August 8, 2018
PARTICIPANT LOANS:
A ROAD MAP
FOR PRACTITIONERS
Summary: The availability of
participant loans from tax-qualified retirement plans often results in
increased Plan participation by non-highly compensated employees. Employers often choose to make loans available
from their plans as a matter of employee relations. However, plan loans are subject to complicated
rules under both ERISA and the Code, and they are a trap for the unwary if they
are not administered properly in compliance with these rules. Recent developments regarding participant
loans include certain changes made by the Tax Cuts and Jobs Act of 2017 and
other recent IRS guidance. This article
provides a roadmap for practitioners in advising clients on instituting and
operating a participant loan program.
The ability of participants in
qualified plans, especially § 401(k) plans, to obtain loans from such
plans is responsible in no small way for the popularity of the plans and the
increased participation of employees in such plans. Plan loans, however, are subject to a very
specific set of rules, which, if not followed, may subject such loans to income
and penalty taxes. Specifically, such
loans must comply with the conditions set forth in § 408(b)(1) of the
Employee Retirement Income Security Act of 1974, as amended (ERISA), and
§ 72(p) of the Internal Revenue Code of 1986, as amended (Code). If these conditions are not met, loans to
plan participants may be prohibited transactions under ERISA, may violate the "anti-alienation"
rules of ERISA and the Code and may be deemed to be taxable distributions to
the participants who received the loans.
This article attempts to chart the course that must be followed so that
unintended consequences are avoided.
Part I examines the prohibited transaction rules of ERISA
§ 408. Part II examines the taxable
distribution rules of Code § 72(p), as well as issues relating to deemed
distributions and foreclosures. Other
miscellaneous issues are examined in Part III.
PART
I - PROHIBITED TRANSACTION STATUTORY EXEMPTION
Generally
Loans from a plan to a
participant are prohibited extensions of credit from the plan to a party in
interest unless the requirements of the statutory exemption of ERISA
§ 408(b)(1) and Code § 4975(d)(1) are met.[1] The requirements of Code § 4975(d)(1)
must also be met in order that the loan not violate the anti-assignment rule of
Code § 401(a)(13) and ERISA § 206(d).
The conditions of this statutory prohibited transaction exemption
of ERISA § 408(b)(1) and Code § 4975(d)(1) are that the loans must:
(1)
be available to all participants
and beneficiaries on a reasonably equivalent basis;
(2) not be available to highly compensated employees in an amount greater than to other employees;
(3) be made in accordance with the loan provisions set forth in the plan;
(4) bear a reasonable rate of interest; and
(5) be adequately secured.[2]
(2) not be available to highly compensated employees in an amount greater than to other employees;
(3) be made in accordance with the loan provisions set forth in the plan;
(4) bear a reasonable rate of interest; and
(5) be adequately secured.[2]
In addition, Department of Labor
(DOL) regulations require that the loan program be legitimate.[3]
Requirement
of Plan-Wide Availability on a Reasonably Equivalent Basis
General. The loans must be available to all
participants and beneficiaries on a reasonably equivalent basis.[4] To meet this requirement, (1) the loans
must be available without regard to race, religion, gender, etc.;
(2) consideration must be given only to factors that would be considered
in normal commercial circumstances by an entity in the business of making
similar types of loans, including, for example, the creditworthiness and
financial need of the applicant; and (3) the loans in actual practice must
not be unreasonably withheld from any applicant.[5]
Availability May Be
Limited to Parties in Interest. The DOL takes the position that the plan-wide
availability requirement is required only with respect to parties in interest,
and that a plan may limit loans to parties in interest.[6] Active employees of the sponsoring employer
are all parties in interest. Former
employees are typically not parties in interest, but certain former employees
by reason of some other relationship to the company or plan may be parties in
interest.[7] A plan could therefore not exclude all former
participants where some are parties in interest.
A plan provision permitting loans is a benefit, right or
feature subject to the nondiscriminatory availability test of Treas. Reg.
§ 1.401(a)(4)-4. Most loan programs
easily meet this rule for active employees.
However, because plan loans are only required to be made available to
those former employees who are also parties in interest, the potential for
discrimination with respect to former employees in favor of highly compensated
former employees is greater. In
recognition of this problem, the § 401(a)(4) regulations provide that
former employees who are parties in interest may be treated as active
employees.[8]
Minimum Loan Amounts. Minimum loan amounts of up to $1,000 may be established
without violating the reasonably equivalent basis requirement.[9]
Other Restrictions
Allowed. A plan is allowed to limit
the availability of loans to specific purposes such as hardship, college tuition,
home purchases, etc., provided that loans continue to be made available to
participants and beneficiaries on a reasonably equivalent basis.[10]
Loans to Particular
Bargaining Unit Employees. A plan
whose participants are members in several unions and makes a loan feature
available only as their collective bargaining agreements are renegotiated would
not violate the reasonably equivalent requirement, if within a reasonable time
period all bargaining units approve the loan feature.[11]
Prohibited
Loans to Executive Officers Under Sarbanes Oxley Act. The Sarbanes Oxley Act of 2002 prohibits
loans to directors or executive officers.
There is no clear authority as
to whether the Sarbanes Oxley Act of 2002 prohibition on loans to executive
officers would apply to 401(k) plan loans, as extensions or arrangements of
credit by the issuer. A joint memo by 25
law firms "Interpretive Issues Under § 402 - Prohibition on Certain
Insider Loans," (Oct. 15, 2002) argued that 401(k) loans should be
permitted, since the officer is effectively borrowing from himself and the loan
is from the plan rather than the issuer, but there has been no SEC guidance on
the matter. The DOL in a field assistant bulletin has held that
possible restrictions on loans to officers and directors under the Sarbanes
Oxley Act would not cause a plan to violate the reasonably equivalent basis
rule for participant loans under ERISA § 408(b)(1)(A).[12]
Loan Fees. The preamble to the DOL
regulations makes it clear that fees may be charged to cover the administrative
cost of making loans.[13]
Requirement
That Loans Not Be More Available to Highly Compensated Employees than to Other
Employees
The loans may not be available to highly compensated
employees[14]
in an amount greater than to other employees.[15] To meet this requirement, it must be
determined upon consideration of the facts and circumstances that the program
does not operate to exclude large numbers of participants from receiving
loans. A loan program will not fail
because it limits loans to a maximum dollar amount or to a maximum percentage
of a participant's vested accrued benefit, despite the fact that under a
percentage limit the maximum loan amount will vary with the size of the
participant's accrued benefit.[16]
Requirement
That the Plan Document Specifically Permit Loans
General. The loans must be made in accordance with
loan provisions set forth in the plan.[17] Regulations provide that plan provisions must
contain explicit authorization for the establishment of a loan program.[18] In addition, the plan document or a written
document forming part of the plan must include:
(1) the identity of the person or position authorized to administer
the loan program; (2) a procedure for applying for loans; (3) the
basis on which loans will be approved or denied; (4) limitations (if any)
on the type of loans offered; (5) the procedure for determining a
reasonable rate of interest; (6) the types of collateral that may secure
the loan; and (7) the events constituting default and the steps that will
be taken to preserve plan assets in the event of such default.[19]
Summary Plan
Description (SPD). The enumerated
items described in the preceding paragraph affect the rights and obligations of
participants and therefore must be set forth in a plan's SPD.[20] The preamble to the final regulations notes
that the SPD alone can satisfy the plan provision requirement if it contains
the required loan provisions and is a document forming part of the plan.[21]
Loan Documentation. Typically, loan documents will include the
plan loan provisions (contained in the plan or SPD), loan application
guidelines, a loan application, a loan disclosure statement, and a promissory
note and security agreement.
