Many qualified profit-sharing and 401(k) retirement plans allow participants to take loans from their account balance. To ensure that the loan is repaid and to avoid administrative headaches, many plans require repayments be made by payroll deduction.
However, even with payroll deduction, payments can be missed, either because of an administrative error or because a participant takes unpaid leave. For plans that allow some or all loan repayments to be made outside of payroll deduction, missed payments can be a more regular occurrence.
Recent advice issued by the Internal Revenue Service (IRS)’s Office of Chief Counsel (see, IRS: Missed 401(K) Loan Repayments Can Be Made Up Without Being Taxed) authorizes two methods of correcting these missed payments: the lump-sum method or the reamortization method. (Office of Chief Counsel Memorandum 201736022 (August 30, 2017)). Neither of these methods, according to the memorandum, will cause the loan to violate the requirement in Section 72(p)(2)(C) of the Internal Revenue Code that the loan have substantially level amortization with payments not less frequently than quarterly.
But before describing these methods, two important caveats. First, the Chief Counsel memorandum is internal IRS guidance, not official guidance upon which taxpayers are allowed to rely. The memorandum gives insight, however, into the IRS’s current analysis of this issue.
Second, the correction needs to be done within the cure period specified in Treasury Regulation Section 1.72(p)-1, Q&A-10(a); that is, before the last day of the calendar quarter following the calendar quarter in which the payment was missed (for example, by June 30 for any payments missed between January 1 and March 31). Also, the memorandum assumes the cure period is allowed by the terms of the plan.
The lump-sum method described in Situation 1 of the memorandum allows any missed loan payments to be paid back in a lump sum before the end of the calendar quarter following the calendar quarter in which the loan was missed. So, for example, a participant takes out a loan in January to be repaid monthly and makes the January and February payments on time, but misses the March and April payments.
If the participant starts making payments again in May and June, those payments would be applied to the missed March and April payments. Come July, the participant still owes three payments, at least two of which need to be made before September 30.
If the participant pays a lump sum equal to three payments in July, the memorandum concludes that the missed installment payments do not violate the level amortization requirement because the missed installment payments were cured within the applicable cure period and, therefore, there is no deemed distribution.
Although the memorandum discusses correcting the missed payments with a single lump-sum payment, presumably multiple lump sums would work as well under the IRS’s analysis. So, for example, say a participant took a loan in January and, due to an administrative error, repayments were never initiated in the payroll system. Assume the error is discovered in late March or early April.
If the plan instituted double payments for April, May, and June (or even full monthly payments in each of the next six payroll periods), according to the IRS analysis, the first two payments made could be applied to the January and February payments, the next two payments made could be applied to the March and April payments, and the next two payments made could be applied to the May and June payments.
All payments would have been made by the appropriate cure period and, under the same rationale, would not violate the level amortization requirement.
Coordination with EPCRS
The value of the IRS advice is that the proposed correction methods mean that the loan repayment terms comply with the terms of Code Section 72(p). The IRS has outlined in its Employee Plans Compliance Resolution System (EPCRS) set forth in Revenue Procedure 2016-51 a means for correcting plan loan failures that fail to comply with 72(p).
According to the advice in the memorandum, if the plan loan payments are brought in line within the appropriate cure period, there is no violation of 72(p) requiring correction under EPCRS. However, if the correction prescribed in the memorandum is not made within the cure period, then EPCRS would be the next alternative.
The Reamortization Method
The reamortization method described in Situation 2 of the memorandum allows for a loan with missed payments to be “refinanced” or “reamortized” with a replacement loan equal to the outstanding balance of the original loan (including the missed payments) within the appropriate cure period.
So, for example, imagine a loan is taken out in January 2017 and monthly payments are made on time from January to September, but the participant misses the October, November, and December payments. All three of those payments must be cured by March 30, 2018.
If the participant takes a new loan and reamortizes the loan with new (higher) monthly payments through the end of the original loan’s repayment term, the memorandum concludes that the missed installment payments do not violate the level amortization requirement because the missed installment payments were cured within the applicable cure period by refinancing the loan; therefore, there is no deemed distribution.
The example used for reamortization in the memorandum assumes a loan is not a home loan, as the original loan term was for 5 years, the longest term permitted for a non-home-related loan under Code Section 72(p)(2)(B). But what would happen if the participant originally had taken out a loan for a period of 4 years? Could the loan be reamortized for a period that exceeds the original repayment date but is not longer than the maximum 5-year period from the original date of the loan? Unfortunately, the memorandum does not address this issue, but instead describes reamortization over the original loan period.
Developing a Plan Policy
In addition to the plan specifying that loan payments can be cured with the appropriate cure period specified in Q&A 10(a) of Treasury Regulation 1.72(p)-1, in light of the analysis in the memorandum, plan sponsors may also wish to adopt a policy for how missed loan payments will be corrected.
Plans may adopt either of the correction methods countenanced in the memorandum, or they may allow participants to decide the method of the two that works best for them. Whatever policy a plan adopts, in must be prepared to administer that policy consistently for all participants.
Todd B. Castleton is counsel with Kilpatrick Townsend & Stockton’s Employee Benefits Practice in the firm’s Washington, D.C., office, where he leads the Qualified Retirement Plans team. He is a contributing editor of The 401(k) Plan Handbook, and formerly was contributing editor of the Guide to Assigning & Loaning Benefit Plan Money.