The following questions and answers are from “Loans: Correcting Taxation, Qualification and Fiduciary Failures,” an April 15, 2020 ASPPA Webinar presented by Stephen W. Forbes J.D., LL.M. of Forbes Retirement Plan Consulting. 

Opinions expressed are those of the author, and do not necessarily reflect the views of ASPPA or its members.

 

Until Grace Period Expiration

Q. In the case of delinquent payments, must an employer wait until the end of the grace period to correct the loan default by reamortizing the loan? 

A. If the plan document or loan policy provides for a grace period, the plan should not proceed with correction (reamortization) until the grace period expires. With the cooperation of the participant, the IRS may not challenge a correction that begins before the grace period expires. 

 

After 5-Year Repayment Period Has Expired

Q. Can a loan default be self-corrected if the 5-year repayment period has expired? 

A. If the 5-year repayment period has expired, the employer cannot use the SCP correction methods (e.g., reamortization) that avoids the requirement to issue the Form 1099-R. However, the employer may use the SCP correction method that allows the employer to issue the Form 1099-R in the year of correction (as opposed to the year of failure).

 

Sporadic Loan Repayments

Q. Full-time participant is making loan payments regularly and then changes to “on-call” status. Loan payments become sporadic; for example, 2 required payments made during the quarter, one in January and one in March. Participant does not make up missed loan payments in between the various payroll deductions. When does the clock start ticking when payments are missed sporadically? 

A. In general, once a payment is missed the clock starts. However, the IRS permits a plan to apply a payment to a previous month to avoid default. For example, in your situation, assuming the plan applied the maximum grace period, the employer could apply the March payment to February and then the May payment could cover the March payment. This approach can work for a while, but if the participant does not get on a steady repayment schedule, there will be a payment that is not made up by the end of the grace period. In that situation, you have a loan default and a deemed distribution. The plan will need to correct or issue a Form 1099-R.

 

Grace Period for 5-Year Repayment Period

Q. Is there any grace period for the 5-year amortization schedule (e.g.., if the 5-year repayment period is exceeded only by a month or two? 

A. No. Neither the Internal Revenue Code nor the Treasury regulations implementing it provide an extension of the 5-year repayment period (other than for military leaves of absence). In other words, if the loan exceeds the 5-year repayment period by one or two months, the loan violates the requirement and the loan is a deemed distribution. However, in practice, an IRS agent may choose not to enforce the rule strictly.

 

Level Amortization Rule

Q. Does the "level amortization" rule prevent a participant from prepaying a loan? 

A. The regulations do not address the impact of prepayments on the level amortization rule. As long as the loan repayment schedule provides for level payments, the plan may allow prepayments. However, the plan may want to charge additional fees for prepayments (unless it is a complete payoff of the loan) because it adds to the administrative costs of loan administration.

 

Late Deposit of Loan Repayments

Q. What interest rate should the plan use to correct a late deposit of elective deferrals or loan repayments? 

A. The correction for a late deposit of deferrals or loan repayments is for the employer to deposit the deferrals or loan repayments, plus the greater of the lost earnings to the plan or restoration of the profits received by the employer for the use of the money. However, under the Voluntary Fiduciary Correction Program (VFCP), the employer may determine lost earnings by using the Internal Revenue Code 6621(a)(2) interest rate. The Department of Labor’s (DOL) has provided an online calculator to determine lost earnings under the Code Section 6621(a)(2) interest rate. The DOL’s position is that employers only should use the online calculator it files under VFCP. However, many practitioners who self-correct use the online calculator.

 

Limiting Loans to Active Participants

Q. May a plan's loan program be limited to active employees (i.e., does not allow a former employee that is a party-in-interest to request a loan)? 

A. A participant loan is a prohibited transaction unless it satisfies all of the statutory exemption requirements, including the requirement to make loans available on a reasonably equivalent basis. A loan program that excludes former employees violates this requirement. DOL Advisory Opinion 89-30. However, a plan may limit loans to former employee participants who are parties in interest. In the situation described, one violates the prohibited transaction exemption requirement and your loan program is a prohibited transaction. The plan needs to amend its loan program to comply with the exemption requirements.

 

Prohibited Transaction Excise Tax

Q. Could an employer deposit the 15% excise tax to participants in the plan rather than send a tiny check to IRS? 

A. If you file under the Department of Labor’s Voluntary Fiduciary Correction Program and satisfy the requirements for paying the excise tax to the plan, the employer can contribute the excise tax to the plan.

 

5-year Loan Term

Q. There are still large record keepers who start the 5-year loan term based on the scheduled 1st payment of the loan rather than the date of the loan origination.  We are a TPA and have many arguments with these record keepers who site loan rules from many, many years ago.  Are there any official sites that discuss the 5-year term beginning on the date of the loan origination we can provide the record keepers? 

A. I also have had discussions with recordkeepers regarding this issue. Generally, when I have asked them to provide a written indemnification to the employer if the IRS challenges their interpretation of the 5-year repayment rule, they decline; which demonstrates to me their position is not that strong.

The IRS’ 401(k) Plan Fix-It Guide states: 

• “The loan terms should require the participant to make level amortized payments at least quarterly. 
• Each payment should include an allocation of principal and interest. 
• The loan must be repaid within five years unless the participant uses the loan to purchase his or her main home. The five-year repayment period is determined from date the loan was made.” 

I am not certain what “old” loan rules to which they are referring. I would love to know the citation. I know that some institutions cite some legislative history that states a reasonable delay in the start of the loan repayments will not violate the level amortization requirement, but that legislative history is not discussing the 5-year repayment rule.

