Tuesday, November 6, 2012

During this economic period many employers have been put in the position of having to help employees by providing loans. While the advantages and disadvantages of such practices may be debated, it is important that the transaction be handled correctly for federal income and employment tax purposes.

It is common for the I.R.S. to use the 7 factor test established Welch v. Commissioner, CA-9:

1. the promise to pay was evidenced by a note or other instrument;

2. interest was charged (if applicable);

3. a fixed schedule for payments was established (prior to the money given);

4. collateral was given or pledged to secure payment;

5. repayments were made;

6. the borrower had a reasonable prospect of repaying the loan, and the lender had sufficient funds to advance the loan; and

7. the parties conducted themselves as if the transactions were a loan.

For employee loans there is a $10,000 threshold. Employee loans that in aggregate exceed $10,000 must include the federal interest rate. If the minimum federal interest rate is not charged then the interest not charged is taxable income to the employee.

Most employers are not making $10,000 loans to employees. For most employers we are loaning an employee less than a $1000.00. Loans of less than $10,000 are not required to include interest. An employer can charge interest if they choose but it is not mandated.

The scenario is an employee borrows $500 from the employer with the following.

1. A loan document is prepared and signed by both the employee and employer;

2. No interest is charged;

3. The employee authorizes withholding from future checks of $50 until the balance is repaid;

4. The employee makes three payments ($150);

5. The employee quits.

Under this scenario the employer must be careful. While the agreement allows the remaining balance to be withheld from the employee's final check, a deduction that would result in the employee's pay dipping below minimum wage could be in violation of the Fair Labor Standards Act and many state wage guidelines. So to avoid a violation of wage and hour rules the employer can deduct an additional $150 from the employee's final check resulting in a total collection against the balance of $300. We now have a $200 balance that is probably uncollectable.

Here is the resolution. If we (the employer) write off the remaining $200 balance, we must add the canceled debt amount to the employee's taxable wages in boxes 1, 3 and 5 of their W-2.  If this write off occurs in a year after we have cut their final W-2 we would should report the write off on a 1099-C.

You can find more details in Publication 535 at the I.R.S. website.

If you have questions regarding payroll law and treatment of employee wages contact gary@illuminaregroupinc.com or go to www.illuminaregroupinc.com and click on the "contact" tab.

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