Making Amends: Problems and Solutions for Participant Loan Missteps

According to the IRS, one of the common retirement plan administration mistakes relates to plan loan failures and deemed distributions. Advisers can assist their clients in implementing administrative measures to ensure that participant loans from the plan are compliant with the plan document and any separate written loan policy adopted by the plan, which will can also help in monitoring loan payments to be sure they are made in a timely fashion.

Loan failures are most commonly caused by three issues, the IRS reports:

• loans that exceed the maximum dollar amount,
• loans with payment schedules that don’t meet the time or payment limits, and
• defaulted loans due to failure to make required payments.

Each of these issues will cause the loan, or a portion of the loan, to become a “deemed’ distribution for tax purposes, which means that the participant is taxed as if the distribution were received. However, that does not excuse the participant from the obligation to repay the loan (frequently the reason cited for the loan would be insufficient to justify a distribution from a 401(k) plan). If the participant fails to repay the loan, he can suffer further tax consequences, including having the loan considered a prohibited transaction. Additionally, when a loan goes into default, whether from participant or administrator error, this results in a deemed distribution of the entire unpaid loan balance plus accrued interest.

Disqualification Issues

A loan failure can also cause a plan to become disqualified, resulting in adverse tax consequences to the employer and employees under the plan but, the Department of Labor’s Voluntary Correction Program (VCP), part of the Employee Plans Compliance Resolution System (EPCRS),can be used to correct these mistakes. In fact, the recent Revenue Procedure 2006-27 adds three new corrections for plan loan failures which, when made through VCP, remove the deemed distribution tax reporting requirements. It is important to note, however, that these corrections are only allowed if the normal maximum period for repayment of the loan has not expired.

Where a plan loan has exceeded the dollar limit ($50,000 or 50% of the participant’s vested account balance, whichever is less), correction will be permitted if there is a payment to the plan based on the excess loan amount. If loan repayments were made before correction, the prior repayments may be applied in three ways, either:

• to interest on the excess so the participant only repays the excess loan amount,
• only to the amount of the loan not exceeding the dollar limit so that the participant repays the excess loan amount (plus interest), or
• pro rata against the loan excess and the maximum loan amount, so that the corrective repayment would equal the outstanding balance remaining on the original loan excess on the date that corrective repayment is made.

Where a plan loan has a payment schedule that is greater than allowable by law, the loan can be reamortized over the remaining period of the proper maximum payment period measured from the original date of the loan.

For loans that are deemed in default, correction can be made in a lump sum payment equal to what should have been made to the plan, plus interest or reamortization of the outstanding balance of the loan over the remaining payment schedule of the original term of the loan; defaults can also be corrected by a combination of either of the aforementioned methods.

Additionally, the IRS says, certain situations could require the employer to pay some of the repayment needed to fix a defaulted loan, such as when an employer did not start payroll withholding for repayment of the loan.