In a recent Tax Court case a taxpayer employee was denied interest deductions on a loan from his employer after the employer forgave the loan.
The taxpayer was recruited as a stock broker and as part of his compensation, the employer lent him $500,000, upfront, which was to be paid back by the taxpayer (including interest) at the end of each year over five years. However, the note provided that the employer could forgive that year’s installment payment if the taxpayer continued working for the employer. (This arrangement is fairly common and allows the employer to give an employee a large signing bonus, while spreading tax payments over several years).
The taxpayer worked for all five years and so all principal and accrued interest was forgiven and such forgiven amounts were properly included in the employee’s income.
However, the taxpayer argued that he should be allowed to deduct the forgiven interest from income because under Section 108(e)(2), the payment of such interest would have been otherwise deductible under Section 212 as being incurred for the production of income (namely, his work as a stock broker).
Unfortunately for the taxpayer, the Tax Court held that he did not produce enough evidence to show that he used the $500,000 loan proceeds to buy stock or securities, but simply produced a list of transactions he had entered into. As such, there was no ability to trace the use of the loan proceeds to those financial transactions.
It is imperative that anytime an employer and an employee enter into a loan arrangement that both parties keep accurate records and seek advice from competent tax advisers to ensure that the loan is structured properly.
(Brooks v. Commisioner, T.C. Memo. 2012-25)