Requirement
of a Reasonable Interest Rate
General. The loans must bear a reasonable rate of interest.[22] To meet this requirement, the loan must
provide the plan with a return commensurate with the interest rates charged by
persons in the business of lending money for loans that would be made under similar
circumstances.[23] A strict reading of the regulations may
require different interest rates depending on each participant's
creditworthiness.[24] Thus, if local banks would lend the participant,
taking into account his or her creditworthiness and the collateral offered, at
a fixed rate of 12%, a plan that loaned at 8% would not be charging a
reasonable rate of interest and would not be entitled to the relief provided by
ERISA § 408(b)(1).[25]
State Usury Laws Not
Relevant. State usury laws may not
be used to justify a low rate of interest.[26]
Rates of Interest
Commonly Used. Some courts have
analyzed reasonable interest taking into account that the loan is a
compensating balance loan with the loan secured by a sum of money deposited by
the borrower with the lender, and therefore, according to expert testimony
cited in one case, a rate of one or two percent above the certificate of
deposit rate would be reasonable. [27] Many plans have been charging the prime
interest rate plus 1 or 2 percentage points.
However, because the prime rate in recent years has been low, IRS officials have indicated at a 2011 phone forum
that prime plus 2 percent is currently what the IRS
deems to be a reasonable rate of interest.[28] Other plans charge the prevailing rate for
home equity loans.
Rates for Loan
Renewals. When a loan is subject to
renewal, the prevailing market rate at the time of renewal must be
charged.[29]
Fixed Versus
Adjustable Rates. Most plans charge
a fixed interest rate for the loan for administrative convenience, although
adjustable rates are also permitted.
Requirement
of Adequate Security
Security That Can Be
Foreclosed With "No Loss."
The loans must be adequately secured.[30] To meet this requirement, the security posted
must be: (1) something more than a mere
promise to pay; (2) capable of being foreclosed on or otherwise disposed of in
the event of default in an amount equal to the amount due; and (3) of such
value and liquidity that it is reasonably anticipated that there will be no
loss of principal or interest.[31]
Use of 50% of
Participant's Vested Accrued Benefit as Security. A participant's vested accrued benefit may be
adequate security, but only up to 50% of such benefit may be so utilized.[32]
Spousal Consent. Because foreclosure of a plan loan is treated
as a distribution, spousal consent to waive the qualified joint and survivor
annuity requirement, where applicable, must be obtained. Spousal consent rules apply mainly to defined
benefit plans (and money purchase pension plans).[33] The spousal consent rules can be met by
obtaining spousal consent to the loan and foreclosure not more than 90 days
before the date the loan is made.[34] The adequate security requirement of ERISA
§ 408(b)(1) may require that spousal consent be obtained at the time a
loan is made from a plan subject to the spousal consent rules.[35]
Mortgage Loans.
Code § 72(p)(3) provides that an interest deduction may not be taken with
respect to a plan loan if it is: (i)
made to a key employee (as defined in Code § 416(i)), or (ii) secured by
the participant's § 401(k) elective deferrals. If a loan to a non-key employee is secured by
the participant's principal residence (i.e.,
a mortgage) rather than by his or her § 401(k) account, the mortgage
interest deduction would be allowed.[36]
In certain limited circumstances, plans that have
investment programs making mortgages available to individuals including plan
participants will not be subject to the limits of Code § 72(p) with
respect to the participant loans.[37]
Source of Loan
Proceeds. Typically, participant
loans from defined contribution plans are taken directly from the participant's
account. Often a special loan subaccount
is created.[38] The loan then becomes an investment of the
individual account but not of the entire plan.
Under another method most commonly used by plans that do not have individual
accounts, the participant borrows from the plan as a whole and, as the loan
principal and interest are repaid, they accrue to the entire plan rather than
to the participant's account. The loan
is then considered a general investment of the entire plan.
Impact of Source of
Collateral on "No Loss" Rule.
Where a loan is treated as an investment attributable solely to the
participant's account, the adequate security requirement will be met and the "no
loss" rule satisfied even if the security interest cannot be immediately
foreclosed on (e.g., because of "in-service distribution"
restrictions).[39] However, if the loan investment is allocated
to the plan as a whole, the preamble to the 1989 DOL regulations states that
the security of the accrued benefit may not be sufficient without some
additional security, such as mandatory payroll deduction or discounting the
value of the vested accrued benefit to take into account the time delay between
any possible default and the first distributable event with respect to the
borrowing participant's account.[40]
Legitimacy Requirement.
PART
II - CODE RULES TO PREVENT TAXABLE DISTRIBUTIONS; DISTRIBUTION VERSUS
FORECLOSURE
Code
§ 72(p) Generally
Code § 72(p) provides that loans to participants or
beneficiaries from a qualified plan (i.e.,
under Code §§ 401(a), 403(a), or 403(b)) will be treated as taxable
distributions from the plan,[44]
unless:
(1)
the loan does not exceed statutory
dollar limit or percentage limit;
(2)
the loan requires repayment within
5 years (or a longer period if the loan is used to acquire a principal
residence);
(3)
the loan requires substantially
level amortization over its term; and
(4)
the loan is evidenced by a legally
enforceable agreement in writing or acceptable electronic medium.[45]
Plans that May Offer Loans
Plans that may offer loans include: (i) qualified plans
under Code § 401(a); (ii) Code § 403(a) and Code § 403(b) annuity plans; and
(iii) governmental 457 plans.[46] However, loans cannot be taken from Individual
Retirement Accounts (IRAs) or Simple Employee Pensions (SEPs).
Requirement That the Loan
Be Limited in Amount
General. The statutory requirement is that the total
of all outstanding loans of the participant from the plan[47]
may not exceed the lesser of:
(i) $50,000
reduced by the excess, if any, of (A) the highest outstanding balance of loans
during the one-year period ending on the day before the date of the loan, over
(B) the outstanding balance of loans from the plan on the date the loan is
made;[48]
or
(ii) the
greater of (A) one-half the present value of the participant's nonforfeitable
accrued benefit, or (B) $10,000.[49]
$10,000 Minimum Not
Typically Relevant. Despite the
statutory authority to do so, plans do not typically provide that a participant
may borrow $10,000 regardless of the size of his or her nonforfeitable accrued
benefit, because the ERISA adequate security requirement,[50]
discussed in Part I above, precludes plans from considering more than 50%
of the participant's vested accrued benefit as collateral, and would require
additional collateral. For example, a
vested accrued benefit of $18,000 would not be adequate security for a $10,000
loan.
$50,000 Limit May Be
Restated in Simpler Way. The complex
statutory formulation of the $50,000 prong of the loan limit may be more simply
stated: the maximum amount of any
individual new loan is limited to $50,000 reduced by the highest outstanding
balance of loan(s) during the one-year period before the new loan is made.[51]
For example, if the highest outstanding balance on prior
plan loans of a participant during the preceding year is $25,000, and the
outstanding balance of prior loans immediately before taking the new loan is
$15,000, the maximum aggregate loan balance the participant may have (under the
statutory formulation) cannot exceed $50,000 reduced by $10,000 (the excess of
$25,000 over $15,000), or $40,000. Since
the $15,000 prior loan is still outstanding, the maximum new loan cannot exceed
$25,000. The same result is reached by
simply limiting the new loan itself to $50,000 minus the highest outstanding
loan balance during the preceding year ($50,000 minus $25,000).
The 50% of vested accrued benefit limit of Code §
72(p)(2)(A) must still be met on an aggregate basis for all loans from
controlled group plans, and cannot be simplified in the above manner.
Loan Considered
Outstanding for Maximum Permitted Amount After Deemed Distribution and
Additional Security for Subsequent Loans.
