Thursday, June 26, 2014

Is IRS Ready to Attack Advance Bonus Arrangements ?

Originally published on Passive Activities and Other Oxymorons on April 22nd, 2011.
CCA 201104039

This is a short one so I will reproduce it in full :

Hi ———-, I haven't encountered the issue before. I don't know whether the arrangement is common in the industry but I suspect it is. I think the issue is whether the advances in anticipation of future bonuses were bona fide loans. The rev ruls attached are the relevant authority (not the material cited in the TAM and the write p which seem -u inapposite). It would be relevant what happens if an employee terminates before the “loan” is repaid, and how the arrangement is documented and what actually occurs in practice. We could discuss factual development with you and the agent.

Attachments: Rev Rul 68 239, Rev Rul 68-337 -

It would be nice if we knew what "the industry" is.  Unless they are cleared up in the same tax year, an arrangement where someone is getting a "loan" against a future bonus is probably fraught with peril for both the employer and the employee.  If it is a common practice in you industry, this might be a heads up.  It's interesting that the Chief Counsel is dusting off some pre-Woodstock revenue rulings.  They are also pretty short so I can give you the bulk of them:

Rev. Rul. 68-239, 1968-1 CB 414

Advance payments made to salesmen against unearned salary, commissions, or other remuneration for which they are to perform services, but which they are not legally obligated to repay are wages at the time of payment for Federal employment tax purposes.

The M company makes advance payments (actually or constructively) to its sales employees against unearned salary, commissions, or other remuneration for services to be performed. The advances are charged to each employee's account, and any advance in excess of the later earned salary, commissions, or other remuneration is carried as an account due from the employee. If an employee's services are terminated, the excess is charged to profit and loss.

Advance payments actually or constructively made by M to an employee for services to be performed are “wages” for Federal employment tax purposes at the time of payment where the salesman's obligation in return is to perform services. Under the circumstances, amounts advanced by the M company to its salesmen are subject to the taxes imposed by the Federal Insurance Contributions Act and the Federal Unemployment Tax Act, and to the Collection of Income Tax at Source on Wages.

Rev. Rul. 68-337, 1968-1 CB 417

Advance payments made to employees that they are legally obligated to repay are not wages for Federal employment tax purposes.
The question is whether advance payments made to employees of the M company are wages subject to the taxes imposed by the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Collection of Income Tax at Source on Wages (chapters 21, 23, and 24, respectively, subtitle C, Internal Revenue Code of 1954).

The M company engages in a general investment banking business and maintains trading departments in its principal offices in several cities. These departments are operated by employees who have profit-sharing agreements with the company. At the end of each calendar month a statement of account is made for the employees showing the net profits credited to their accounts. The net profits represent the gross earnings of such employees, less expenses incurred in the operation of the trading departments. The employees may make withdrawals at any time of amounts standing to their credit. They are also allowed, with limitations, cash advances where there is no credit balance in their accounts. At the time such cash advances are made, they are set up by the company on its books as amounts due from employees and are acknowledged by the employees either by note or letter.

In the instant case, there is an acknowledgment of the indebtedness by note or letter, the M company carries the balances as accounts due from employees, and there is a legal obligation on the part of the employees to repay the advances. This obligation must be satisfied although the employment is terminated prior to payment. The advance payments in the present case are, therefore, distinguishable from those in Revenue Ruling 68-239.

Under these circumstances, the advance payments to the employees of the M company are loans and are not wages for purposes of the taxes imposed by the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, or the Collection of Income Tax at Source on Wages.

So the revenue rulings are pretty clear.  If you want to have a deferral, there has to be a legal obligation to repay.  Since when these revenue rulings were written George Orwell's famous dystopian novel still had a future date, they did not address interest.  (Code Section 7872 was added in 1984.  Thanks to a novel called The Pale King, literary tax geekiness is going to become trendy.  I just got the novel for my Kindle.  It remains to be seen whether I'll write about it here or in my bizzaro blog.)  With the short term AFR at 0.55% charging or imputing on advances will not be that big a deal.  Nonetheless, I think this sort of thing is a very bad idea.

The reason it is a bad idea is that in order for it to work the employer must be able to legally enforce repayment from employess who don't earn the expected bonuses.  I can only think of two possible reasons that you would be advancing them their bonuses.  One is because they think they are  investment geniuses.  The other, probably more common, is that they need the money to maintain their desired lifestyle.  In the first instance, there is significant risk that they won't be able to repay.  In the latter, there is a virtual cetainity.  Not only that, they are in effect either investing or living on their gross income rather than their after tax income.  Even if they continue as employees there will be a strong inclination to put off the day of reckoning.

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