Overview

Forgiving an employee’s debt or loan can help retain talent and ease hardship, but it also creates tax consequences that affect both the employee and the employer. How the forgiven amount is classified—compensation (wages), cancellation-of-debt (COD) income, or something else—dictates whether it’s subject to income tax, employment taxes, and which IRS forms are required for reporting.

In my 15+ years as a CPA and financial advisor I’ve seen small-business owners inadvertently create large tax bills for employees by forgiving advances without documenting the tax treatment. This guide explains the key rules, shows common scenarios, and gives a practical checklist to reduce surprises. All references to IRS rules below are current as of 2025 (see IRS guidance on Cancellation of Debt and employer tax reporting).

Sources: IRS, “Cancellation of Debt (COD) Income” and Form 1099-C guidance (irs.gov).

When is forgiven employee debt treated as wages?

If an employer forgives a loan made to an employee, the IRS frequently treats the forgiven amount as compensation (wages) rather than COD income. Key indicators that the forgiven amount is wages:

  • The loan arose from the employer–employee relationship (employer made the loan).
  • The forgiveness is in exchange for services (e.g., bonus, severance, retention incentive) or offered as part of employment terms.
  • The employer intends the forgiveness to be taxable compensation.

Tax consequences when treated as wages:

  • The forgiven amount is subject to federal income tax withholding and employment taxes (Social Security, Medicare, and employer payroll taxes).
  • The amount should be reported on the employee’s Form W-2 in the year of forgiveness (see IRS Pub. 15 and Form W-2 instructions).

Example: Employer forgives a $10,000 loan to an employee as a retention incentive. That $10,000 is generally wages, must be included in the employee’s pay, reported on Form W-2, and is subject to payroll taxes.

Practical note: If the employer fails to withhold, the business may still be liable for employer-side payroll taxes; the employee will owe income tax on the included wages.

When is forgiven employee debt cancellation-of-debt (COD) income?

COD income typically arises when a creditor cancels or discharges a debt and the debtor is freed from repayment. However, in the employer-employee context, IRS treatment can vary.

  • If a third-party creditor forgives debt (for example, a bank writes off a personal loan), the lender generally issues Form 1099-C when cancellation meets IRS criteria (commonly $600 or more), and the borrower reports COD income on their tax return (see IRS Form 1099-C rules).
  • When the employer is the creditor, COD rules sometimes apply, but many employer-originated cancellations are treated as wages (see above). Employers do not typically issue Form 1099-C for amounts that should be reported as wages.

Reference: For general COD reporting rules, see the IRS Form 1099-C and COD guidance (irs.gov/forms-pubs/about-form-1099-c).

Special rules and common exceptions

  • Insolvency: A debtor who is insolvent (liabilities exceed assets) may exclude some or all COD income. The exclusion is claimed on Form 982 (Reduction of Tax Attributes). (IRS: “Cancellation of Debt (COD) Income”.)

  • Bankruptcy: Debts discharged in a Title 11 bankruptcy are generally excluded from COD income.

  • Qualified student loan forgiveness programs: Many federal and some state student loan forgiveness programs (e.g., Public Service Loan Forgiveness) are not treated as taxable income. Recent legislative changes may also affect certain student loan relief—check IRS guidance current to 2025.

  • Gifts vs. income: If forgiveness is truly a gift (rare between employer and employee), it may not be taxable to the employee—but the IRS looks at intent. Employer-to-employee forgiveness is usually not a gift.

Imputed interest and below-market loans

If an employer makes a below-market loan to an employee (low or zero interest), the tax code may require imputed interest. Under IRC Section 7872, the lender (often the employer) must treat the forgone interest as taxable income to the employee (imputed compensation) and report it accordingly. Employers may have additional withholding and reporting obligations for imputed interest. (IRS guidance on below-market loans and imputed interest.)

Example: Employer makes a $20,000 interest-free loan to an employee. The IRS may impute interest based on applicable federal rates; the imputed interest is treated as additional wages.

Employer tax treatment and deductibility

How the employer treats the forgiven debt on its books depends on classification:

  • If the forgiven amount is treated as wages: The employer generally deducts the amount as a compensation expense (ordinary business expense) in the year it is paid or incurred, subject to normal rules and reasonable-compensation principles.

  • If the forgiven amount is recorded as a business loan receivable that is later uncollectible: The employer may be able to claim a bad-debt deduction. Whether that deduction is ordinary or capital depends on whether the loan was a business or nonbusiness bad debt (see IRS Publication on Bad Debts). Business bad debts are deductible as ordinary losses; nonbusiness bad debts are treated as short-term capital losses.

