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eturn of the interest is a gift and is thus excluded from income. The lender receives interest income
and has no compensating deduction for the return gift. In fact, if the interest amount is large enough,
he may have incurred an additional gift tax on the returned interest. The amount of income created for
the lender, however, is limited to the borrower‟s investment income, except in very large loans. In the
corporation/stockholder situation, the lender incurs interest income and has no compensating
deduction, as its deemed return of the interest is characterized as a dividend. Thus the IRS gets
increased tax from both parties unless the corporation has selected subchapter S.
All may not be lost in this situation, however. Brad‟s additional income tax arises from the fact that
there is no deduction allowable for interest paid on unsecured personal loans. Interest is deductible,
however, in limited amounts on loans secured by a mortgage on the taxpayer‟s principal or secondary
residence. If Brad grants Plant Supply a mortgage on his home to secure the repayment of his no- or
low-interest loan, his deemed payment of market interest may become deductible mortgage interest
and may thus offset his additional deemed compensation from the imaginary return of this interest.
Before jumping into this transaction, however, Brad will have to consider the limited utility of
itemized deductions described earlier, as well as certain limits on the deductibility of mortgage
interest.
Sharing the Equity
If Brad is as sophisticated and valuable an executive employee as Morris believes he is, Brad is likely
to ask for more than just a compensation package, deferred or otherwise. Such a prospective employee
often demands a piece of the action—a share in the equity of the business—so that he may directly
share in the growth and success he expects to create. Morris may even welcome such a demand
because an equity share (if not so large as to threaten Morris‟s control) may serve as a form of golden
handcuffs, giving Brad additional reason to stay with the company for the long term.
Assuming Morris is receptive to the idea, there are a number of different ways to grant Brad a share
of the business. The most direct way would be to grant him shares of the corporation‟s stock. These
could be given to Brad without charge, for a discount from fair market value, or for their full value,
depending on the type of incentive Morris wishes to design. In addition, given the privately held
nature of Morris‟s corporation, the shares will probably carry restrictions, designed to keep the shares
from ending up in the hands of persons who are not associated with the company. Thus, the
corporation will retain the right to repurchase the shares should Brad ever leave the corporation‟s
employ or wish to sell or transfer the shares to a third party. Finally, in order to encourage Brad to stay
with the company, the corporation will probably reserve the right to repurchase the shares from Brad
at cost should Brad‟s employment end before a specified time. As an example, all the shares (called
restricted stock) would be subject to forfeiture at cost (regardless of their then actual value) should
Brad leave before one year; two-thirds would be forfeited if he left before two years, and one-third if
he left before three years. The shares not forfeited (called vested shares) would be purchased by the
corporation at their full value should Brad ever leave or attempt to sell them.
One step back from restricted stock is the stock option. This is a right granted to the employee to
purchase a particular number of shares for a fixed price over a defined period of time. Because the
employee‟s purchase price of the stock does not change, the employee has effectively been given the
ability to share in whatever growth the company experiences during the life of the option, without