For purposes of calculating the maximum permitted amount of a subsequent
loan under Code § 72(p)(2)(A), a loan that has been deemed distributed under
§ 72(p) and has not been repaid (such as by plan loan offset) is still considered
outstanding until the loan obligation has been satisfied for purposes of
determining the maximum amount of any subsequent loan to the participant.[52]
As amended in December 2002, regulations provide that if a
loan is deemed distributed to a participant and has not been repaid (such as by
plan loan offset), then no payment made thereafter to the participant will be
treated as a loan for purposes of § 72(p)(2), unless there is an enforceable arrangement among the plan,
participant, and employer, under which repayments will be made by payroll
withholding or the plan receives adequate security in addition to the
participant's accrued benefit for the additional loan. [53]
Frequency of Loans. Some plans provide that no more than one loan
may be outstanding at any time. Others
provide for waiting periods between loans.[54]
Requirement
That the Loan Be Repaid within Five Years
General. A loan by its terms must require repayment
within five years.[55] If the loan is not required to be repaid
within five years, it is an immediate taxable distribution. In addition, if a loan providing for
repayment over five years is not repaid during such period, the amount
remaining payable at the end of the five years is a taxable distribution.[56] If there are required periodic payments, the
first of which is due to be made within two months of the date the loan was
made, legislative history indicates that the five-year repayment period will be
measured from the due date of that first payment, but some practitioners recommend
amortization over 59 months in such cases.[57]
Principal Residence
Loans. Loans used to acquire a
principal residence are an exception to the five-year repayment requirement.[58] Nonetheless, plans typically do impose some
limit on principal residence loans, such as 10, 15 or 20 years. A principal residence loan that is for a
significantly longer period than the period under commercially available loans
(e.g., longer than 30 years) may not
be permissible.[59]
A principal residence has the same meaning as under
Code § 121 (relating to exclusion of gain from sale of principal
residence).[60] There is no requirement that it be a
principal residence for any specific period of time.[61] Tracing rules similar to those applicable
under Code § 163(h)(3)(B) (relating to the deduction for home acquisition
indebtedness) apply.[62] Refinancings do not qualify as principal
residence loans, although a plan loan that would otherwise qualify may be used
to repay a bank loan.[63]
Requirement
of Level Amortization
General. Substantially level amortization over the
term of the loan is required, and participants must make payments no less
frequently than quarterly.[64]
Payroll Deductions
and Written or Electronic Authorizations.
Most plans provide for loan repayment by payroll deduction.
Some state wage-and-hour laws require that payroll
deductions be in writing. These laws,
however, may be preempted by ERISA. For
example, a 1994 DOL Advisory
Opinion held that a New York Law requiring written authorization for payroll
deductions, is preempted by ERISA to the extent it prevents a plan from
implementing a salary reduction arrangement by a telephone voice response
system.[65] Similarly, a 1996 DOL
Advisory Opinion held that ERISA preempts a Puerto Rico
law that allows authorized payroll deductions only for contributions to pension
plans and not for loans.[66]
Cessation of
Payments during Leave of Absence.
The level amortization requirement will not be violated if repayments
cease while an employee is on a leave of absence for a period of up to one
year.[67] However, the loan (plus interest accruing
during the leave of absence) must still be paid within the original five-year
period, and therefore when the employee returns to work an accelerated payment
schedule or a lump sum repayment at the end of the five year period would be
necessary.[68] If repayments cease while an employee is on a
military leave of absence even for a period beyond one year as permitted under
Code § 414(u)(4), the suspension will not cause the loan to be deemed
distributed, as long as loan repayments resume upon the completion of the
military service, the amount then remaining due on the loan is repaid in
substantially level installments thereafter, and the loan is fully repaid by
the latest permissible term of a loan (five years for a non-principal residence
loan) plus the period of the military service.[69]
Level Amortization
in Loan Refinancings. Regulations as
added in 2002 provide that while a loan can be refinanced and additional
amounts may be borrowed, the prior loan and additional loan must each satisfy
the requirements in § 72(p)(2)(B) and (C) that each loan be repaid in level
installments, not less often than quarterly, over five years.[70] The loans collectively must satisfy the
amount limitations of § 72(p)(2)(A). A
refinancing is, in effect, treated as a new loan that is then applied to repay
a prior loan if the new loan both replaces a prior loan and has a later repayment
date. This rule does not apply to a refinancing loan under which the amount of
the prior loan is to be repaid by the original repayment date of the prior
loan.[71]
Regulatory
Requirement of an Enforceable Agreement in Writing or Electronically
The Treasury regulations impose an additional requirement
in order to avoid a deemed distribution under Code § 72(p): the loan must be evidenced by a legally
enforceable agreement (which may include more than one document), and the terms
of the agreement must demonstrate compliance with the requirements of Code
§ 72(p) (specifying the amount of the loan, the date of the loan and the
repayment schedule in accordance with the rules of § 72(p)).[72]
Regulations issued in 2000 provide that the loan agreement
must be in a written enforceable agreement or in an electronic medium
reasonably accessible to the participant under a system (i) reasonably designed
to preclude anyone other than the participant from requesting a loan, (ii) that
provides a reasonable opportunity to review the terms of the loan and to confirm,
modify or rescind the terms of the loan, and (iii) that provides a confirmation
of the loan terms through a written document or an electronic medium.[73] If an electronic medium is used to provide
confirmation of the loan terms, it must be reasonably accessible and must be provided
in a manner no less understandable than a written paper document. Also, the participant must be advised of the
right to receive a copy of the confirmation on a written document without charge.[74] The regulations provide that the loan
agreement does not have to be signed if the agreement is enforceable under
applicable law without signature.[75]
The IRS has indicated that a Plan sponsor should maintain
the loan application, executed promissory note, proof that loan proceeds were
used to purchase or construct a primary residence (if applicable), proof of
loan repayments, in the event of default, proof of collection activities, and
if there is a deemed distribution on Form 1099-R.[76]
Consequences
of Violating Code § 72(p)
Violation in Form or
in Operation. A deemed distribution
will occur when the requirements of Code § 72(p) are not satisfied in form
or in operation.[77]
Deemed Distribution
at Time Loan Is Made.[78] If the terms of the loan do not require
repayment within five years and level amortization or are not evidenced by an
enforceable agreement in accordance with § 72(p) and the regulations, the
entire amount of the loan is deemed distributed at the time the loan is made. If the terms of the loan merely fail to
satisfy the amount requirement of § 72(p)(2)(A), only the amount in excess
of the permissible loan amount is a deemed distribution at the time the loan is
made.
Later Deemed Distribution for Not
Making Level Installment Payments.
If the loan initially satisfies the requirements of Code § 72(p),
but repayments are not being made in accordance with the level amortization
requirement of Code § 72(p)(2)(C), a deemed distribution occurs at the
time of such failure.[79] However, the plan administrator may allow a
cure period extending up to the end of the calendar quarter following the
calendar quarter in which the required installment payment was due and not
made. Such cure period given by the plan
administrator will avoid a deemed taxable distribution until the end of the
grace period.[80] If the installment payment is not made before
the expiration of the cure period, the entire outstanding balance of the loan
(including accrued interest) will be a deemed distribution.[81]
Chief Counsel Advice 201736022
provides two examples of failures to make loan payments under a qualified plan
that were timely corrected, so that a loan default was avoided, and the loan
was deemed to be satisfactorily reinstated.[82]
Case-Law Regarding
Deemed Distributions for Not Making Timely Payments.
There are various cases regarding deemed distribution under Code § 72(p)
with income tax and Code § 72(t) early distribution tax for failure to make
timely payments on participant loans. [83]
Several cases have held that failure to provide documentary evidence of
the loan would result in a deemed distribution with ordinary income (and a 10%
early distribution tax). [84]
Interest on Loan Not
Included in Income. Interest that
accrues after a deemed distribution under Code § 72(p) is not included for
purposes of Code § 72, and therefore the additional interest is not
treated as an additional loan and does not result in an additional deemed
distribution under Code § 72(p).[85]
Section 72(t) Tax. When there is a deemed distribution of a plan
loan, in addition to the income tax under § 72(p) there will also be a 10% Code
§ 72(t) early distribution tax if the deemed distribution occurs prior to
age 59-1/2.[86]
Distinction
between Taxable Deemed Distribution and Foreclosure
A Taxable Deemed Distribution
Is Not Necessarily an Actual Distribution.
