Brokerage Firms Use Advance Commission Loans as Part of Compensation
Brokerage firms often use advance commissions incentives to stockbrokers, financial advisors, and other financial professionals as an employee recruitment tool. The intent of this type of industry-standard compensation package is generally three-fold. First, and most significantly, the advance on future commissions functions as a financial subsidy for the broker during the transition from the former employer to the new employer. Because of the regulated nature of the securities industry, it often takes months for a broker's license to clear and transfer to a new firm. Similarly, it takes time for the broker's clients' account paperwork to be completed and returned to the new firm. Even once these documents are received by the new firm, the transferred accounts are subject to the firm's internal account approval process. It is only after completion of this internal approval process that the asset transfer process between financial institutions can be completed. And only after the transfer of the clients' assets from the old firm to the new firm can the revenue streams associated with the client accounts commence with the new employer.
The second purpose of these compensation arrangements is to acknowledge and compensate for the reality that brokers often lose clients when transitioning from one firm to another. For instance, some clients may decide to remain with the broker's former firm. This might happen for a variety of reasons. In many cases, the extended re-licensing process allows another professional at the former firm to establish a relationship with the client during the lengthy license-transfer process. In other cases, the client may have a pre-existing relationship with the new firm or may have previously had a bad experience with the new firm that left a sour taste.
The third and final purpose of these types of compensation arrangements is to provide proceeds which the broker may use for business development. For instance, a portion of the proceeds are typically used to pay for additional sales help (e.g., assistant), to purchase leads for potential clients, and to pay other costs of marketing and general business expenses. More importantly, however, the proceeds can be used to fund a platform of investments which the broker can then showcase to existing and potential clients as evidence of the broker's investment and money management skills. In this way, the broker is able to create a performance track record which conveys the broker's competence and qualification to existing and prospective clients.
Forgiveness of Debt In Connection With Termination of Employment
These arrangements are generally evidenced by a promissory note to be repaid over a period of several years through paycheck deductions. If the broker leaves the employ of the firm prior to full repayment, the notes are often due and payable on demand. In the vast majority of cases, however, the outstanding principal amount will be forgiven in part or full.
Subject to some exceptions, cancellation of debt generally constitutes taxable income insofar as the debtor receives an economic benefit as a result of the debt forgiveness. The effect of a debt cancellation is to reduce the debtor's liabilities and, thereby, increase the debtor's overall net worth. Thus, the amount of debt forgiven is generally treated as taxable income received. Generally, brokerage firms and financial institutions report this income to the IRS as non-employee compensation on Form 1099-MISC. As a result, brokers who leave the employ of a firm prior to repayment of the employment-related loan end up not only with income tax liability, but also self-employment tax liability (about 14% for Social Security, Medicare, FICA, etc). However, since most brokers and financial professionals are W-2 employees, use of a 1099-MISC is often an improper method of reporting the income.
Cancelled Debt as W-2 Wages
The use of a 1099-MISC to report the cancellation of debt as non-employee compensation is, in essence, an explicit statement by the brokerage house that the recipient employee is not an employee. So then why would the employer report this employment-related income as non-employee compensation rather than as W-2 wages?
Maybe to avoid the employer-portion of payroll tax (e.g., FICA, Social Security, Medicare). Maybe due to other non-tax commercial considerations. Whatever the case may be, both the Internal Revenue Service and the United States Tax Court have found stockbrokers and financial advisors to be employees for federal tax purposes. E.g., Gierek v. Commissioner, T.C. Memo 1993-642; Rev. Rul. 76-138, 1976-1 C.B. 315. Most brokers and financial advisors are provided with an office, equipment, and other benefits. In addition, commissions are usually reported on a Form W-2. Finally, and most significantly, stockbrokers and financial advisors are subject to the firm's control with respect to trading and other business activities. Moreover, the promissory notes are issued in connection with the employment. In these respects, the loan proceeds are in the nature of employee compensation. Consequently, the forgiveness of debt is properly reportable on Form W-2 rather than on a 1099-MISC. See Chief Counsel Advice 200130038. In this respect, it should be of no moment whether the cancellation occurs prior to or subsequent to the broker's resignation or termination from the firm. Under relevant United States Supreme Court jurisprudence, an amount constitutes W-2 wages if it arises in connection with the employment relationship. This is true even where the employment relationship no longer exists at the time taxable income is realized to the former employee as a result of the debt forgiveness.
If you or someone you know has incurred a tax liability in connection with the cancellation or forgiveness of an employment-related loan, you might be paying too much in tax.