Editor's Note: Different types of employee loans have different tax consequences.
Overview: Employers are often willing to provide financial assistance to employees who are short on cash as part of their fringe benefit package. Loans made to employees by employers take various forms and each type has its own particular federal income and employment tax consequences.
- Salary advances. Salary advances made to employees are considered short-term loans on the net after-tax amount of the employee's next paycheck. Therefore, they are not subject to federal income tax (FIT) or Social Security and Medicare (FICA) tax withholding or to federal unemployment insurance (FUTA) taxes. Employees pay back salary advances through payroll withholding.
- Compensation related loans. Loans made by employers to employees or independent contractors with below market interest rates and which exceed $10,000 and create a creditor-debtor relationship are called compensation related loans. The difference between the interest rate charged and the applicable federal interest rate (AFR) is taxable income to the loan recipient. This amount is not subject to FIT withholding, but is subject to FICA and FUTA taxes. This rule also applies to loans of $10,000 or less, if the purpose of the loan is to allow the recipient to avoid taxes.
- Draws against commissions. Salespersons' draws against commissions are also considered loans. Whether they are taxable wages depends on the employment agreement between the salesperson and the employer. Draws that a salesperson is not legally obligated to repay are wages when paid for FIT and FICA tax withholding and FUTA. A draw that a salesperson is legally obligated to repay according to a signed note or a letter, is not wages for FIT and FICA withholding or FUTA tax.
Author: Rena Pirsos, JD, Legal Editor