Even if Code § 72(p) is violated and there is a deemed taxable
distribution under Code § 72(p), such distribution is not treated as an
actual distribution for purposes of the in-service distribution restrictions
under § 401 regulations for money
purchase plans, the eligible rollover distribution rules of Code § 402,
the in-service distribution restrictions of Code § 401(k)(2)(B), or the
vesting requirements of Treas. Reg. § 1.411(a)-7(d)(5) (regarding graded
vesting schedule where prior distribution occurred).[88] Thus, it is possible to be taxed on the deemed
distribution at an earlier time than the actual distribution. A deemed
distribution will therefore not be considered an in-service distribution or an
eligible rollover distribution. After a
taxable deemed distribution occurs, the participant may still want to repay the
loan, in order, for example, to be able to take a new plan loan.
A Plan Loan Offset
(But Not a Default Alone) Is Treated as an Actual Distribution. The regulations provide that an actual
distribution occurs when, under the terms governing the plan loan, the accrued
benefit of the participant is reduced (offset) in order to repay the loan.[89] This might occur, for example, where the
terms governing the plan loan require that if a participant requests a
distribution, a loan must be repaid immediately or treated as in default. A distributable event under the plan, e.g.,
age 59-1/2 or severance from employment, may be required to offset the
loan. The amount of the account balance
that is used to offset the loan is treated as an actual distribution. On the other hand, an event of default under
the loan documents without an actual offset does not automatically cause there
to be a Code § 72(p) taxable event.
Plan loan
procedures may provide for offset for failure to make payments when due if a
distribution is permitted. Other common offset
triggers are termination of employment or termination of the plan.[90]
Foreclosure Should
Be Avoided if Restrictions on In-Service Distributions Apply. Restrictions on in-service distributions (e.g., under
Code § 401(k)(2)(B)) are violated if foreclosure occurs and the
participant's accrued benefit is offset by the loan amount.[91] (The same should apply with respect to the
Code § 72(t) 10% penalty tax on early distributions.) A taxable distribution under § 72(p) by
itself, however, is not considered an in-service distribution, as stated above.
Coordination of
Foreclosure with Requirement of Participant Consent to Actual Distributions. Plan distributions in excess of $5,000
require a participant's consent under Code § 411(a)(11). Thus, plan loan documents should provide that
the participant consents both to the taking of the loan and to a foreclosure in
the event of a default.
Coordination with
Spousal Consent Requirements. To
foreclose on a plan loan, spousal consent, if applicable, is required. Code § 417(a)(4) requires that no part
of a participant's accrued benefit may be used as security for a loan from a
plan subject to the qualified joint and survivor annuity rules and the
qualified pre-retirement survivor annuity rules of Code § 401(a)(11)
unless there is spousal consent.
Accordingly, spousal consent should be obtained at the time the loan is
made. See above, Pt. I, discussion of
adequate security and spousal consent.
Foreclosure as
Eligible Rollover Distribution; 20% Withholding Obligation. A distribution from a qualified plan is
subject to 20% mandatory withholding if the distribution is an "eligible
rollover distribution" and the participant fails to elect a direct
rollover. As stated above, if a loan
becomes a deemed taxable distribution because it does not comply with Code
§ 72(p), it is not an eligible rollover distribution and cannot be rolled
over.[92] The pre-1993 10% voluntary withholding rules
apply in such case.[93]
If a loan is foreclosed by offsetting the accrued benefit,
however, there is an actual distribution, and if this offset occurs prior to a
deemed distribution this offset is considered an eligible rollover distribution
which may be rolled over and is subject to 20% withholding.[94] Although the foreclosed amount constitutes an
eligible rollover distribution and is included in the amount subject to
withholding, withholding need only be made from cash or other property
distributed, and if there is no other cash or property distributed, there is
nothing to withhold from.[95]
If a deemed distribution of a loan or a loan offset
results in income at a date after the loan is made, withholding is required
only if a transfer of cash or property is made to the participant or
beneficiary from the plan at the same time.[96]
Direct Rollovers and
Trust-to-Trust Transfers of Notes. A
trust-to-trust transfer of assets (under Code § 414(l)) from one plan to another can include the transfer of a
participant note.[97] Ordinary rollovers, where amounts are first
distributed to participants and then rolled over, should intuitively not be
able to be made with a note because the interest of the lender and the borrower
will merge once the note is distributed to the participant. Nevertheless, recent regulations and rulings
provide that a direct rollover under Code § 401(a)(31) may be made with a
note even though a direct rollover is considered a distribution.[98]
Extension of Rollover Period for Offset Loans under Tax
Cuts and Jobs Act of 2017. If an
offset of a loan occurs before the amount has been taxed as a deemed
distribution (e.g., on account of termination of employment or termination of
the plan), the offset loan is eligible for a tax-free rollover to an eligible
retirement plan (including a qualified plan or an IRA) under Code §
402(c)(3)(A).[99] Prior to the Tax Cuts and Jobs Act of 2017,
the offset loan rollover would have to be made within 60 days from the date of
offset. The Tax Cuts and Jobs Act added Code
§ 402(c)(3)(C) to provide that, for plan loan offsets in tax years beginning
after Dec. 31, 2017, the period during which a "qualified plan loan offset
amount" (i.e., an offset due to termination of employment that results in
failure to meet repayment terms of loan, or an offset due to termination of the
plan) may be rolled over to an eligible retirement plan is extended from the 60
day period after the offset to the due date (including extensions) for filing
an income tax return for the tax year in which the plan loan offset occurs.[100]
Note that a rollover of an offset loan cannot be made where there was already a
deemed distribution, since the tax was already paid.
PART
III - MISCELLANEOUS ISSUES
Exemption
from Truth-in-Lending Requirements
Plan loans used to be subject to federal truth-in-lending disclosure
statement requirements under Regulation Z of the Truth-in-Lending Act. However, effective July 1, 2010 Regulation Z was
amended to specifically exempt 401(a), 403(b) and 457(b) participant loans from
the truth-in-lending disclosure requirement, provided that the loan is
comprised of fully vested funds from the participant's account and the loan is
in compliance with the requirements of the Internal Revenue Code.[101]
Applicability
of Loan Provisions to Individual Retirement Accounts (IRAs)
Loans from IRAs are not permitted. Although IRAs are not subject to ERISA, they
are subject to the Code § 4975 excise tax on prohibited transactions.[102] Furthermore, pursuant to Code
§ 408(e)(2), if in any year an individual for whose benefit an IRA is
established engages in any transaction prohibited by Code § 4975 with
respect to the IRA, the IRA ceases to be an IRA as of the first day of such
year (and all of the assets of the IRA on the first day of such year are
treated as having been distributed on such day).[103]
Loans
in Bankruptcy
The Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005 ("BAPCPA") provides that all
retirement funds exempt from taxation under Internal Revenue Code §§ 401, 403,
408, 408A, 457 or 501(a) are protected from bankruptcy creditors. Bankruptcy Code §§ 522(b)(3)(C) &
522(d)(12). (IRAs are limited to $1
million as adjusted. Bankruptcy Code §
522(n).) With regard to participant
loans, BAPCPA provides in Bankruptcy Code § 362(b)(19) that the bankruptcy
petition does not operate as a stay for the withholding of wages to pay for
participant loans under ERISA § 408(b)(1) or Code § 72(p). Thus, withholding from wages for participant
loans could remain in effect even though the participant is in bankruptcy.
With regard to Chapter 7
liquidations, BAPCPA introduced a means test (measuring monthly disposable
income), and there are some cases regarding whether amounts withheld to repay
participant loans are counted as part of the means test.[104] This issue would not be applicable to a
Chapter 13 individual bankruptcy filing, as the means test does not apply to
Chapter 13 filings (and in fact was instituted to limit Chapter 7 filings to
encourage Chapter 13 filings instead).
