By Lisa K Loesel. Loans against a qualified retirement plan can go wrong in a variety of ways, exposing employers and workers to taxes and penalties. But employers and workers can avoid trouble if they remain aware of key factors to prevent the worst from happening. And even if potential violations occur, there are ways to make things right – and avoid those expenses.
Back in September 2011, IRS officials hosted a phone-in event on participant loan rules. Topics included: setting “reasonable interest” rates; what triggers a “deemed distribution;” maximum loan amounts; and how to work with the IRS to repair potential violations.
Failure to comply with plan loan requirements may result in: (1) a prohibited transaction, which can result in excise tax liability for both plan sponsors and plan participants; and (2) a deemed distribution, which can result in taxable income for the participant.
Lisa K. Loesel, an attorney with McDermott Will & Emery in Chicago, summarized the key topics discussed at the event, and she added some of her own “practice pointers” for plan sponsors and plan administrators to use.
Reasonable Interest Rate. In order to avoid classification as a prohibited transaction under Section 4975, a plan loan to a participant must bear a “reasonable rate of interest.” During the telephone forum, the IRS said it generally considers “prime plus 2 percent” to be a reasonable rate of interest. However, the IRS recognized that “there is nothing in stone” regarding the suggested prime plus 2-percent interest rate, and mentioned that plan sponsors could argue that a lower interest rate was reasonable so long as the participant could obtain a loan on the open market with such a lower interest rate. Check here for a daily summary of prime rates.
Practice Pointer: Many plan loan programs currently use an interest rate that is less than prime plus 2 percent. Plan sponsors and plan administrators should review their plan loan procedures and determine whether the interest rate should be increased accordingly. Also note that any increases to the interest rate should only be applied prospectively to new loans, and should not be retroactively applied to any existing loans. Applying a new interest rate to an existing loan would violate the level amortization requirement of Section 72(p), dealing with taxability of participant loans.
Signed Loan Agreement. IRS review manager David Boyd and revenue agent Kathleen Wack reiterated the importance of having a signed loan agreement on file. Without a signed loan agreement, the loan will not be considered a “legally enforceable agreement,” IRS rules state. The IRS said that both written and electronic signatures are acceptable.
Spousal Consent. The IRS officials reminded callers that a plan is generally not required to obtain spousal consent before approving a plan loan. (The spousal consent rules only apply to plans subject to the qualified joint and survivor annuity rules, such as defined benefit pension plans and money purchase plans.) These rules can be found in Code Section 417(a)(4). However, a plan not otherwise subject to the spousal consent rules is still permitted to request spousal consent as a precondition to issuing a plan loan.
Practice Pointer: If the plan requires spousal consent before approving a loan, this requirement must be stated in the plan document and the plan loan procedures.
Exception to Maximum Loan Amount. Under Section 72(p)(2), the maximum amount a participant may borrow is 50 percent of his vested account balance or $50,000 (less certain outstanding loan balances), whichever is less. However, if 50 percent of the vested account balance is less than $10,000, the plan sponsor may still allow the participant to borrow up to $10,000. The IRS reminded callers that the $10,000 exception is optional; plan sponsors are not required to utilize this exception, and may limit loans to 50 percent of the vested account balance, even if such amount is less than $10,000.
Practice Pointer: The maximum amount available for loan must be specified in the plan document and/or the plan loan procedures. And if the plan allows for loans in excess of 50 percent of the vested account balance and up to $10,000, the plan administrator must always make loans available in accordance with this exception.
Repayment Term. Plan loans must generally be repaid within five years, and participants must make regular loan repayments at least quarterly. However, Boyd and Wack reminded callers that there is nothing that precludes plan sponsors from adopting a shorter repayment period, such as two or three years.
Practice Pointer: A plan sponsor could adopt a standard repayment period that is shorter than five years (such as two or three years). Plan sponsors may also allow participants to choose their own repayment term, so long as the term is not longer than five years and is determined at the inception of the loan. If the plan sponsor adopts a shorter repayment period or allows participants to choose the length of their repayment periods, these administrative rules must be specified in the plan document and/or the plan loan procedures.
Deemed Distributions. Plan loans that do not meet the legal requirements are considered “deemed distributions.” The timing and amount of a deemed distribution is dependent upon how and when the loan failed to comply with legal requirements. During the telephone forum, the IRS discussed the deemed distribution that occurs when a participant fails to make a regularly scheduled loan payment. In this case, the remaining loan balance is deemed to be a distribution upon the expiration of any applicable cure period and is subject to income tax, as well as the 10-percent penalty tax on early distributions if the participant is under age 59½. The plan administrator must issue a Form 1099-R for a deemed distribution.
However, if the participant continues to participate in the plan after the deemed distribution occurs, he may still be required to make loan repayments. These repayments are treated as “tax basis” for accounting purposes and will not be taxable upon distribution to the participant.
Cure Periods. A “cure period” is the period that a participant has to make up a loan payment in the event he misses a regularly scheduled payment. Under Treas. Reg. 1.72(p)-1, Q/A-10(a), the plan may provide that a participant has until the end of the calendar quarter following the quarter in which the repayment was missed to make up the payment. However, a plan is not required to have a cure period, and may also adopt a cure period shorter than the maximum cure period outlined above. If the plan has a cure period, a loan in default is treated as a “deemed distribution” upon the expiration of the cure period.
Practice Pointer: Because the existence of a cure period is optional, and the length of any such cure period is discretionary (so long as it is equal to or shorter than the end of the calendar quarter following the calendar quarter in which the payment was missed), the existence and length of the cure period must be documented. Plan sponsors and plan administrators should review their plan documents and plan loan procedures in order to confirm that the documentation correctly reflects the chosen cure period (if any).
Common Administrative Errors. Through the Learn, Educate, Self-Correct and Enforce (LESE) Project #2, the IRS was able to identify the following common administrative errors related to plan loans:
- failure to follow plan provisions, including the failure to limit the loan amount to the maximum amount specified in the plan;
- making certain loans that were not “bona fide” participant loans from inception because there was either no loan documentation or no legitimate attempt at repayment; and
- loans made from plans that did not specifically provide for plan loans.
Practice Pointer: The IRS identified these errors in its review of small plans (less than 10 participants) with outstanding loan balances exceeding $100,000. However, larger plans can still learn from these findings. Plan sponsors and plan administrators should regularly review their plan documents and plan loan procedures, as well as the administration of their loan programs, in order to ensure that the plan terms and loan requirements are being followed.
Serial Loan Defaulters. One caller raised the issue of serial loan defaulters. According to this caller, certain participants would take a loan from the plan, immediately default on this loan, pay the income tax related to this loan, and then take another plan loan. The caller wanted to know if the plan loan procedures could prohibit participants who had previously defaulted on a plan loan from taking another plan loan. The IRS stated that such a restriction was permissible.
Practice Pointer: Plan sponsors and administrators should confirm that recordkeepers are not “dropping” those participants who have received a Form 1099-R for a deemed distribution from the loan report. Despite the deemed distribution, these loans are still considered unpaid and should be counted against the participant’s plan balance available for loan.