The Tax Man Cometh: Loan Forgiveness is Taxable Income

Scenario: An organization forgives a loan it made to an employee. Motivation: A charitable act or gesture of goodwill. Unintended consequence: Potentially significant tax implications for the employee. 

Internal Revenue Service (IRS) regulations stipulate that any loan that is forgiven can be classified as "cancellation of debt" (COD) income — which is treated as taxable. This distinction is crucial for both employers and employees to understand as it can impact the employee’s tax obligations and financial situation.

The nature of the loan itself is key to grasping the tax consequences associated with loan forgiveness. When an employee receives a loan from their employer or through an employer-sponsored program, the expectation is that it will be repaid over time. If the organization forgives this debt, the IRS considers it as income that has been “canceled.” For example, the IRS requires that a forgiven $10,000 loan be reported as income on the employee’s tax return as if they had earned an additional $10,000. This potentially could push them into a higher tax bracket. Ouch.

Importantly, COD income extends to other situations where debt is forgiven or discharged. IRS guidelines require that anytime a borrower — whether an individual or an entity — is relieved of their obligation to repay a debt, the forgiven amount is treated as income. 

Other aspects surrounding the issue of loan forgiveness can be potentially confusing. Employees may believe the forgiveness is a gift or outright financial relief, leading them to mistakenly believe that it would not have tax implications. However, the IRS stands firm on this regulation. Employers should ensure that they inform employees about how debt cancellation impacts their tax obligations. Employers also may want to provide educational resources or consult with tax professionals to clearly communicate these implications to their employees who benefit from loan forgiveness.

But there is good news! There are several situations in which forgiven debts might not be considered taxable income. For instance, if the employee qualifies for certain exemptions under IRS guidelines — such as those involving insolvency or bankruptcy — they may not have to report the forgiveness as taxable income. Be aware that such exemptions are limited and involve specific criteria that must be met, making them unlikely for the average employee.

In summary, organizations should approach the topic of loan forgiveness for employees with transparency. Being informed empowers employees to make better financial decisions and prepares them to handle the unexpected effects of loan forgiveness at tax time.

Talk with your Auxilio Partner Strategist about the best way for a church to offer one-time benefits such as loan forgiveness to employees. If you’re not yet an Auxilio client partner, contact us to learn how we can serve your church or faith-based nonprofit and reduce your administrative burden to free you up for ministry.