Impact
of Loan Repayments on Code § 415 Annual Additions
Loan repayments are not treated as annual additions for
purposes of Code § 415.[105]
Code
§ 411(d)(6)-Anti-Cutback Protection Not Applicable
Plan loans are not Code § 411(d)(6) protected
optional forms of benefit and may be cut back or taken away without violating
the anti-cutback rules.[106]
EPCRS Correction for Plan Loan Defaults
The Employee Plans Compliance Resolution System
("EPCRS") program in Revenue Procedure 2016-51 provides that where
there is a failure to repay a plan loan by the end of the calendar quarter
following the quarter in which the payments are due, which generally would be a
taxable deemed distribution under § 72(p), the voluntary correction program
("VCP") of EPCRS can be used by reamortizing the loan balance over
the remainder of the loan period or by repaying the arrears in lump sum, or a
combination of the two.[107] This may cure not just the operational
failure but can also avoid the deemed distribution under § 72(p) (and a Form
1099-R reporting the deemed distribution will not be required), provided relief
is specifically requested from the IRS that the loan failure will not result in
§ 72(p) deemed distribution tax.[108] Alternatively, the VCP relief can be limited
to reporting the deemed distribution in the year of correction instead of the
year of failure.[109] Examples when the IRS may limit the VCP
relief to reporting the deemed distribution in the year of correction instead
of the year of failure (and not avoiding the deemed distribution tax entirely)
could be, for example, where the affected employee is a key employee or an
owner-employee[110]
or where the loan cannot be reamortized within the five year term and will need
to be defaulted in the correction year. [111]
Prior
to 2018, there were reduced VCP correction fees for loan failures based on the
number of participants: (i) $300 for 13 or fewer affected participants; (ii)
$600 for 50 or fewer affected participants; (iii) $1,000 for 100 or fewer affected
participants; (iv) $2,000 for 150 or fewer affected participants; and (v)
$3,000 for greater than 150 affected participants.[112] However, Rev. Proc. 2018-4
eliminates the reduced VCP fees for loan errors and provides for uniform VCP
user fees (for all failures) based on the entire plan's assets as follows: (i)
$1,500 if the plan's assets are of $500,000 or less; (ii) $3,000 if the plan's assets
are $500,001 to $10,000,000; and (iii) $3,500 if the plan's assets are of over
$10,000,000.[113]
Charles C. Shulman
[1] In general,
ERISA § 408(b)(1) and Code § 4975(d)(1) mirror each other. There are some differences, however. For example, ERISA applies even to
nonqualified plans. In addition, any
employee of a plan sponsor is a party in interest under ERISA § 3(14);
only a highly compensated employee is a disqualified person under Code
§ 4975(e)(2). Therefore, prohibited
transaction excise taxes under § 4975 would only apply to prohibited loans
to employees who are highly compensated or are otherwise disqualified persons.
The Department of Labor (DOL )
regulations cited below apply equally to the ERISA requirements and the Code requirements
pursuant to § 102 of Reorganization Plan No. 4 of 1978, which transferred the authority relating to these
provisions from the Treasury Department to the Labor Department. See, DOL Reg. § 2550.408b‑1(a)(1).
[2] ERISA
§ 408(b)(1) and Code § 4975(d)(1); DOL Reg. § 2550.408b-1.
[3] DOL Reg. § 2550.408b-1(a)(3).
[4] ERISA
§ 408(b)(1)(A).
[5] DOL Reg. § 2550.408b-1(b)(1).
[6] ERISA
Advisory Opinion 89-30A; Preamble to DOL
Regulations, 54 Fed. Reg. 30522 (July 20, 1989).
[7] Note that a
loan cannot be made available to certain owner-employees or certain shareholder-employees
because the exemptions of ERISA § 408(b) do not apply to these individuals. ERISA § 408(d). (See, DOL Info. Ltr. to Thomas M. Curtin (Oct. 7, 1999) regarding
a loan to a participant who later becomes an owner employee, quoted in 26 BNA
Pen. & Ben. Rptr. 2437 (October 18, 1999).)
[8] Treas. Reg.
§ 1.401(a)(4)‑10(c).
[9] DOL Reg. § 2550.408b-1(b)(2).
[10] DOL Reg. § 2550.408b-1(a)(4), Ex. 8.
[11] DOL Adv. Op. 95-19A.
[12] DOL Field Assistance Bulletin 2003-1 (April 15,
2003).
[13] 54 Fed. Reg.
30520, 30522 (July 20, 1989). See DOL Field Assistance Bulletin 2003-3 that based on DOL Reg. § 2550-404c-1(b)(2)(ii)(A), reasonable
expenses associated with taking a plan loan may be charged to the participant's
account.
[14] For 2018,
highly compensated employees are: those
earning over $120,000 in 2017 (who, if the top-paid group election is made, are
also in the top 20% group), or 5% owners.
Code § 414(q).
[15] ERISA
§ 408(b)(1)(B).
[16] DOL Reg. § 2550.408b-1(c).
[17] ERISA
§ 408(b)(1)(C).
[18] DOL Reg. § 2550.408b-1(d)(1).
[19] DOL Reg. § 2550.408b-1(d)(2).
[20] DOL Reg. § 2550.408b-1(d), Ex. (1).
[21] 54 Fed. Reg.
30520, 30523 (July 20, 1989).
[22] ERISA
§ 408(b)(1)(D).
[23] DOL Reg. § 2550.408b-1(e).
[24] In practice,
plan-wide rates are typically used, possibly in recognition of the fact that
the 50% account balance collateral makes participants' other creditworthiness
less meaningful.
[25] DOL Reg. § 2550.408b-1(e), Ex. (1).
[26] DOL Reg. § 2550.408b-1(e), Ex. (3). See, preamble
to final DOL regulations. 54 Fed. Reg. 30520, 30525 (July 20,
1989). See, also, McLaughlin v. Rowley, 698 F. Supp. 1333 (N.D. Tex.
1988), which held that state usury laws with respect to plan loans are preempted
by ERISA.
[27] See McLaughlin v. Rowley, 698 F. Supp.
1333 (N.D. Tex. 1988) (where trustees of a defined contribution plan were held
liable, among other things, for charging less than a prudent interest rate on
plan loans to participants; the plan was an individual account defined
contribution plan, although assets were pooled for investment purposes; the
plan charged only 7% during the period 1977 to 1982; the DOL's expert witness
testified that loans in such case are comparable to "compensating balance
loans," which are loans that are secured by a sum of money deposited with
the lender; the expert further testified that prudent lenders would charge fair
market rates of interest at one or two percentage points above the rate paid on
the a borrower's certificate of deposit; the rate would also vary in accordance
with the size and the term of the deposit; the fact that the security for the
loan is substantially the same as the amount of the loan does not matter; the
court rejected the claim that the participants were merely borrowing their own
money).
[28] Participant
Loans IRS Phone Forum, Sept. 12, 2011,
https://www.irs.gov/pub/irs-tege/loans_phoneforum_transcript.pdf; 38 BNA
Pension & Benefits Reporter 1694 (Sept. 20, 2011).
[29] DOL Reg. § 2550.408b-1(e), Ex. (2).
[30] ERISA
§ 408(b)(1)(E).
[31] DOL Reg. § 2550.408b-1(f)(1).
[32] DOL Reg. § 2550.408b-1(f)(2). See Part II below regarding 50% loan limit
under Code § 72(p)(2)(A).
Note that while the 50% § 72(p) limit is a requirement at the
time the loan is taken, it is not clear if the 50% adequate security
requirement of DOL Reg. §
2550.408b-1(f)(2) must be met over the term of the loan.
