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Participant Loans In A Troubled Economy. SUNGARD Stephen W. Forbes, J.D. LL.M. Taxation requirements (Code §72(p)). Prohibited transaction requirements (Code §4975) and DOL Regs . Loans must comply with both sets of requirements. Two Sets Of Statutory Rules. Plan Documentation.

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Participant Loans In A Troubled Economy


Stephen W. Forbes, J.D. LL.M.

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Taxation requirements (Code §72(p)).

Prohibited transaction requirements (Code §4975) and DOL Regs.

Loans must comply with both sets of requirements

Two Sets Of Statutory Rules

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Plan Documentation

  • Plan must authorize loans

  • Plan loan provisions may be in more than one document

  • Plan loan policy

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Loan note

Irrevocable pledge and assignment

Participant Documentation

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Regulation Z

More than 25 loans

Disclosure requirements

annual percentage rate

finance charge

APR includes loan fees

Amount financed

Total payments

Truth In Lending

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Regulation Z and participant loans

  • Federal Reserve Board issued final regulations in January 2009

  • Will exempt from Truth in Lending Act and Regulation Z participant-directed loans from employer-sponsored retirement plans

  • Effective 7/1/10

  • Affects

    • Qualified plans

    • 403(b) plans

    • Gov’tal 457(b) plans

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Bottom line

  • Requirements for exemption:

    • 1. Loan is from fully vested funds from participant’s account (i.e., participant-directed)

    • 2. Loan is made in compliance with Code (i.e., 72(p).

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Bottom line cont’d

  • Change does not apply to loans that are plan assets, rather than participant-directed

    • Not many out there

  • Plan may continue to apply existing rules

    • Same disclosures as currently apply

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Taxation Requirements Code §72(p)

  • Amount limitation

  • Enforceable agreement

  • 5 yr repayment period (home loan exception)

  • Level amortization

  • Applies to

    • Qualified plans

    • 403(b) plans

    • Government plans

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Violation of 72(p) Taxation Rules

  • Consequences for violation

    • Taxable (deemed) distribution to participant

    • Premature distribution tax if employee is not 59½

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Amount Limitation

  • All outstanding plan loans cannot exceed lesser of:

    • $50,000 with adjustments; or

    • Greater of

      • 50% of vested account balance

      • $10,000

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Reduce $50,000 limit by the amount by which

The highest outstanding loan amount within previous 12 month period

Exceeds current loan balance

If only one loan was outstanding, the adjustment equals the principal paid in the prior 12 months

Does not apply to 50% limit

$50,000 Limit/Lookback Rule

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Lookback Rule

  • Kathy obtains $50,000 loan on 9/1/08

  • On 12/1/09, paid loan down to $41,000

  • Kathy requests $9,000 loan on 12/1/09

  • First loan paid down to $41,000

  • Highest outstanding loan balance in previous 12 months = $48,500

  • Kathy’s vested account balance exceeds $100,000

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Lookback Rule (cont.)

Code §72(p) calculation:$50,000

- 7,500 ($48,500 - $41,000)


December 1, 2009 Loan limit = $42,500

December 1, 2009 Outstanding loan = $41,000

Available loan limit = $1,500

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Level Amortization

  • Amortize principle and interest at least quarterly

  • Missed payment will cause 72(p) violation

  • Most common cause of deemed distributions

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Grace (Cure) Period

  • Plan can provide a grace period for missed payment

  • Maximum: Last day of following calendar quarter

  • Plan may use smaller grace period (e.g., 90 days or 30 days)

  • Good to have some grace period. Otherwise, one day late = deemed distribution

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Loan Default Reporting

  • What is the amount of her deemed distribution?

  • How should the employer report the loan default?

  • Does the deemed distribution create a basis in her account?

  • On 12/31/09, no payments since 8/1/09

  • Plan defaults loan on 12/31/09

  • Missed payments = $1,100; unpaid balance = $8,000

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Reporting Default – 1099R

  • Outstanding loan amount, not just missed payment

  • Code L and 1 (if not 59½) in box 7

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Deemed Distribution vs. Loan Offset

Deemed Distribution

Loan Offset

  • Taxable event

    • Line 2g, Sch. H and I

  • Occurs regardless of whether EE is eligible for distribution

  • Not eligible for rollover

  • Must maintain loan on books

  • Affects vesting, TH, future loans

  • Foreclosure on security interest (i.e., offset against participant’s account)

  • Offset is actual distribution

    • Reported as distribution on 5500

  • Need distributable event

  • Eligible for rollover

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Post-default (Phantom) Interest

  • Interest still accrues after deemed distribution

  • Interest accrues until the loan is repaid or offset

  • Phantom interest is neither taxable nor reportable

  • However, phantom interest is still relevant

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Conditions for New Loan After Deemed Distribution

  • After deemed distribution, if old loan not repaid, there is mandatory payroll deduction or additional collateral

  • Some plans allow only one outstanding loan at a time

    • Forces borrower to repay defaulted loan in order to get new one

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Phantom interest

  • Kathy - 100% vested participant defaults on $8,000 loan

  • Plan reports deemed distribution

  • Plan accrues $1,000 phantom interest after deemed distribution

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Tracking Defaulted Loan may receive?

