Hospitals: Watch Out for Tax Implications of Physician Loan Agreements – Forgiven Repayments Might Be Taxable Wages!
Health Law Update 10/24/13 Patricia A. Hintz, Sarah E. Coyne
A common recruiting structure is for hospitals to loan money to physicians who relocate to the community, with an agreement that a portion of the loan will be forgiven each year that the physician remains in the community until the entire value is “repaid” with no actual money changing hands. This is a frequent mechanism used by hospitals to recruit physicians to their communities.
One court has concluded that such payments are taxable wages that constituted income to the physicians at the time that the cash was advanced to the physician (rather than as repayment installments on the loan were forgiven) on the basis that the transfers were not bona fide loans for tax purposes. This could be highly problematic for hospitals who have not treated the advances when made as “wages” for employment tax purposes and who have reported the income when the repayment obligation is forgiven on Form 1099-MISC.
Specifically, on April 8, 2013, in Vancouver Clinic, Inc. v. United States, the United States District Court in the Western District of Washington decided that advances used by a clinic to recruit physicians were compensation for services that should have been taxed as wages when the amounts were advanced, not loans, because the parties never intended that there would be actual repayment.
The Legal Dispute - Loan or Wages
In the Washington case (which is not binding authority in Wisconsin, but which will likely be persuasive to courts deciding the issue for Wisconsin litigants and will certainly be persuasive to the IRS in audits), the Vancouver Clinic, Inc. (the “Clinic”) entered into agreements, called “Associate Physician Loan Agreements,” with newly hired physicians. The Clinic used such agreements to recruit and retain physicians. The agreements required a new physician to work for the Clinic for five years in exchange for two advances of funds paid to the physician during the physician’s first and second years of employment. If the physicians left the clinic before the five-year mark, the agreements required the physician to repay the advances. The Clinic did not treat the loans as compensation until the fifth anniversary of the physician’s employment, at which time the Clinic forgave the advances and issued a Form 1099 (Miscellaneous Income) to each physician whose loans were forgiven. This arrangement arguably allowed the Clinic to avoid withholding certain taxes from the physician advances at the time paid, in particular income tax withholdings and FICA taxes, because the Clinic considered the advances loans. Loans are not reported as income to the employee, and there is no withholding employment and income taxes from loans.
The IRS, however, thought that the advances should be treated as wages. If an advance from an employer to an employee is compensation for services (wages), then the employer must withhold the appropriate employment and income taxes. The IRS assessed against the Clinic withholding and FICA taxes, together with interest, for the advances paid to newly hired physicians in tax years 2007, 2008, and 2009 (the advances in those years totaled roughly $1.5 million). The Clinic disagreed with the IRS about classifying the advances as wages, and this lawsuit followed.
Determining whether a Transaction is a Loan
For a transaction to constitute a bona fide loan, there must be an unconditional promise to repay the funds at the time they are advanced. A transaction is not a loan if the parties do not intend repayment, though determining the intent of the parties is a factual question that requires the court to consider all of the facts and circumstances. In this case, the court determined that an unconditional promise to repay did not exist: The parties to the agreements did not expect any loan to repaid because the physicians would fulfill their obligation for five years, there was no fixed schedule for repayment when the parties signed the agreement, and the parties’ expectation — their intent — was that the advances would be forgiven. Furthermore, the Clinic used the agreements to recruit physicians and offer an incentive for them to work for five years. Because of these factors, the court decided that the advances were wages for services, which the Clinic must treat as taxable “wages” when the advances were made.
The court’s decision in the Vancouver Clinic case instructs hospitals and clinics to structure physician advances and recruitment payments carefully. As noted in the court’s decision, courts will consider a number of different factors when deciding whether an advance or transaction is a true loan. The list of factors considered is non-exclusive, and the list forms a general basis upon which courts may analyze a transaction. Such factors include, among other things:
- an unconditional promise to repay the loan;
- the parties’ intent;
- whether the agreement included a fixed schedule for repaying the loan;
- whether the agreement included penalties for breaching the terms of the transaction (e.g., leaving the clinic before working there for five years);
- whether the loan was secured;
- whether the terms of the loan were negotiated by the parties similar to third-party financing (e.g., financial background and credit checks are done to evaluate credit worthiness);
- whether a “borrower” has reasonable prospects of repaying the loan; and
- whether the advances included interest charged.
Accordingly, hospitals or clinics advancing loans to physicians as a recruitment package may want to consider 1) structuring advances with these factors in mind to help ensure that they are treated as true loans, 2) using a separate employment agreement to detail the physician’s compensation and other employment terms, 3) using a promissory note that requires periodic payment of the principal and interest on the loaned amount over the course of the physician’s employment, or 4) structuring the physician’s compensation to allow the physician to repay the loan amount to the lender in full with interest once the physician meets the length of service required by the employment agreement.
For help with structuring physician recruitment agreements and payments, please contact your Quarles & Brady attorney.