 

VFCP

Q. I have a client that self-corrected and just got a letter last week a Department of Labor (DOL) office due to late deferrals reported on the 2018 Form 5500-SF. The letter is not threatening, but still suggests that they file through theVoluntary Fiduciary Correction Program (VFCP). They already self-corrected with lost earnings and the filing of a Form 5330. Should I be concerned if we do NOT file with the DOL VFCP?  Do you expect we will get many of these letters this year? I thought the DOL would stop sending them after the feedback that they received last year. 

A. The DOL letter for late deposit of deferrals and loan payments is common. Many practitioners respond to the letter outlining the correction methods they employed. Generally, this satisfies the DOL. However, you may want to seek the opinion of the plan’s attorney.

 

Seasonal Employees

Q. What about loans to seasonal employees who are off from May 15 to Oct. 15 every year?

A. This issue has been posed to the IRS and they have never provided any exceptions for seasonal employees. So an employer would need to make arrangements for seasonal employees to make payments (e.g., ACH) during the periods when they are “off.” Alternatively, if the plan can pass the nondiscrimination requirements, they could exclude the seasonal employees from loans.

 

Loan Offsets

Q. If an employee has terminated and has a loan balance and remaining funds in the plan but has not initiated a distribution of their plan, should the balance of the loan be offset or considered a deemed distribution? 

A. If the participant has terminated employment, the plan can affect a loan offset (distributable event) even if the participant does not initiate distribution regarding the balance of his/her account. Of course, the plan would need to provide for such an offset.

 

Loan Repayments Withheld but not Deposited

Q. Beginning in July 2018, payments for an existing loan continued to be withheld from pay, but were not remitted to a trust account. A Form 1099-R was issued in January 2019 on the “defaulted” loan. The error was discovered in March 2019 and all loan payments were forwarded to the trust on March 25, 2019. Does the plan sponsor need to file through both the IRS Voluntary Correction Program (VCP) and the DOL’s Voluntary Fiduciary Correction Program (VFCP), along with a Form 5330? Should it issue a revised Form 1099-R for 2019 or 2018? 

A. If loan repayments were withheld but not deposited, the plan does not have an Internal Revenue Code Section 72(p) failure (i.e., payments were timely made to a fiduciary of the plan). Therefore, no correction through the IRS Employee Plans Compliance Resolution System (EPCRS) needs to be made (i.e., no Form 1099-R should have been issued).

However, the failure to deposit the loan payments timely is both a prohibited transaction and a breach of fiduciary duty. You may resolve the failure under the VFCP. Some practitioners use the VFCP methodology for correction but do not file. In such a case, the employer should note the correction on its Form 5500 filing.

 

Using ACH to Repay Participant Loans

Q. Plan uses ACH to repay loan. Loan goes into default when participant has insufficient funds for loan repayment. Under the new loan correction rules, may a plan use the reamortization correction option for a loan which uses ACH to repay the loan (or, is it limited to plans that use payroll deduction)? 

A. Although it is less likely that an employee using ACH to repay a participant loan will cooperate in self-correcting a loan failure, IRS Employee Plans Compliance Resolution System (EPCRS) does not preclude a plan using ACH from self-correcting a loan failure by reamortizing the loan over what is left of the 5-year loan repayment. I suspect that when some employees realize the tax consequences, including the premature distribution tax, they may get "religion" and cooperate with the employer on the self-correction option (reamortization). If not, the employer has the option of issuing the Form 1099-R for the year of correction (rather than the year of failure).

The question, however, brings up a valid point that should be emphasized. To effect a self-correction of a loan failure (employer or employee caused) using reamortization or a lump sum payment of the missed payments, the employer will need the cooperation of the participant. 

The plan sponsor (plan administrator) retains the authority as to how and whether to implement an EPCRS correction option. In other words, it is not the employee's decision.

 

Self-Correction

Q. I am getting hung up on the old rules when only VCP could be used to correct loan failures and in order to do so there had to be employer action that caused the failure to repay the loan. Is the IRS more lenient under the new rule? Is this when the employer needs to review the facts carefully to make sure the employee is not playing the system? 

A. Under the IRS’ 401(k) Plan Fix-it Guide, it states, “Generally, for a plan loan to be eligible for relief from income tax reporting under VCP: Employer action caused the participant’s failure to repay the loan, and correction should be done within the maximum time for the loan, usually five years from the date the original loan was made.”

The 401(k) Plan Fix-it Guide is very helpful and informative but does not have any legal standing. Furthermore, there is often a delay in the IRS updating the website. The current EPCRS procedure (and the previous version) states the following: 

(3) Correction methods for certain § 72(p) plan loan failures. (a) In general. The correction methods set forth in section 6.07(3)(b), (c), and (d) apply to plan loans that do not comply with one or more requirements of § 72(p)(2); however, these correction methods are not available if the maximum period for repayment of the loan pursuant to § 72(p)(2)(B) has expired. Further, the IRS reserves the right to limit the use of these correction methods to situations that it considers appropriate, for example, if the loan failure is caused by employer action.

The key phrase in the provision is that the "IRS reserves the right to limit the use of these correction methods." In other words, if the IRS felt the plan or the employees were abusing the self-correction option, they could limit its use to loan failures caused by employer action. Otherwise, the correction option is available regardless of the cause of the failure. Therefore, if an employer felt that the employee was "playing the system," the employer is well within its rights to deny the correction and issue the Form 1099-R.