  • For plan accounting and top heavy purposes, what is her account balance?

  • If she is 80% vested in her account balance, what is her vested account balance?

  • If she terminated employment the following year (12/1/10), how would the plan report the distribution?

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Repayment of Defaulted Loan may receive?

  • To repay entire loan, EE must repay loan + phantom interest

  • EE obtains basis for repaid defaulted loan

  • Not after-tax EE contributions — not subject to ACP test

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Offset Following may receive?Deemed Distribution

  • If plan cannot offset, loan remains on the books

    • However, not on 5500 financials

  • When distributable event occurs, plan may offset

  • Plan does not report offset on 1099-R

  • Not eligible for rollover

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Taxation of Offset may receive?

  • Kathy terminates 3/1/09

    • 12/31/07 – deemed distribution

  • Non-loan a/b = $22,000

    • loan receivable = $9,100 ($8,000 defaulted loan + $1,100 accrued interest)

    • May the plan offset the defaulted loan?

    • How does the plan report the distribution and the offset?

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Loan Refinancing may receive?

  • Employee uses replacement loan to repay another loan

  • Replacement loan has repayment date more than 5 years after original loan

    • Regs make clear that date can be extended up to 5 years after original loan, or longer for a home loan

  • Even though one loan replaces other loan

    • Employee considered to have two loans

    • Two loans may not exceed limits

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Loan Refinancing may receive?

  • Jim has $30,000 vested account balance

  • Outstanding loan:

    • Paid down to $8,000

    • 3.5 years left in repayment period

  • Jim requests $15,000 w/ 5 year repayment

  • Will use loan proceeds to pay off $8,000 loan

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Special Amortization may receive?

  • First loan disregarded if new loan due 5 years from original loan

  • First loan disregarded if EE repays first loan within original 5 year period, and repays replacement loan during normal repayment period

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Amortized as Two Loans may receive?

  • Mary borrows $10,000 @ 8% on 5/1/05 due 5/1/10. Payment $203

  • 5/1/06 balance is $8,300. Mary ($25,000 a/b) wants new loan

  • Mary borrows $12,500 @ 7%, paying old loan and taking $4,200 cash. New loan due 5/1/10. Pays $282 until 5/1/10, and thereafter $83.

  • Do the two loans violate the 50% limit?

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Valuation Date may receive?

  • Determine loan limit

  • Use latest valuation date for loan limit

  • Adjust for distributions and contributions between valuation date and date of loan

  • Subsequent events will not cause violation

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50% Limit in a Falling Market may receive?

  • 50% limit under Code §72(p) limit

    • Use latest valuation date to apply limit

      • Notice 82-22

    • Benchmark date should be the date the loan proceeds issued, not application date

  • Adequate security requirement

    • 50% of vested account balance

    • Also, use latest valuation date

  • May want to alert participants to the rule in loan policy or website

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50% Limit may receive?

  • SPL maintains a 401(k) plan

    • Daily valuation

    • Plan considers loans participant directed

    • Ted requests a $40,000 loan on 2/18/09

    • Vested a/b on 2/18/09: $80,000

    • Plan issues loan check on 2/25/09: a/b = $70,000

    • What loan amount should the plan provide Ted?

    • Assume the plan is valued annually and the 12/31/08 value of his a/b was $80,000. What loan amount should the plan provide?

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Hardship Distribution may receive?

Does Jim’s loan violate amount limitations under Code §72(p)?

  • Jim takes a $20,000 loan from his $40,000 a/b on 11/1/09

  • Jim obtains hardship distribution one week following loan

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Leave of Absence may receive?

  • Plan may suspend loan payments for leave of absence

  • One year maximum suspension

  • Interest continues to accrue

  • Does not extend 5 year repayment period

  • Participant must repay within 5 years from original loan

    • Can extend to full 5 years

  • Balloon payment or reamortization

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Plan may suspend for may receive?military service

Entire period of military service, not just 1 year

Military service does not count against 5 year repayment period

Employee must repay loan and accrued interest by end of 5 year period not counting the military service. Can use full 5 years even if original loan was shorter

Can use same payments with a balloon at the end

Can increase payments to avoid balloon

Military Leave of Absence

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Military Interest Rate may receive?

