I would not allow the hardship. The regs state that the hardship is to prevent foreclosure not to stop the possibility of foreclosure. I have heard IRS agents at conferences and in audits state that if the bank is just sending a letter stating the loan could go into foreclosure it does not meet the hardship rules. In order to meet the hardship rules, the lender must be starting foreclosure proceedings. A letter from the lender stating the exact amount required to stop the proceedings and the date it must be paid by is the preferable form of proof. As for the gross up of additional payments, I have heard a mixed bag. Some agents have said the only amount a participant can get is the exact amount needed grossed up for tax withholding others have said it is ok to add 1 additional mortgage payment.
With all the scrutiny on hardships and loans it is better for the plan sponsor to take a very conservative approach.
