13 Sep Physician Incentive Loan Clawback Triggers Tax
Doctors who participate in a physician incentive compensation plan featuring a forgivable loan must be cautious in how they handle the tax reporting on their income tax returns, particularly if they bail out and have to pay a clawback to the employer. A recent decision of the U.S. Tax Court, Salloum v. Comm’r., T.C. Memo 2017-17, is instructive. Reporting taxable income derived from a forgivable loanunder a physician incentive compensation plan must be well-timed. If the income is not properly reported, there may be additional taxes, interest and penalties. Moreover, these incentive compensation plans can become hot-button issues when licensed professionals are involved in a complex divorce or child support proceeding.
Hospitals hoping to attract talented physicians these days may offer forgivable loans as part of their physician incentive compensation plans. In a typical physician incentive compensation plan, the medical system extends a loan to the new doctor to assist with a home purchase, relocation expenses or debt retirement (student loans), and if the physician stays with the employer for a certain number of years, the loan is gradually forgiven. Consulting firms also seem to favor these incentive compensation plans. As the loan is forgiven (which may be monthly, quarterly or annually), the forgiven portion must be recognized as taxable income of the professional. If the physician departs before the loan is fully forgiven, the physician must repay the unforgiven portion, with or without accrued interest.
In Salloum, the physician (a vascular surgeon) received $146,500 in 2009 as part of a physician incentive compensation plan. He signed a promissory note by which the $146,500 loan would be forgiven ratably over 30 months, and agreeing to repay the unforgiven portion if he did not continue to work for the medical practice for 30 months. Dr. Salloum did not report the $146,500 loan proceeds as taxable income for 2009. That year, a small portion of the loan was forgiven, and in the following year, a more substantial chunk was forgiven.
In the third year (2011), Dr. Salloum resigned from the practice, and he subsequently repaid the unforgiven portion of the loan, which was approx. $47,000. Dr. Salloum reported the repayment as a business expense on his 2012 Schedule C, thereby offsetting his taxable income from other employment. The IRS disallowed the business expense deduction, and the case ended up in the U.S. Tax Court. There, Dr. Salloum took the position that the $146,500 he received in 2009 was not a loan, but an advance of wages; he conceded that if it was a loan, then he was not entitled to deduct the 2012 loan repayment. See Brenner v. Commissioner, 62 T.C. 878, 883 (1974); Crawford v. Commissioner, 11 B.T.A. 1299, 1302 (1928).
To resolve this question, the Tax Court applied the legal standard: whether, at the time the funds are transferred, there was an unconditional obligation (i.e., an obligation that is not subject to a condition precedent) on the part of the transferee to repay, and an unconditional intention on the part of the transferor to secure repayment of, the funds. See, e.g., Haag v. Commissioner, 88 T.C. 604, 616 (1987), aff’d without published opinion, 855 F.2d 855 (8th Cir. 1988); Dickinson v. Commissioner, T.C. Memo. 2014-136, at *10-*11. The Court also considered relevant factors surrounding the transfer, including the existence of a debt instrument, the existence of a written loan agreement, the provision of collateral securing the purported loan, the accrual of interest on the purported loan, the solvency of the purported borrower at the time of the purported loan, the treatment of the transferred funds as a loan by the purported lender and the purported borrower, a
demand for repayment of the transferred funds, and the repayment of the transferred funds.
Here, the Court noted that Dr. Salloum had not reported the $146,500 as taxable income (compensation) when received in 2009. He signed a promissory note, agreeing to pay interest and granting a security interest in his receivables; and he repaid the unforgiven portion of the loan. In support of his argument that the $146,500 was really a salary advance, Dr. Salloum noted that his obligation to repay the medical practice was not “unconditional.” He claimed that he owed the repayment only if he materially breached the contract. Yet, the Tax Court held that the penalty for material breach was a separate provision from other contract terms that required repayment, even in the absence of a breach. And, the forgiveness provision of the promissory note was a condition subsequent, not a condition precedent that might cause the loan to be characterized as something other than a loan.
The Tax Court affirmed the disallowance of Dr. Salloum’s 2012 Schedule C business expense arising from the repayment of an unforgiven loan granted as part of a physician incentive compensation plan. Dr. Salloum’s tax deduction was disallowed, and he was assessed with accuracy-related penalties, interest and additional taxes.
Physician incentive compensation plans can be complex financial issues in divorce and child support proceedings. Forgivable loans, restricted stock, appreciation rights and other forms of incentive compensation may be treated differently in family court than they would for tax purposes. For instance, the recognition of taxable income might not coincide with the timing of income for child support and alimony purposes. A family court might try to include incentive compensation as income even if it could be subsequently clawed back or is unvested. And, there is the issue of double dipping. Because incentive compensation does not fully vest until the passage of time, it may be erroneously divided twice, once when property is divided and again when child support or alimony is paid.
These issues, which are important to licensed professionals, are analyzed in my book, Frumkes & Vertz on Divorce Taxation. For more than 25 years, my law firm has been representing licensed professionals and their spouses in family law cases involving physician incentive compensation plans. For legal representation in Western Pennsylvania, call Brian Vertz at 412-471-9000 or use the contact form.