  • During the period of military service, a plan cannot charge more than 6% compounded annually on loan to serviceman made prior to entering the service. Serviceman must give notice to plan to claim this rule.

  • The 6% limit includes all service or maintenance charges.

  • If you want to charge a higher rate, it requires a court order.

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Home Loan may receive?

  • Loan to acquire participant’s principal residence

  • May exceed 5 year repayment period

  • Commercially reasonable period

  • No need to secure by home

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Principal Residence may receive?

  • Includes house, condominium, mobile home not used on transient basis

  • Vacation home does not qualify

  • Applies to construction of home

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Rollover of Loan Offset may receive?

  • EE may roll over loan offset

  • Procedure: EE contributes rollover amount out of his/her pocket

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Rollover of Loan Note to New Plan may receive?

  • May roll over loan note to a plan if loan is not offset

  • Direct rollover

  • Plan may accept

  • Plan must permit loan

  • Assignment of loan

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Withholding Rules (Loan Offset) may receive?

  • Loan offset is eligible rollover distribution

  • Subject to 20% withholding to extent distribution includes cash in addition to offset

  • Withholding cannot exceed cash to participant

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Loan Offset – Taxation may receive?

  • Susan terminates employment with $100,000 account balance, including $20,000 loan

    • If Susan receives a distribution of her entire account balance and the plan offsets the loan, what is the taxable amount reportable on the Form 1099-R?

    • If Susan does not roll over any of the distribution, how much should the plan withhold?

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Withholding/Reporting may receive?

  • If she rolls over directly the $80,000 to an IRA and the plan offsets the loan, how should the plan report the distributions? How much should the plan withhold?

  • If she rolls over $50,000 and the plan offsets the loan and distributes the balance of her account, how much should the plan withhold from the distribution?

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Partial Rollover may receive?

  • May she roll over her entire vested account balance (including the loan note) to another plan? IRA?

  • Must the recipient plan accept the rollover of the loan note? Must the receiving plan permit participant loans to accept the rollover of the loan note?

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Partial Rollover cont’d may receive?

  • May she use the 60-day rollover rule to effect a rollover of the participant loan note?

  • How does a plan effect a rollover of a participant loan note?

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Prohibited Transaction (PT) Requirements may receive?

  • Loan is a PT because it is a transaction between plan and party-in-interest

  • Statutory exemption to the PT rules

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Exemption Requirements may receive?

  • Available on reasonably equivalent basis

  • Not available to HCEs in greater amounts

  • Plan provisions

  • Reasonable interest rate

  • Adequate security

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Reasonably Equivalent Basis may receive?

  • Limit by percentage of account balance is not a violation

  • Can take credit worthiness into account

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Reasonable Interest Rate may receive?

  • Commercially reasonable rate

  • What a financial institution would charge for similar type of loan

  • If reasonable interest rate would violate usury laws; plan should not offer loans

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Adequate Security may receive?

  • Plan may not use more than 50% of vested account balance as security

  • Can use other security, such as a mortgage

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Current Employee Limitation may receive?

  • PT rules do not permit plan to limit loans to current employees

  • However, plan may limit loans to parties-in-interest

  • Former employees generally are not parties-in-interest

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Acceleration may receive?

  • Plan may provide for acceleration of loan upon separation from service if employee is not a party-in-interest

  • Plan may accelerate upon plan termination

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Minimum Loan Amount may receive?

  • Plan may impose loan minimums

  • $1,000 safe harbor

  • If plan imposes higher minimum, plan will need to apply nondiscriminatory availability test

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No J&S plan: no spousal consent may receive?

J&S plan: need spousal consent

Binding on subsequent spouse

Spousal Consent

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Loans are not may receive?protected benefit

Employer may eliminate loans

Protected Benefit

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Delinquent deposit of loan repayments may receive?

  • Transaction: ER’s retention of participant loan repayments longer than plan asset rules permit

  • Correction: pay to plan Principal Amount plus greater of Lost Earnings or Restoration of Profits

    • Principal Amount = amount of delinquent contribs.

    • Loss Date: date contribution reasonably could have been segregated (not later than 15th bus day)

    • If contributions were paid, but late: just pay greater of Lost Earnings or Restoration of Profits

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Problem #2: PT excise tax may receive?

  • To correct prohibited transaction, ER generally must:

    • File 5330

    • Pay excise tax

      • 15% of “amount involved”

        • Each year or portion of year during which transaction continues

      • May use 6621(a)(2) interest rate to determine

      • There is no de minimis amount

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Failure to withhold loan repayments may receive?

