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Taxing Issues: Retention Loans

May 20, 2015

By Jonathan Flora

Borrowing money is a non-event for income tax purposes on the theory that you’re not any richer since you have to pay it back. A corollary is that if your repayment obligation goes away before the loan is repaid, there’s taxable income to the extent of any unpaid principal. Compensation is a different animal. It’s taxable as ordinary income when it’s received (or even constructively received) and it’s subject to employment taxes, withholding and W-2 reporting. Couldn’t possibly conflate these two things, right?

But hospitals (among others) have seized on the tax-free nature of a loan to counteract the high-tax compensation rules. A good example is Wyatt v. Commissioner, T.C. Summary Op. 2015-31 (2015). In that case, a hospital paid a physician to relocate to its low-income community and set up a practice. But rather than characterize the payment as compensation, it called it a loan. More specifically, the hospital guaranteed the physician would make a fixed monthly amount his first year of practice. If there was a shortfall between the guaranteed monthly amount and the actual income from his practice, the hospital would loan him the difference.

All of the monthly loans became due and payable immediately at the end of 12 months, except on one condition.   If the physician continued to practice in the  low-income area where the hospital was located, the hospital agreed to forgive the loan 1/36th per month until it went away entirely.

A fundamental characteristic of a loan is an unconditional promise to repay. You’re probably thinking this can’t be a loan because repayment is conditioned on the physician not sticking it out in the community. Oddly, though, the Tax Court blew past this issue and found the payment to be a loan. (But see below for a different outcome.) It also ruled that as the loan was ratably forgiven in later years, the forgiveness resulted in taxable income to the physician. In other words, the tax planning was successful! The physician, however, seemed only to like the initial tax-free nature of the loan, but not so much the taxable part as it was ratably forgiven. He failed to include the forgiven amounts in his gross income, and the Tax Court ruled he should have.

A very similar arrangement with a different result arose in a District Court in Washington. See The Vancouver Clinic, Inc. v. U.S., Case No. 3:12-cv-06016-RBL (2013). In ruling on a summary judgment motion, the court never even made it past the “is it a loan?” analysis. In that case, the loan was forgiven if the physicians remained in the neighborhood for five years. The court found that the physicians had no intent to ever repay the loan – rather, the court found they intended to stick out the five year period so that it would be forgiven. So unlike Wyatt, the “loan” payments were in fact taxable compensation. This meant the money was taxable at the time received, not when the purported loan was forgiven. The hospital had intended to report the payments on a 1099 as it was forgiven, but the court ruled the payments were W-2 compensation subject to withholding at the time they were made.

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