Below-market executive loans are loans a nonpublicly held company makes available to its executives as a supplement to their regular compensation. Typically, such loans are interest free or made at a favorable interest rate. In other words, these loans are provided at a rate of interest below the applicable federal rate (AFR), set monthly by the IRS. (The AFR is based on the average yield on U.S. Treasury obligations.)
Caution: The Sarbanes-Oxley Act of 2002 (the Corporate Responsibility Act) was signed into law on July 30, 2002. This law prohibits publicly traded companies from making personal loans, directly or indirectly, to executive officers and directors. Civil and criminal penalties will be imposed for making such loans. Loans to executives of nonpublic companies are not prohibited by the act.
At one time, loans with below-market interest rates were a popular executive benefit. In 1984, however, Congress amended the tax laws to clarify that where a loan’s interest is below the market rate (predetermined by the IRS monthly), interest is imputed under a series of rules. If an executive loan fails to provide for adequate interest, the loan is recharacterized as a two-step transaction in which the company is deemed to transfer additional compensation (or dividends) to the executive equaling the foregone loan interest for the period the loan is outstanding. The executive, in turn, is deemed to pay the foregone interest to the company.
Executive loans are typically offered for the following:
- Mortgage or “bridge” loans to help in the purchase of a home when the employee is moving from one of the employer’s business locations to another
- College or private school tuition for members of the executive’s family
- Purchase of the employer’s stock through a company stock purchase plan or other method
- Meeting extraordinary medical needs, tax bills, or other personal or family emergencies such as divorce settlement costs
- Purchase of life insurance
- Purchase of a car, vacation home, or other expensive item
When Can It be Used?
Below-market executive loans are usually restricted by the employer to specified purposes (such as the ones listed previously). These loan programs can be very attractive as a compensation supplement to help executives meet cash needs in special situations. Employers can use these programs whenever they wish to help attract, motivate, and retain key employees and executives.
ERISA Considerations
The avoidance of substantial requirements under the Employee Retirement Income Security Act of 1974 (ERISA) is usually a prime concern to employers when designing compensation arrangements (and employee plans in particular). Fortunately, below-market executive loans do not appear to fall within the definition of either a “welfare benefit plan” or a “pension plan” for ERISA purposes. Therefore, ERISA requirements should not apply.
Strengths
There are a number of advantages to below-market executive loans. These include the following:
Helps business to attract, motivate, and retain key employees. A principal challenge to employers is to attract, motivate, and retain key employees (and executives in particular). These goals can be promoted by providing below-market executive loans because obtaining a loan at favorable or below-market rate is an unusual perk.
Avoids cumbersome Employee Retirement Income Security Act (ERISA) requirements and provides flexibility. Because ERISA does not apply, executive loan programs do not need to comply with nondiscrimination rules. In other words, loans can be provided to selected groups of executives or even to a single executive. Moreover, the terms, amounts, and conditions of executive loans can be varied from one executive to another as the employer wishes.
Provides financial benefits to executives. Below-market executive loans provide a valuable benefit to executives in that these loans make cash available where regular bank loans might be difficult to obtain. Furthermore, the loans are provided at a more favorable rate of interest.
Certain of these loans are exempt from the imputed interest rules. Some below-market loans to executives are exempt from the normal imputed interest tax rules. These exclusions include the following:
De minimis loans aggregating less than $10,000. The below-market rules do not apply to a compensation-related loan if the aggregate loans outstanding between the company and the executive do not exceed $10,000 and the loans do not have tax avoidance as a principal purpose. A husband and wife are treated as one borrower for this purpose.
Low-interest loans without “significant tax effect” on the lender or borrower. A loan is exempt if the taxpayer can show that the interest arrangements will have no significant effect on any federal tax liability of the lender or borrower. The Internal Revenue Service will consider a number of factors here, including whether items of income and deduction generated by the loan offset each other.
Sometimes employers will provide loans to certain employees in order to enable them to purchase a principal residence at a new place of work. In such cases, the AFR for testing the loan will be the AFR as of the date the written contract to purchase the residence was entered into.
Obviously, the topics discussed here are quite complicated; more detailed treatment is beyond the scope of this discussion. For more information, consult additional sources.
Tradeoffs
Tax rules for these loans are complex. The tax rules for below-market loans are complicated and confusing, which increases the administrative cost of the loan program for both employer and employee.
Tax treatment may be unfavorable to employee. The tax treatment of term loans (as opposed to demand loans) is unfavorable–the employee must include a substantial portion of the loan in income immediately in some cases.
Employer must bear administrative costs and risk of default. If the employee defaults, the employer will lose the money altogether or incur expenses to pursue foreclosure. Furthermore, the employer must bear the cost of administering the loan (for instance, by monitoring the payback).
How to do It
Consult an attorney and accountant to set up the plan. It is important to ensure that proper tax rules are understood and followed. An attorney will consider the goals of your business and your financial situation and advise you of the most advantageous compensation plan to adopt. In addition, it may be necessary to consult a certified public accountant to ensure that proper accounting methods are followed.
Tax Considerations
If loan is a below-market demand loan: Interest actually paid along with any interest deemed to be paid by the executive is taxable income to the company (lender) and is deductible by the borrower, subject to the usual limitations on interest deductions. For instance, if the loan qualifies as a home mortgage loan, the interest is fully deductible. If it is a personal loan not secured by a home mortgage, it is nondeductible. If no exception applies, the employer is treated as if it paid additional compensation to the employee in the amount of the difference between the actual rate of interest and the AFR. This additional compensation income is deductible by the employer and is taxable to the executive. The executive is treated as if he paid interest in the amount of the aforementioned additional compensation to the employer. This amount is additional taxable income to the employer. The amount is deductible by the executive, again under the usual limitations on interest deductibility.
If loan is below-market term loan: The executive is treated as if he or she immediately received an amount equal to the excess of (1) the amount of the loan over (2) the present value of all payments required to be made under the loan. This amount is treated as additional compensation income. The company can deduct this amount. Interest is also imputed at the AFR, and the company must include this interest in income. For more information, consult additional sources.
Gift and estate tax: Typically not applicable unless it is a small corporation and there is a family relationship. The loan must qualify as compensation-related and not a gift loan, or else there may be gift and estate tax consequences.
Alternatives
These loan programs are complex and involve substantial administrative costs. Two alternatives that would provide substantially the same benefits to executives:
- Provide loans to your executives at full market interest rates and then “bonus” the interest cost to the executive as additional compensation.
- Guarantee a regular bank loan taken out by your employee.
If you have questions, contact the Experts at Henssler Financial: experts@henssler.com or 770-429-9166.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