  • Issues:

    • Operational failure

    • Fiduciary breach

    • Triggers deemed distribution

  • VCP offer:

    • We’ll forgive the operational failure

    • In most cases, we’ll forgive deemed distribution

      • Alternatively, we’ll postpone it

    • VFCP correction method: Go through VCP

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Failure to withhold loan repayments: Correction may receive?

  • ER contributes interest which accrues because of failure to withhold

    • Greater of plan loan rate or plan earnings rate

  • Participant still must repay principal and interest under note by either

    • Making lump sum repayment = missed payments

    • Reamortizing loan over remainder of original term

      • Can extend up to original 5-year period

    • Combination of above

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Loan example may receive?

  • I borrow $10,300 May 1, 2008

    • 6.25%

    • Pay $100 from each semi-monthly paycheck

    • Last payment April 30, 2013

  • January 3, 2009 we realize no withholding

  • Consequences:

    • If no VCP, loan defaulted

      • Deemed distribution September 30, 2008 (if not sooner)

      • I get 2008 1099-R for $10,849 (outstanding balance September 30, 2008)

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My repayment options: may receive?

Pay $1,600 and ER withholds $100/paycheck as planned

ER withholds $138.86/paycheck until April 30, 2013

Something in between

Loan Example Correction

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An ounce of prevention . . . may receive?

  • Borrower in best position to avoid problem

    • The BORROWER is responsible for making certain that the employer is withholding the proper loan payments. If the BORROWER determines that a loan payment has not been withheld, the BORROWER must notify the employer and arrange for a make-up loan payment(s) before a default occurs. If the BORROWER does not make the missed loan payment(s) and a default occurs, the BORROWER will be subject to adverse federal income tax consequences.

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Terminating Payroll Withholding may receive?

  • Many plans require payroll withholding as a condition for receiving the loan

  • After obtaining loan, may participant terminate the withholding agreement?

    • State law generally permits EEs to terminate withholding agreements (except for taxes, child support)

    • Preemption: DOL and courts have not addressed

    • Regs require plan to use payroll withholding or obtain additional collateral if participant obtains a loan when he/she has an outstanding defaulted loan

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Payroll Withholding may receive?

  • Issue: If you allow the participant to terminate withholding, loan almost certainly will default

    • Plan will need to administer a loan that it probably cannot offset until participant terminates

    • Off the 5500 financials but on the plan books

    • Participants may discover this as a method for circumventing the distribution restrictions

  • Two alternative approaches:

    • Hard line: we believe ERISA preempts state law and unless participant raises state law and threatens plan with litigation, we will not allow you to terminate withholding

    • Conservative: If you ask us to terminate, we will

      • Place restriction on future loans?

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Bankruptcy: Plan loans not subject to auto stay may receive?

  • BK courts had ruled that BK automatic stay allowed court to order ER not to withhold from payroll to repay plan loan

    • EE essentially repaying himself/herself to detriment of creditors

  • 2005 law reverses:

    • ER can continue to withhold and pay to plan

    • Doesn’t apply to payments directly from debtor

  • Applies to loans:

    • Subject to ERISA participant loan PT exemption, or

    • Subject to Code §72(p)

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Loan exemptions may receive?

  • Chapter 13 plan can’t alter plan loan terms

  • Plan loan repayment amounts aren’t “disposable income” for Chapter 13

    • Don’t have to figure into Chapter 13 analysis

  • But many courts find that retirement plan loans aren’t “secured debt” for Chapter 7 (liquidation)

    • May force debtor to go to Chapter 13

  • Plan loan excepted from discharge

    • Combined with relief from stay, means debtor doesn’t have taxable deemed distribution because of BK and can continue loan repayment

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Loan: Death of a Participant may receive?

  • Not taxable to the beneficiary

    • Not beneficiary’s liability

  • Options:

    • Offset

      • Payment stops

      • Loan accelerated (see loan policy)

    • Estate pays off loan

    • Estate (or beneficiary) continues paying loan

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Participant’s death with participant loan outstanding may receive?

  • Loan offset

    • 1099-R issued to the participant’s estate

      • Code 4 in box 7

      • Reportable on estate’s tax return (1041)

  • Estate could arrange to pay off loan

    • May have state law issues if beneficiary of plan isn’t beneficiary of estate

      • Shouldn’t use estate funds to benefit individuals who aren’t beneficiary of the estate

    • Benefit: increases the amount eligible for rollover

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Website For Downloading may receive?

  • Participant loan outline:

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Thanks for joining us may receive?