The Forgivable Loan: A Recruitment Tool With Tax Implications For Physicians And Employers
It has become commonplace for hospitals and health systems to extend loans to newly recruited physicians to entice them to join the hospital. The loans are often forgiven over time, assuming the physician satisfies certain conditions. A common condition is to remain employed and in good standing at the hospital or with the health system for a period of time (anywhere from one to five or more years is common). With each year of service, a portion of the principal amount of the loan plus accrued interest is forgiven. From a tax standpoint, the amount of the loan plus interest forgiven in any given year is treated as income to the physician.
Forgivable loans differ from traditional signing bonuses in that signing bonuses are considered compensation and are fully taxable in the year paid. Signing bonuses may or may not be coupled with a promissory note. Due to their treatment as income, signing bonuses are subject to withholding.
While the use of forgivable loans as a recruiting tool has been around for quite some time, they have received scrutiny in recent years both in tax courts and in technical advice memoranda issued by the IRS.
Forgivable loans are advantageous to the physician provider due to the fact that the principal amount of the loan is not considered compensation for tax purposes at the time it is advanced. Instead, taxation will occur over time as the loan is forgiven. Because of the difference in timing as between receipt of funds and payment of taxes, physicians will want to ensure they are prepared to pay taxes over time on the amount advanced up front. The tax may be significant depending upon how much is advanced (the principal amount of the loan) and how much is being forgiven in each year.
The “Bona Fide” Loan
Physicians should be cautious when entering into a forgivable loan arrangement to avoid having the upfront amount of the loan treated as compensation in the year it is advanced. To avoid taxation issues, the loan must be a “bona fide loan” rather than a cash advance. To qualify as a loan, the physician should ensure that there is a formal loan agreement signed by both parties which evidences the understanding of the parties as it relates to the loan. The loan document should specify a rate of interest to be charged on the loan, and should specify the conditions that must be satisfied in order for the loan to be forgiven over time. The loan agreement should explicitly require that the physician repay the loan if he or she fails to satisfy the conditions of the loan. For added protection, the loan agreement should be a stand-alone document coupled with a promissory note and be independent of the employment agreement that the provider enters into. Recent caselaw suggests that the term of the employment agreement should be at least as long as the term of the forgivable loan.
In addition to covering all bases to ensure the arrangement is a true loan, the parties will want to exclude certain terms from the loan documents. For instance, phrases such as “signing bonus” or “compensation” should be avoided, as these call into question the true nature of the payment.
A physician will also want to ensure that the hospital or health system has a practice of enforcing the loan documents that it enters into with its newly recruited providers. For instance, if a hospital or health system has a practice of failing to enforce the terms of the loan agreement (i.e. by not seeking repayment from providers who fail to meet the conditions of the loan), then all loans that the hospital enters into with its physician providers may be scrutinized by the IRS.
Forgivable Loans and Private Inurement Issues
Section 501(c)(3) of the Internal Revenue Code provides exemption from federal income tax for organizations that are organized or operated exclusively for religious, educational or charitable purposes. Nearly half of hospitals in the U.S. are organized under this section of the Internal Revenue Code. Tax exempt status is conditioned on the organization meeting a myriad of rules, one of which is to ensure that “no part of the net income” of the exempt organization “inures to the benefit of any private shareholder or individual.” Modern physician compensation arrangements can trigger inurement/private benefit issues to the extent compensation exceeds “fair market value.”
Hospitals and health systems should have mechanisms in place to ensure the health system is not overcompensating its physicians. Often, national benchmarks or surveys are used to gauge whether compensation is both competitive and fair.
To the extent that a health system fails to offer forgivable loans in a manner that satisfies IRS rules relating to true debt, the health system could be putting its nonprofit status in jeopardy. This occurs because if the loan is not true debt, the total amount on money advanced upfront would be considered compensation to the physician in the year it is advanced. The additional compensation could very easily result in the total amount of compensation to the provider exceeding what would be considered fair market value. This will also have implications under the federal Stark and Anti-Kickback statutes which regulate the relationship between hospitals and physicians.
In summary, forgivable loans can be a useful recruiting tool for hospitals and health systems, but must be documented and structured carefully. Physicians and hospitals should be careful to make sure that loan documents will stand up to IRS scrutiny and evidence bona fide debt.