To help attract physicians in a competitive environment, hospitals and other health care providers may extend loans to newly recruited doctors. The cash can help physicians and their families in many ways, including offsetting the inconveniences and costs of a job change or relocation.
However, if not handled carefully, these loans may be recharacterized as compensation, which can trigger unexpected income and payroll taxes for the doctor. In addition, the recharacterized debt could cause a total pay package to be considered unreasonable compensation that is in excess of fair market value (FMV).
The Tax Court recently examined the tax treatment of a loan extended by a health care provider to a newly recruited physician (Salloum, T.C. Memo. 2017-127). In this case, Centerpoint Medical Center of Independence, LLC (the hospital) transferred $146,500 to Dr. Ellis Salloum when he joined the hospital's medical practice. At the time, both parties agreed that the transfer of cash was a loan.
In 2009, Salloum agreed that he would join the hospital's medical practice in Missouri for at least 36 months. He was to engage in private practice as a vascular surgeon within the geographic area served by the hospital and be treated by the hospital as an independent contractor. He signed a physician recruiting agreement, a compensation guarantee with forgiveness agreement, and a promissory note. These documents stated that:
- The hospital would loan the physician $146,500, and that amount was to be advanced in monthly installments over the first six months (the guarantee period);
- Interest would begin to accrue at the end of the six months at the lower of the prime rate reported in the Wall Street Journal plus 1% or the maximum rate permitted by law;
- As security for the payment of principal and interest on the loan, the physician granted the hospital a security interest in the accounts receivable of his private practice;
- To encourage prompt payment, the hospital would forgive interest on any amounts repaid within six months after the sixth monthly installment had been made to Salloum;
- To encourage the doctor to remain in the geographic area, the hospital agreed to forgive and cancel one thirtieth (1/30th) of the loan amount for each calendar month after the end of the first six months that he remained in the full-time practice of medicine in the community, maintained privileges in good standing at the hospital, and remained available for emergency room coverage at the hospital; and
- Salloum's income from any forgiveness of debt on the loan would be reported as nonemployee compensation on Form 1099-MISC, Miscellaneous Income.
The compensation guarantee with forgiveness agreement explained that the hospital would treat the loan as an advance of compensation. The guarantee amount was limited to the compensation paid to him. The parties agreed and verified that the guarantee amount represented no more than FMV for the doctor's specialty in that community.
In accordance with the agreements, the hospital reported a small amount of nonemployee compensation to Salloum on a Form 1099-MISC for 2009, but did not include the $146,500. Likewise, Salloum did not include the $146,500 in his taxable income in 2009. During 2010, the hospital again paid nonemployee compensation and reported it on Form 1099-MISC.
In February 2011, Salloum terminated his relationship with the hospital. As required under the agreements, during 2012 he transferred $46,884 to the hospital to repay the remaining balance that the hospital had loaned to him in 2009.
In its opinion, the court remarked that the determination of whether a transfer of funds constitutes a loan is a question of fact. For a cash transfer to be a loan for tax purposes, two important conditions must exist when the funds are transferred. First, the transferee must be unconditionally obligated (i.e., the obligation is not subject to a condition precedent) on the transferee's part to repay the funds. Second, the transferor must unconditionally intend to secure repayment of the funds.
Whether these two conditions exist is inferred from the following factors:
- The existence of a debt instrument;
- The existence of a written loan agreement;
- Collateral securing the purported loan;
- The accrual of interest;
- The borrower's solvency;
- The treatment of the transferred funds as a loan by the purported lender and borrower;
- A demand for repayment of the funds; and
- The repayment of the transferred funds.
Various factors surrounding the 2009 transfer to Salloum indicated that it was indeed a loan. This included the fact that he had executed a promissory note in which he agreed to repay all amounts that the hospital transferred to him and that the compensation guarantee with forgiveness agreement referred to the "Loan Repayment Amount."