  • Payroll tax liabilities: If forgiveness constitutes wages, employer withholding and employer-side payroll taxes apply. Failure to withhold does not transfer the obligation to the employee—employers remain responsible for employer taxes in many situations.

Reporting forms and practical filing guidance

  • Form W-2: Use when forgiveness is wages. Include the forgiven amount in Box 1 (wages), and report Social Security/Medicare wages and taxes in Boxes 3/4 and 5/6 as applicable.

  • Form 1099-C: Generally used by non-employer creditors to report canceled debt of $600 or more. Employers should not file Form 1099-C for amounts that are properly treated as wages; instead follow payroll reporting rules. (See IRS Form 1099-C instructions.)

  • Form 982: Used by taxpayers to claim exclusions from COD income (insolvency, bankruptcy, qualified farm indebtedness, qualified real property business indebtedness).

  • Form 1099-MISC/1099-NEC: Generally not appropriate for forgiven employer loans that are wages; these forms cover nonemployee compensation and other payments.

When in doubt, consult a CPA—misfiling can create mismatched IRS records (W-2 vs. 1099) and trigger notices.

Internal references: For background on 1099-C reporting see FinHelp’s article on Form 1099-C: Cancellation of Debt. For employer student loan programs and when they count as taxable income see When employer student loan repayment counts as taxable income.

Real-world examples (illustrative)

1) Forgiveness treated as wages

  • Loan forgiven: $5,000
  • Employee tax result: $5,000 added to taxable wages; ordinary income tax plus employee share of payroll taxes on the amount.
  • Employer result: Must include the $5,000 on W-2 and pay employer payroll taxes; deduction as compensation expense.

2) Creditor files 1099-C (non-employer creditor)

  • Bank cancels $8,000 personal debt and issues Form 1099-C.
  • Borrower must report $8,000 as COD income unless they qualify for exclusion (insolvency, bankruptcy, etc.).

3) Insolvency exclusion

  • Employee debtor has liabilities of $40,000 and assets of $10,000, then $12,000 of forgiven debt may be excluded up to the insolvency amount—complex calculations and Form 982 required.

Practical checklist for employers (step-by-step)

  1. Document the loan terms in writing (principal, interest rate, repayment schedule).
  2. Clearly document the reason for forgiveness and whether forgiveness is intended as compensation or debt cancellation.
  3. Consult payroll or tax counsel before granting forgiveness to determine withholding and reporting obligations.
  4. If forgiveness is wages, report on Form W-2, withhold appropriate federal and state taxes and remit employer payroll taxes.
  5. If treating as a business bad debt instead, ensure you meet the IRS documentation and substantiation rules for bad-debt deductions.
  6. Notify the employee in writing about the tax treatment and provide copies of forms (W-2 or 1099 as applicable).
  7. Keep records for at least seven years in case of IRS inquiries.

Common mistakes to avoid

  • Assuming all forgiven debts are gifts and therefore tax-free. Employer-to-employee forgiveness is usually taxable.
  • Filing Form 1099-C when the amount should be reported as wages on a W-2 (mismatches can trigger IRS notices).
  • Neglecting imputed interest rules for below-market loans.
  • Failing to withhold payroll taxes when forgiveness constitutes income.

Final thoughts and professional tips

  • Start with classification: Is the forgiveness compensation or COD income? That single decision determines most downstream tax effects.
  • Work with a CPA before documenting and executing debt forgiveness. In my practice, proactive tax treatment conversations prevent year-end surprises for employees and avoid employer liability for unpaid payroll taxes.
  • When offering employer-paid student loan assistance or partial forgiveness, design the program with tax consequences in mind. Recent policy changes sometimes affect student loan tax treatment—stay current with IRS releases.

Frequently referenced authorities

  • IRS, “Cancellation of Debt (COD) Income,” Topic No. 431 and Form 1099-C instructions (see irs.gov).
  • IRS, Employer’s Tax Guide (Publication 15) and Form W-2 instructions for wage reporting (see irs.gov).
  • IRC Section 7872 on below-market loans and imputed interest.

Professional disclaimer: This article is educational and does not constitute tax or legal advice. For advice tailored to your situation, consult a qualified CPA or tax attorney.

If you’d like, I can help draft loan documents, sample employee notices, or a payroll treatment checklist for your business—tell me which you need.