda gets a tax-deferred lump sum up front as payment for future services, to use in whatever way she chooses.
The loan amount, while taxable as income to the employee, is taxable over the life of the loan. So, with a $50,000 five-year loan $10,000 will be taxable as income to Wanda each year. It is taxable only as it is repaid or forgiven over time. Per the IRS, and applicable case-law, a forgivable loan is not compensation for tax purposes, as long as the loan represents a true debt agreement, as opposed to compensation, which is taxable when it is paid. To ensure that the loan is not deemed taxable compensation by the IRS or its state counterpart you must provide proper documentation in the form of a promissory note or some type of legally binding agreement between your company and the employee. The note/agreement must include a forgiveness/repayment schedule, clear terms for forgiveness, repayment, default, and interest charges based on market rates. The note/agreement should not include any language referring to the loan as a bonus, award or compensation.
You can see why a forgivable loan could be an attractive option under the right circumstances. First, it might enable you to attract good talent. Second, it might enable you to retain that same talent by giving the employee an incentive to stay. Third, if the employee does not stay for the stipulated amount of time your loss is minimized in that you have a claim for repayment. Now, that last point, for some, may be more theoretical, depending on how much money the employee still owes on the loan, versus how much it might cost you to enforce the loan provisions. The point, however, is that you have additional options you might not otherwise have — at least in theory. There may be some tax laws that come into play, and, if the loan is made to a director or officer, Sarbanes Oxley (SOX) provisions may restrict or prohibit such loans. Otherwise, in general, a forgivable loan will work primarily in accordance with contract laws.
How else might you use a forgivable loan? Suppose in addition to attracting and retaining top talent, you want to ensure a certain performance level. You can also make the loan and/or its forgiveness contingent on the employee’s performance. For example, if the loan is a 5-year loan, your agreement can stipulate a minimum performance level the employee must meet. Again, it’s really about setting the conditions the employee must meet so that the loan, or a portion thereof, is forgiven–or not– depending on whether the employee meets the terms.
Can you use a forgivable loan to ensure non-competition over a period of time? Possibly. Suppose, for example, you hire a top salesperson and you don’t want him/her leaving to work for a competitor for two years after termination of his/her employment. You might provide the payment up-front and then stipulate that half the loan is forgiven at the end of that first year post-termination that the former employee does not compete and the remaining half if forgiven after the expiration of the second year. Again, however, the devil is in the details. If the main objective is to ensure non-competition, is the amount of the forgivable loan sufficient incentive? The amount your former employee will earn working for a competitor will often be more than the amount of the remaining balance on the loan. There may be another option, however. Let’s say you hire Eddie the Executive and you offer him a $100,000 forgivable loan provided he stays with your company for at least five-years. Suppose Eddie leaves after two years. You can call in the remaining $60,000, or you can agree to forgive the remaining $60,000 on condition that Eddie not work for or start a competing business, solicit clients, divulge confidential information, etc for the next three years. You in effect get to decide whether you want to make Eddie pay for leaving early, or whether you want to re-write the terms to induce non-competition. Now, if you entertain this option, you will a) need to draft a new agreement or include this language in a severance agreement; b) consult with a tax attorney to be certain of any adverse federal and state tax consequences to either your company or the employee. This option then essentially becomes a variant of deferred compensation, but may present yet another option for you.
Is a forgivable loan a viable alternative for your company? Of course, it depends on your specific circumstances. You will, of course, want to consult with your friendly in-house or outside employment counsel and make sure that any forgivable loan agreements you offer are properly drafted–and your counsel will need to be knowledgeable of the laws in the state(s) where you employ people.
For a discussion of situations in which a non-competes do not apply, join The EmpLAWyerologist next week.
Disclaimer: This post and all its contents are for educational/informational purposes only, are not intended as legal advice, do not create an attorney-client relationship, and are not intended to replace consultation with competent employment counsel in the state(s) in which you employ people.
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