In addition, there was a loan agreement that comprised the recruiting agreement, the compensation guarantee with forgiveness agreement, and the promissory note. The physician agreed to pay interest at the rate specified in that note; he had granted the hospital a security interest in the accounts receivable of his private practice; the borrower had the ability to repay the loan; he in fact repaid the $146,500; and both parties treated the cash transfer as a loan in that the hospital did not report it on Form 1099-MISC and the physician did not include it in his 2009 gross income.
Despite these factors, by 2012, Salloum took the position that the $146,500 that he received from the hospital should be considered an advance payment of his salary, not a loan. This was inconsistent with the way he had originally treated the transfer, because he had not reported the amounts in income in 2009 and treated the money as a loan. Since he now had decided that the original transfer was an advance of compensation, he thought his repayment should be a deductible expense. Therefore, he deducted the $46,884 repayment to the hospital as an expense on his Schedule C, Profit or Loss From Business.
When the IRS challenged his deduction, he contended that he was not unconditionally obligated to repay the amount that had been extended to him. He claimed that any repayments of the $146,500 would become due only if he materially breached the physician recruiting agreement and that his obligation to repay was subject to a condition precedent, and consequently his obligation to repay the hospital was not unconditional.
According to the physician, when he terminated his employment with the hospital, any unearned advanced amounts became due to the hospital.
In support of his position, the physician pointed to this language in the compensation guarantee with forgiveness agreement:
Any failure by Physician to comply with the terms of Paragraph E of this Addendum shall be considered a material breach of this Addendum and the Recruiting Agreement by Physician and shall authorize Hospital, at its option, to pursue the remedies described in the Material Breach Section of the Recruiting Agreement.
The Tax Court said that his reliance on the above paragraph ignored other important provisions in the agreements. For example, the compensation guarantee with forgiveness agreement also contained the following provisions:
A. Hospital hereby agrees to loan Physician [the physician] certain amounts of money which Hospital shall advance as a guarantee of compensation for Physician totaling a maximum of $146,500.00 (hereinafter the "Guarantee Amount"). . . .
E. Physician agrees to actively engage in the full-time practice of medicine in the Community and geographic area served by Hospital, to bill all patients and third-party payors promptly for all services rendered, and to use his/her best efforts to collect all patient accounts. Hospital shall have the right to review and audit Physician's books and records for whatever period of time is necessary to assure compliance with the Recruiting Agreement and any Addenda thereto.
F. At the end of the Guarantee Period, the sum of all Guarantee Payments made by Hospital to Physician during the Guarantee Period, not otherwise repaid or recouped pursuant to any other provision in this Addendum shall be calculated. This amount represents the "Loan Repayment Amount" which shall be due and payable by Physician as evidenced by the attached Promissory Note (Exhibit "A") executed by Physician. Interest on the Loan Repayment Amount will begin to accrue at the end of the Guarantee Period. However, in an effort to encourage prompt payment, interest will be forgiven on any amounts repaid within six months of the end of the Guarantee Period. Amounts so forgiven, if any, (as well as any imputed income as required by law) will be reported on Form 1099.
Despite the doctor's argument, the court decided that he had an unconditional obligation to repay the $146,500 that the hospital had transferred to him, even though that obligation was subject to a condition subsequent in that the loan would be forgiven if the doctor continued to practice in the area and met the requirements summarized above.
Therefore, the Tax Court ruled that Salloum did not fulfill his burden of proving that the $146,500 was not a loan.
Salloum did not dispute that, if it was a loan, he would not be entitled to deduct the 2012 repayment.
Hospitals and their recruits need to be careful how these loans are structured and be consistent in their documentation. Also, tax advisers should remind borrowers that forgiveness of a loan creates taxable income, even if there is no cash transfer or withholding related to it in that same year.
Stephen D. Kirkland is a compensation consultant with Atlantic Executive Consulting, LLC (www.ReasonableCompensation.expert).