[33] Code
§ 401(a)(11). Profit-sharing plans
are not subject to spousal consent rules if the participant's entire accrued
benefit is payable on death to his or her surviving spouse (or another
designated beneficiary with the spouse's consent) and a life annuity payment
form is not elected. Code
§ 401(a)(11)(B)(iii).
[34] Treas. Reg.
§ 1.401(a)-20, Q&A 24.
[35] The preamble
to Treas. Reg. § 1.401(a)-20, 53 Fed. Reg. 31837, 31840 (August 22, 1988),
states that the DOL has indicated
that a loan may not be adequately secured if consent to a reduction in the
accrued benefit is not obtained before the loan is secured. Mardy, Loesel & Hamburger, Guide to Assigning & Loaning Plan Money
¶ 416 (Thompson Publishing Group), provides that the DOL concern is lessened by the "no loss"
rule of the 1989 DOL regulations
under which a delayed foreclosure is permissible as long as there are precautions
taken to avoid loss of principal or interest on the loan. It would seem, however, that since the
inability to foreclose without spousal consent could result in loss of
principal or interest on the loan, plans subject to the spousal consent
requirement should require such consent at the time of the loan.
[36] See, PLR
8933018 (interest on loans made to non-key employees that are secured by recorded
deed on residence and not by amount attributable to § 401(k) deferrals is
deductible).
[37] See, Conference Report to TEFRA, H.R.
Conf. Rep. No. 97-760 (1982), which states that residential mortgage investments
made in the ordinary course of an investment program are not considered plan
loans under § 72(p) if the loans do not exceed the fair market value of
the property, are not self-directed investments of an individual account and
are not made to officers, directors or owners.
The fiduciary duty and prohibited transaction rules must still be
complied with. Id. See, also, Treas. Reg. § 1.72(p)-1, Q&A 18 which states
that a mortgage investment program exists only if the plan has established, in
advance of a specific investment, that a certain percentage or amount of the
assets will be invested in residential mortgages. The above regulations also impose certain
additional requirements. See, also, PLR
8824045 (mortgage loans made available only to plan participants are subject to
§ 72(p)); PLR 9110039
(mortgage loan program primarily for plan participants is subject to
§ 72(p)); DOL Adv. Op. 81-12A
(mortgage loan program as a plan investment must be prudent).
[38] When plans
take the loan proceeds directly from a participant's accounts, this is often
done in a certain order; for example, the following order: 401(k)
contributions, catch-up contributions, rollover contributions, matching contributions,
employer contributions, Roth contributions, Roth catch-up contributions, Roth
rollovers, after-tax contributions.
[39] See, DOL
Reg. § 2550.408b‑1(f)(1) and Preamble to final DOL
regulations, 54 Fed. Reg. 30520, 30526 (July 20, 1989).
[40] Id.
[41] DOL Reg. § 2550.408b-1(a)(3).
[42] Id.
See also, Treas.
Reg. § 1.72(p)-1, Q&A 17 that if the loan is not bona fide (e.g., an understanding that the loan
will not be repaid) the amount transferred is treated as an actual distribution
and not as a loan or deemed distribution under Code § 72(p).
In determining whether there is a bona fide loan, courts will
focus on: existence of a debt
instrument, security, interest and fixed repayment date, record of loan,
ability to repay, relationship of parties, and other factors. See,
e.g., Patrick v. C.I.R., T.C.
Memo 1998-30 (transfers from profit sharing plan to two participants who were
shareholders of the employer were taxable income to the participants and not
plan loans). See also, Fuller v. C.I.R., T.C. Memo. 1980-370,
1980 WL 4206 (1980) (as long as the proper formalities are observed, the burden
is on the IRS to prove that the transaction was not a loan; the court held that
even though the employer, sole shareholder and loan recipient was also one of
the plan's trustees, and even though loan repayments had been sporadic, a loan
transaction in which the proper formalities had been observed was a loan,
rather than a taxable distribution, from the plan).
[43] Id.
[44] A taxable
distribution, in turn, may also trigger a 10% early distribution penalty tax under
Code § 72(t), if applicable. Treas.
Reg. § 1.72(p)-1, Q&A 11, 65 Fed. Reg. 46591 (July 31, 2000).
[45] Code
§ 72(p)(2); Treas. Reg. § 1.72(p)-1, Q&A 3.
[47] All plans of
an employer (determined under the rules of subsections (b), (c) and (m) of Code
§ 414) are treated as a single plan for purposes of the loan rules. Code § 72(p)(2)(D)(i) and (ii).
[48] The reason for adjusting the maximum by the
repayment amount is to prevent an employee from effectively maintaining a
permanent outstanding $50,000 loan balance. 21 H.R. Rep. 99-426 at 735 (1985).
With respect to the maximum participant
loan amount when the participant has prior loans, the IRS in Memorandum for
Employee Plans (EP) Examinations Employees, revised at TE/GE-04-0417-0020 (July
26, 2017) (to be incorporated into IRM 4.71.1.14), provides that the IRS will
permit two alternative methods for computing the highest outstanding balance
within one year of the request for a new loan. As stated in the Memorandum for
EP Employees, if a participant borrowed $30,000 in February which was fully
repaid in April, and $20,000 in May which was fully repaid in July, before applying
for a third loan in December, the plan may determine that no further loan would
be available, since $30,000 + $20,000 = $50,000. Alternatively, the plan may identify "the
highest outstanding balance" as $30,000, and permit the third loan in the
amount of $20,000. Both methods will be acceptable on audit.
[49] Code
§ 72(p)(2)(A). Note that the 50%
limit appears to be a requirement at the time the loan is made but not an ongoing
obligation. See Treas. Reg. § 1.72(p)-1,
Q&A 4.
[50] DOL Reg. § 2550.408b-1(f)(2).
[51] This could be
the sum of the highest outstanding balances for each loan during the one year
period or alternatively the highest outstanding balance of all loans combined
at any point during the one year period.
See discussion above regarding Memorandum for EP Employees (July 26,
2017).
[52] Treas. Reg.
§ 1.72(p)-1, Q&A 19(b)(1).
See, Raymond H. v. C.I.R.,
T.C. Memo. 2011-139, aff'd, 2012-1 U.S. Tax Cas. (CCH) P 50391, 2012 WL 2036776
(5th Cir. 2012) (an individual who was a long time U.S. Air Force employee had
borrowed money from his thrift savings plan; repayments were to be made by
payroll withholding; the individual lost his job and the plan notified the
individual that the remaining portion of the loan was due; he did not timely
repay the loan and received a Form 1099R for a deemed distribution; the
individual filed with the Tax Court, which held that he received a constructive
distribution and was subject to the additional 10% tax under IRC § 72(t) for a
premature distribution); Marquez v.
C.I.R., T.C. Summ. Op. 2009-80, 2009 WL 1405883 (T.C. 2009) (the
refinancing of a plan loan under which both the original and new loan were
treated as being outstanding for purposes of IRC § 72(p)(2), resulted in a
constructive distribution and the imposition of a 10% premature distribution
tax; when the refinancing was authorized, the participant was advised that an
additional loan could be made on the same terms as the original loan, or a new
loan for a smaller amount could be made, either of which alternatives would
have avoided exceeding the permissible loan limitation); Billups v. I.R.S., T.C. Summ. Op. 2009-86, 2009 WL 1519901 (T.C.
2009) (a participant refinanced a loan from a qualified plan, which resulted in
exceeding the permissible loan limitation under IRC § 72(p); the individual had
an outstanding loan balance of $27,013, and the participant refinanced it to
borrow an additional $12,630, thus increasing his loan balance to $39,748; Tax
Court determined that his loan would violate IRC § 72(p) limitations if it
exceeded one-half of his $52,863 loan balance; court concluded that the sum of
the new loan and the loan it replaced was $66,655 ($39,642 + $27,017), and that
amount exceeded the applicable 50% of his account balance (the highest amount
of permissible loan value without exceeding IRC § 72(p) limitation) by $39,748).
