The Ultimate Guide to Smarter Forgivable Loans

One of the most effective (and underutilized) strategies that companies use to attract top talent is the forgivable loan – a practice that has recently come under scrutiny following Morgan Stanley's attempt to collect a $6 million recruiting loan balance. This move has sparked a legal battle, shedding light on the complexities and potential challenges associated with forgivable loans - especially in the financial sector. If Morgan Stanley had structured this program differently they could have avoided all issues.

There are some key steps one can take to safeguard forgivable loans. But let’s start at the beginning.

What is a forgivable loan? Forgivable loans are a common recruiting tool where an employer provides a loan to an employee (either at the time of hiring or while employed). The principal of the loan must be repaid to the employer unless the employee fulfills a minimum retention period (and sometimes some performance objectives). Once these requirements are satisfied, the principal of the loan is forgiven and, therefore, not required to be paid back to the employer. The principal of the loan is considered income to the employee and is taxable. Some typical use cases include enticing financial advisors to join a financial services firm or in the healthcare space to attract credentialed professionals to hospitals, among others.

The rationale behind forgivable loans is clear: to attract and retain top talent, firms offer substantial upfront financial incentives. For employees, the significant upfront capital provided by forgivable loans can have an incredibly positive impact on their financial health.

However, the recent legal dispute involving Morgan Stanley highlights the need for both employers and employees to fully comprehend the terms and conditions surrounding forgivable loans and the regulatory/legal environment in which they’re provided.

Here are a few downsides to forgivable loans for employers, that could wreak havoc if not proactively thought through.

⚠️ Tax Implications: Court cases over the last two decades have often found that the principal of a forgivable loan is taxable at the time the loan amount is provided to the employee. At first blush, this might seem reasonable but, in reality, this payment has not yet been earned! So, if the employee leaves before the required objectives have been met, they’ve already been taxed on money they now have to return. This creates many challenges for both the employer and the employee. First, the employer and employee have to forego the benefit of tax amounts that may never be actually due. This will require new tax filings and corrected W-2s, not to mention the administrative hassle and cost associated with these efforts. It's crucial to consult with tax professionals to ensure compliance with tax laws and to properly communicate the tax implications to employees.

⚠️ Administrative Complexity and Expense: A forgivable loan must be structured carefully. Therefore, the involvement of attorneys familiar with these structures is mandatory. Further, whether an organization is completing a one-off forgivable loan or forgivable loans are part of an organization’s regular compensation strategy, managing vesting schedules and generally keeping track of recipients requires a thoughtful system. Failure to manage this program can lead to diminished benefits, ungrateful employees, and an ineffective compensation tool.

⚠️ Risk of Non-Recovery: If an employee leaves before the specified forgiveness period is complete, the employer may face challenges in recovering the loan amount. This is typically due to lack of experience in collections, failure to designate employees to pursue claims, and concern over an employer’s reputation as it tries to collect amounts due from former employees. Using a third party to collect amounts will typically cost up to 40% of the principal amount, significantly detracting from benefits of the program.

⚠️ State and Federal-Specific Regulations: Lending money is a regulated activity. Your organization may unwittingly be in violation of lending laws when issuing forgivable loans as compensation. This can lead to civil penalties as well as a significantly reduced benefit from the program. Also, employment laws vary by jurisdiction, and employers need to be aware of specific regulations regarding bonus structures, employment contracts, and loan arrangements. Courts in certain states are unsupportive of the forgivable loan structure or they can make it difficult to collect amounts due from former employees.

Working with a third party to execute and manage your retention and performance compensation is ideal to safeguard against all of the above complications. A third party can provide you turnkey transparency, enforcement, reviews, management, automation, and more.

Reach out to our team if you’re looking to deliver the benefits of forgivable loans without the headaches!

For companies looking to offer forgivable loans on their own, here are a few tips to establish clear guidelines and practices, avoid legal challenges, and maintain a positive employer-employee relationship:

✅ Consult Experienced Professionals: You should find attorneys and accountants who have set up forgivable loan programs previously. As the saying goes, the doctor who operates on himself or herself has a fool for a patient!

✅ Transparent Communication: Clearly communicate the terms and conditions of forgivable loans to prospective employees. Transparency can help manage expectations and reduce the likelihood of misunderstandings later on. Think: Ongoing dashboard to proactively see the status of your loan, the vesting period, milestones, and more

✅ Consistent Enforcement: Ensure that the enforcement of forgivable loans is consistent across all employees. Inconsistencies can lead to legal complications and negatively impact the company's reputation.

✅ Automate Collections: Leverage a third party to handle collections for you. Not only will this save you the administrative burden but it will protect your corporate brand from having to chase after former employees for their unvested loan amounts. As we said above, it’s not cheap to use a third party collection agency, but you will probably recover a lot more than attempting to do so by yourself.

✅ Understand Your Legal Environment and Enforceability: Some states reject the enforcement of forgivable loans against employees who do not fulfill the obligations set forth in the documentation. As we stated above, you may have subjected yourself to lending regulations as you are now considered a “lender” under state and other laws. Some courts restrict enforceability against prior employees or set-offs against other amounts owed. By working with a third party who has existing relationships and state agreements, you avoid any complications here.

While forgivable loans remain a valuable tool for companies to attract top talent, it's crucial to structure the loans properly, establish clear and automated communication, and make a plan for collections - at a minimum. By understanding the conditions for loan forgiveness and maintaining open dialogue, both employees and employers can navigate the complexities of forgivable loans and build mutually beneficial relationships.