Guest Article

(From the December 9, 2002 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

IRS Issues Final Plan Loan Regulations

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The IRS's section 72(p) plan loan regulations are finally final. On July 31, 2000, the IRS simultaneously published final plan loan regulations and a set of proposed regulations relating to suspending loan repayments during military leaves, extending subsequent loans to participants who have previous deemed distributions, refinancing plan loans, and making multiple plan loans to a participant within a single year, among other things. After reviewing comments on the proposed regulations and making a few minor changes, the IRS has now issued those in final form as well. 67 FR 71821 (December 3, 2002).

Statutory Rule

In general, loans from a tax-qualified retirement plan-- including section 403(b) plans and section 457 plans maintained by government entities-- are treated as distributions (i.e., "deemed distributions") to the participant unless the following requirements are satisfied:

The total outstanding balance of all the participant's plan loans does not exceed the lesser of $50,000 (this limit may be reduced if the participant has outstanding loans), or one-half the participant's vested benefit (or $10,000, if greater); The loan is repaid over a period of no more than 5 years (unless the loan is a home loan); and The payments are made at least quarterly according to a substantially level amortization schedule.

See IRC Sec. 72(p).

If a plan loan is treated as a distribution (i.e., if the loan arrangement fails to satisfy these requirements in form or operation), the loan proceeds will be treated as taxable income to the employee and may be subject to a 10 percent excise tax for early distributions. See IRC Sec. 72(t).

Background

The final plan loan regulations IRS issued in July 2000, which are codified at Treas. Reg. Sec. 1.72(p)-1, address a number of issues relating to the statutory requirements in a series of 22 questions and answers. The December 3 final regulations fill in some of the gaps left by the 2000 regulations. Following is a summary of some of those gaps and the relevant guidance provided by the 2002 final regulations.

Loan Repayment Suspension During Leave of Absence for Military Service

As a general rule, qualified plans may suspend loan repayments for up to one year while a participant takes a leave of absence without violating the level amortization rule. However, interest must continue to accrue during the suspension, and the loan still must be repaid within the original 5-year term (unless the loan is a home loan). See Treas. Reg. Sec. 72(p)-1, Q/A 9(a). (If the original loan term was less than 5 years, the term can be extended to 5 years from the loan date after the suspension ends. However, the payment amounts after the suspension period cannot be less than before the suspension.)

According to IRC section 414(u)(4), a plan that permits suspension of loan repayment during a period of absence for military service will not cause the loan to be deemed distributed, even if the leave (and thus the suspension) exceeds one year. The 2002 final regulations update Q/A 9 to clarify that this exception applies only if--

repayments resume when the participant's military service ends, the remaining balance is repaid in substantially level installments, and the loan is fully repaid by the end of the original term of the loan, plus the period of military service.

Note that suspensions for military service can effectively cause the terms of a plan loan to be extended beyond 5 years, whereas suspensions for any other leave of absence cannot cause such an extension. Assume, for example, a participant takes out a 5-year plan loan on January 1, 2003. If she suspends repayment during a 1-year leave of absence in 2004, she still must repay the loan by the end of the original 5-year term-- i.e., January 1, 2008. However, if she takes a 1-year leave of absence to serve in the military, she does not have to finish paying off the loan until January 1, 2009.

Of course, as with any other suspension, interest must continue to accrue during the military leave suspension period. (The 2002 regulations include an example to reflect the maximum 6 percent interest rate that can be charged during military leave periods, pursuant to the Soldiers' and Sailors' Civil Relief Act Amendments of 1942.) As a result, the pre-suspension installment rate will not be sufficient to cover the principle plus additional interest.

The 2002 regulations provide several alternatives for addressing this problem. If the original loan term was less than 5 years, it can be extended to 5 years after the suspension ends. Unlike suspensions relating to non-military leave, the new installments do not have to be at least as much as the pre-suspension installments.

If the original loan term was 5 years, the participant can either be allowed to increase his installment payments to cover the additional interest or continue paying at the pre-suspension rate with a balloon payment due at the end of the term. (These options are also available for suspensions relating to non-military leave.)

Loans to Participants Who Have Previous Deemed Distributions

If there is a deemed distribution to a participant under section 72(p), can that participant take out another plan loan? The 2002 final regulations modify Treas. Reg. 1.72(p)-1, Q/A 19 to specify that if a loan is deemed distributed and has not been repaid, then all future loans will be deemed distributions unless either of the following conditions is satisfied for the entire term of the new loan:

• There is an arrangement among the plan, the participant or beneficiary, and the employer, enforceable under applicable law, under which repayments will be made by payroll withholding. For this purpose, an arrangement will not fail to be enforceable merely because a party has the right to revoke the arrangement prospectively.

• The plan receives adequate security from the participant or beneficiary that is in addition to the participant's or beneficiary's accrued benefit under the plan.

Because all of an employer's plans are treated as one plan for purposes of section 72(p), some commentators expressed concern that a plan may not know a participant has defaulted on a loan from another plan. This is a particular problem in the 403(b) plan context, where individuals often hold contracts with more than one issuer.

However, according to the preamble to the 2002 regulations plans must ask participants about other plan loans in order to apply the maximum loan limit anyway. As part of that process, an issuer can condition a new loan on a participant's disclosure of such prior loans, and can rely on the participant's certification unless the issuer has reason to doubt the certification.

Refinancing Plan Loans/Multiple Plan Loans

The 2002 final regulations clarify that plans may make multiple loans to participants during a single year, so long as the additional loan(s) does not cause the participant to exceed the maximum loan limit and each loan satisfies the 5 year term and level amortization requirements of section 72(p)(2)(B) and (C). The proposed regulations had included a 2 loan per year limit, but that limit was dropped from the final regulation.

Also, the 2002 final regulations specify plan loans may be refinanced. The preamble explains the refinancing rules this way: "A refinancing is treated as a continuation of the prior loan, plus a new loan to the extent of any increase in the loan balance. Thus, while a refinancing loan can be repaid over a five-year period from the date of the refinancing to the extent the refinancing loan exceeds the prior loan amount, the prior outstanding loan must be repaid in substantially level installments over a period not longer than the original term remaining on the prior loan in order for the refinancing not to result in a deemed distribution."

A participant that refinances a plan loan may encounter problems if the arrangement results in a replacement loan with a term ending later than 5 years from the original date of the loan it replaced (i.e., the latest permissible term of the replaced loan). In this case, both the replacement and the replaced loans will be treated as outstanding on the date of the transaction, meaning the arrangement may cause the participant to exceed the maximum loan limit. [The 2002 final regulations do provide an exception to this rule, which is explained in the new Q/A 20(b), Example 1.] Amounts borrowed in excess of the maximum loan limit are treated as deemed distributions.

Effective Date

The 2002 final regulations are effective immediately, and apply to assignments, pledges, and loans made on or after January 1, 2004.

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The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2002, Deloitte.

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