[53] Treas. Reg. §
1.72(p)-1, Q&A 19(b)(2). 67 Fed.
Reg. 71821 (December 3, 2002).
[54] See discussion
below in section entitled "Proposed Amendments Regarding Refinancing and
Multiple Loans" regarding a controversial proposed regulatory limit of two
loans per year.
[55] Code
§ 72(p)(2)(B).
[56] Conference
Report to TEFRA 1982; Treas. Reg. § 1.72(p)-1, Q&A 4.
[57] Joint
Committee of Taxation General Explanation to TEFRA 1982 (Blue Book) § IV.D.2.
[58] Code
§ 72(p)(2)(B)(ii).
[59] See, Mardy, Loesel & Hamburger, "Guide
to Assigning & Loaning Plan Money," ¶ 465. See also, Treas. Reg. § 1.72(p)-1 (“The
examples included . . . are based on the assumption that a bona fide loan is
made to a participant . . . with adequate security and with an interest rate
and repayment terms that are commercially reasonable”).
[60] Treas. Reg.
§ 1.72(p)-1, Q&A 5.
[61] Treas. Reg.
§ 1.72(p)-1, Q&A 6.
[62] Treas. Reg.
§ 1.72(p)-1, Q&A 7.
[63] Treas. Reg.
§ 1.72(p)-1, Q&A 8. See
Part I above regarding mortgage loans and mortgage investment programs.
[64] Code
§ 72(p)(2)(C).
[65] DOL Adv. Op. 94-27A. It held that Dreyfus Service Corporation's
telephone voice response system could be used to make salary deferrals into
pension plans because New York Labor Law § 193, which requires written
authorization for payroll deductions (implying that telephone requests are not
sufficient), is preempted by ERISA with respect to employee benefit plans.
The New York State Department of Labor has issued at least
one opinion that written authorization for payroll deductions may be satisfied
when a blanket authorization has been made in writing for any future loan
requests by electronic communications.
Butterworth, "Paperless Plan Administration: Electronic Communications from Employees,"
22 Tax Mgmt. Comp. Plan. J. 8 (August
5, 1994).
[66] DOL Adv. Op. 96-01A. It involved § 5(g) of Puerto Rico Act No. 17,
which allows payroll deductions in writing for purposes of mandatory
contributions to pension and savings plan, implying their payroll deductions
for purposes of repaying plan loans would not be permitted. The DOL
held that § 5(g) is preempted by ERISA and ERISA § 514, since particularly, §
5(g) attempts to specifically regulate ERISA-covered plans.
[67] Treas. Reg.
§ 1.72(p)-1, Q&A 9(a).
[68] Treas. Reg.
§ 1.72(p)-1, Q&A 9(a) & Q&A 9(d) Ex. (1).
See, however, Frias v. C.I.R., T.C. Memo 2017-139 (a plan loan
taken before a leave of absence was considered a plan distribution since the
participant failed to begin making payments even though she was received
paychecks from her employer while on leave).
The participant loan interest rate may be restricted during the military
service to 6% under the Soldiers & Sailors Civil Relief Act Amendments of
1942. See, Treas. Reg. § 1.72(p)-1,
Q&A 9(d), Ex (2).
[70] Treas. Reg.
§ 1.72(p)-1, Q&A 20(a)(1). 67
Fed. Reg. 71821 (Dec. 3, 2002).
[71] Treas. Reg.
§ 1.72(p)-1, Q&A 20(a)(2).
[72] Treas. Reg.
§ 1.72(p)-1, Q&A 3(b).
[73] Treas. Reg.
§ 1.72(p)-1, Q&A 3(b)(2).
[74] Id.
[75] Treas. Reg.
§ 1.72(p)-1, Q&A 3(b). In 65
Fed. Reg. 46677 (July 31, 2000) the Treasury asked for comments on the
impact of the Electronic Signatures in Global and National Commerce Act, P.L.
106-229, June 30, 2000, 15 U.S.C. §§ 7001-7031, on plan loan transactions.
[76] Employee Plans
News (April 1, 2015). See also Fidelity
Points of View (April 2015) criticizing the requirement to have documentation
verifying that the loan proceeds were used to purchase or construct the home.
[77] Treas. Reg.
§ 1.72(p)-1, Q&A 4(a).
[78] Id.
[79] Treas. Reg.
§ 1.72(p)-1, Q&A 4(a) & 10(a).
The same is true for the other requirements of § 72(p) such as the
five-year repayment requirement. Treas.
Reg. § 1.72(p)-1, Q&A 4(a).
[80] Treas. Reg.
§ 1.72(p)-1, Q&A 10(a).
[81] Treas. Reg.
§ 1.72(p)-1, Q&A 10(b).
[82] In
the first situation, loan payments were missed in two consecutive months, March
31 and April 30, which fell in different calendar quarters. Loan payments
were resumed in the following two months and applied to the previously missed
payments. In the third calendar quarter, the individual caught up all
payments so that the loan was current. In the second situation, the
taxpayer missed payments for three consecutive months during the fourth quarter
of the year. In the following quarter, the taxpayer refinanced the loan
with a new replacement loan equal to the outstanding balance of the original
loan including the missed payments. In both cases Chief Counsel Advice
201736022 held that the missed loan payments were timely corrected, so that a
loan default was avoided.
[83] See, e.g., Leon
v. C.I.R., T.C. Summ. Op. 2008-86, 2008 WL 2796058 (T.C. 2008)
(distribution following termination of employment includible in income under §
72(p) and subject to § 72(t) 10% penalty on early distribution on the
expiration of the 90-day grace period to repay the loan); Plotkin v. C.I.R.,
T.C. Memo. 2001-71, T.C.M. (RIA) P 2001-071 (2001) (money purchase plan loan to
sole shareholder violated the five year payment requirement and in addition to
being a taxable distribution under § 72(p) would also be subject to the
additional 10% early distribution tax under § 72(t)); Raymond H. v. C.I.R.,
T.C. Memo. 2011-139, T.C.M. (RIA) P 2011-139 (2011), aff'd, 2012-1 U.S. Tax
Cas. (CCH) P 50391, 109 A.F.T.R.2d 2012-2433, 2012 WL 2036776 (5th Cir. 2012)
(an individual who was a U.S. Air Force employee had borrowed money from his
thrift savings plan; repayments were to be made by payroll withholding; the
individual lost his job and the plan notified the individual that the remaining
portion of the loan was due; he did not timely repay the loan and received a
Form 1099-R for a deemed distribution; the individual filed with the Tax Court,
which held that he received a constructive distribution and was subject to the
additional 10% tax under IRC § 72(t) for a premature distribution); Matthews
v. C.I.R., T.C. Summ. Op. 2014–84, 2014 WL 4251116 (T.C. 2014) (a
participant who had a plan loan outstanding requested a distribution of funds
from his 401(k) plan; he asked that the funds be used first to pay off the
loan, a portion of the funds were withheld for income tax and the remaining
were distributed to him and used for a rollover IRA; the Tax Court held that
the 10% premature distribution penalty under IRC § 72(t) applied to the amount
of the distribution used for the loan payoff); El v. C.I.R., Tax Ct.
Rep. (CCH) 60251, Tax Ct. Rep. Dec. (RIA) 144.9, 2015 WL 1063061 (T.C. 2015)
(Tax Court held that the 10% tax imposed under IRC § 72(p) for exceeding the
permissible requirements for a loan under IRC § 72(p)(2) is not a penalty for
purposes of IRC § 7491(c); therefore, the IRS does not bear the burden of
proving that an assessment under § 72(p) is proper); Gowen v. C.I.R., TC
Summary Opinion 2017-57 (Tax Court held that a CPA who defaulted on a plan loan
during one tax year must include the deemed distribution once the cure period
for repayment expires in the next tax year; the CPA who had a master's degree
in taxation allowed a loan payment to a qualified plan to go into default in
the third quarter of the year and failed to cure the default by the end of the
fourth quarter; the CPA argued that the failure should be reported in the
following tax year because he did not receive final notice from the plan
custodian until after the end of the year; however, the Tax Court held that the
failure was reportable for the year in which the failure occurred rather than
the following year).
[84] Olagunju v.
C.I.R., T.C. Memo. 2012-119, 2012 WL
1392677 (holding that a distribution had to be included in gross income when the
record contained no loan documents or other evidence showing that the
distribution was evidenced by a legally enforceable agreement); Bormet v.
C.I.R., T.C. Memo 2017-201 (an individual who obtained an initial loan,
suffered an injury and received short-term and then long-term disability
benefits, was reported by the retirement plan's TPA as being in default for
nonpayment of a loan for $26,954; the individual claimed that the loan had been
renegotiated but was unable or unwilling to offer any evidence that the loan
was renegotiated or evidence of his disability; the Tax Court concluded that
there was insufficient evidence of a renegotiated loan and determined that the
entire unpaid balance of $26,954 should be includable in the individual's
income)..
[85] Treas. Reg.
§ 1.72(p)-1, Q&A 19(a).
[86] Treas. Reg. § 1.72(p)-1,
Q&A 11. See, e.g., Leon and Tilley v.
C.I.R., 2008 WL 2796058, 44 E.B.C. 2405 (2008) (distribution following
termination of employment includible in income under § 72(p) and subject
to § 72(t) 10% penalty on early distribution on the expiration of the 90
day grace period to repay the loan); Plotkin
v. C.I.R., T.C. Memo 2001-71 (2001) (money purchase plan loan to sole
shareholder violated the five year payment requirement and in addition to being
a taxable distribution under § 72(p) would also be subject to the
additional 10% early distribution tax under § 72(t)).
[87] Treas. Reg.
§ 1.72(p)-1, Q&A 14.
[88] Treas. Reg.
§ 1.72(p)-1, Q&A 12. See also, Treas. Reg. § 1.402(c)-2,
Q&A 4(d), Treas. Reg. § 1.401(k)-1(d)(6)(ii), and Notice 93-3, 1993-1
C.B. 293.
[89] Treas. Reg.
§ 1.72(p)-1, Q&A 13; Treas. Reg. § 1.402(c)-2, Q&A 9(a).
[90] Plan loan
procedures typically provide for various events of default. The most basic one is failure to make
payments when due. Some administrators
treat loans as being in default if payments are not made for three months,
since that is the period after which they will be considered to be taxable
distributions. Another common event of
default is termination of employment. Termination
of the plan will often cause an event of default. Once an event of default has occurred the
administrator may foreclose (unless otherwise prohibited from doing so) by
offsetting the account balance. A
foreclosure is generally treated as a distribution. Foreclosure occurs when the participant's account
balance is offset by the loan amount.
[91] Treas. Reg.
§ 1.72(p)-1, Q&A 13(b).
[92] Treas. Reg.
§ 1.402(c)-2 Q&A 4(d); Treas. Reg. § 1.72(p)-1, Q&A 12;
Notice 93-3, 1993-1 C.B. 293.
[93] Treas. Reg.
§ 35.3405‑1T, Q&A F‑4 & F-5.
[94] Treas. Reg.
§ 1.402(c)‑2, Q&A 9; Notice 93‑3, 1993-1 C.B. 293.
[95] IRS Notice 93‑3 § III(b)(3), 1993-1 C.B. 293.
[96] Treas. Reg.
§ 1.72(p)-1, Q&A 15. To the
extent that a loan constitutes a deemed distribution that results in income at the
time the loan is made, withholding is required for such deemed distribution
regardless of whether there is other cash or other property to withhold
from. Id.
[97] PLR 8910034; PLR 8950008.
[98] Treas. Reg.
§ 1.401(a)(31)-1, Q&A 16 ("A plan administrator is permitted to
allow a direct rollover of a participant note of a plan loan to a qualified
trust"). See also, PLR 9617046 (Jan. 31, 1996)
(newly-transferred employees rolled over loan notes from one plan to another
plan, with the transferee plan requiring the participant to acknowledge that
transferee plan is new obligee; IRS
held that the transfer of a loan note as a direct rollover under
§ 401(a)(31) could be made and would not be a taxable distribution under
Code § 402(a) or 72(p); also since substantive terms of loan have not
changed, not considered a revision or renegotiation of the loan and therefore
not a new loan under § 72(p); PLR
9729042 (direct rollover of note is permissible, and will not be a taxable
distribution). See, also, Treas. Reg. § 1.402(c)-2, Q&A 9; 23 BNA Tax Mgmt. Compensation Plan. J. 195
(Aug. 4, 1995); 18 BNA Pen. Rptr. 2118 (Nov. 30, 1992); 92 TNT 235-3 (Nov. 24, 1992). It is not clear from the regulations if a
direct rollover of a note would be considered like a new loan from the transferee
plan.
[99]
A deemed
distribution is not eligible to be rolled over to an eligible retirement plan
since it is not considered a distribution. Treas. Reg. § 1.72(p)-1, Q&A 12.
[101] 12 CFR § 226.3(g).
[102] Although an IRA
does not explicitly fit within the definition of disqualified person under Code
§ 4975(c)(2), the Conf. Rep. to ERISA, Rep. No. 43-1280 at 501, and PLR 8849001 support the view that transactions
between the IRA and the IRA owner are prohibited transactions.
[103] Code §
408(e)(2)(A) and (B). See, also, Code § 408(e)(4).
[104] See, e.g., In
re Egebjerg, 574 F. 3d 1045 (9th Cir. 2009) (holding that a 401(k) loan is
not a debt since the participant is merely paying it to himself, and Egebjerg
could not include his payments on the participant loans as deductions for calculating
monthly disposable income for the means test).
See also, Welmerink, "Cleaning the Mess of the Means Test: The Need
for a Case-by-Case analysis of 401(k) Loans in Chapter 7 Bankruptcy Petitions,"
41 Golden Gate U.L. Rev. 121 (Fall 2010).
[105] Treas. Reg. §
1.415-6(b)(3)(ii).
[106] Treas. Reg.
§ 1.411(d)-4, Q&A 1(d)(4).
[107] Rev. Proc.
2016-51, §§ 6.02(6) & 6.07. This
relief was originally provided in Rev. Proc. 2006-27, §§ 6.02(6) & 6.07.
[108] Rev. Proc.
2016-51, § 6.07(2)(a) & (3). See Rev.
Proc. 2016-51, § 6.02(6) that for defaulted loans the employer should pay a
portion of the correction payment equal to the interest that accumulates as a
result of such failure (generally determined at a rate equal to the greater of
the plan loan interest rate or the rate of return under the plan).
[109] Rev. Proc.
2016-51, § 6.07(1).
[110]
Form
14568-E (Model VPC Compliance Statement for Plan Loan Failures), § IIA & B,
provides that if the affected participant is either a key employee under Code §
416(i)(1) (e.g., an officer earning over $175,000 in 2018) or an owner-employee
under Code § 401(c)(3), relief will be limited to reporting the deemed
distribution in the year of correction instead of the year of failure.
[111]
See also Rev. Proc. 2016-51, § 6.07(2)(a), that
the IRS can deny correction to entirely avoid a deemed distribution if it deems
appropriate, e.g., where the loan failure is not caused by employer action.
[112] Rev. Proc. 2015-27, at § 4.13 and Rev. Proc. 2017-4, App. A .08.
[113] Rev.
Proc. 2018-4, at § 2.03(4) (eliminating specific reduced VCP fees, beginning in
2018); Rev. Proc. 2018-4, at § 2.03(1) and App. A .09 (beginning in 2018, VCP
user fees now based on plan assets).
