Luke Bailey

Mike, the first loan payment is made. It is cash. The principal portion of the payment reduces the outstanding loan amount. The interest portion is treated as investment earnings of the borrowing participant's, and only the borrowing participant's, account. The other participants all have a slightly larger share of the earnings of the pooled investments than they would if the earnings were spread based on gross account size, and the borrowing participant a smaller share, because we are spreading earnings based on gross account size net of the outstanding balance of any participant loan allocated to the account, not gross account size. The cash from the first payment is immediately invested in the pooled investments, but because it reduces the outstanding amount of the loan (including the accrued interest since the last payment) allocated to the participant's account, it increases the borrowing participant's account size, net of the outstanding amount of the loan, for purposes of spreading future pooled earnings. That does not seem complicated to me.

Mike, if the loan is treated as an individually directed investment for all purposes, the first (second, third, etc.) loan payment is credited to the participant's account. The principal portion of the payment reduces the outstanding principal of the loan and the interest portion is the borrowing participant's investment gain for the portion of his/her account that consists of the loan. Since the loan was treated as an asset of the participant's account, reduction of its principal is not a gain or loss, just the replacement of a portion of one asset (the debt) by another (cash). The other participants get whatever the gain or loss is from the rest of the portfolio. How is that complicated?

chc93, thanks. I think that is the only right answer. So in effect the loan is allocated as an individually directed investment of the borrower's account in the case of default, but not for "normal" rate of return purposes, i.e., interest. Seems more complicated than just saying that, whether or not the rest of the plan's investments are pooled or individually directed, a participant loan is treated as an individually directed investment of the borrowing participant for all purposes.

Larry, since we seem to have gotten a lot of side issues out of the way, let's just go back to the example, and you tell me where I go wrong. I am going to skip interim gains and/or losses, interest on participant loan, etc. for sake of simplicity. Assume plan has pooled investments and 2 participants, A and B. Each has 100k account. Plan is invested in mutual funds at time 0, so $200k in mutual funds. Let's assume distributions can only be made in cash. If plan terminated at time 0, plan would sell $200k in mutual funds and distribute $100k cash to A, $100k cash to B. Now, at time 1, B takes a loan for $50,000. Plan sells $50k in mutual funds to raise $50k cash, pays the $50k cash to B. So now plan still has $200k in assets, but they now consist of $150k in mutual funds and a $50k promissory note. A and B each still have an account of $100k. Assume that B terminates without paying any portion of the loan back, and then terminates employment. The plan needs to make distributions on termination. It holds $150k in cash from liquidation of mutual funds and a $50k worthless participant loan note. Does A get $100k in cash and B $50k of cash? That's all I'm asking.

I think what you're saying, Larry, is that if the plan terminated at the next step in the example, which would force you to stop thinking of it as a "plan" and realize that ultimately this is about assets allocated to accounts belonging to people (we are talking only about DC, i.e., "individual account" plans here, right, not DB? None of what I have been describing applies to DB), A would suffer half the financial loss attributable to B's having taken the loan. Meanwhile, B did get the cash when he took the loan, so he suffers no real loss at all. In fact, he ultimately gets $125k out, $50k as loan cash, $75k as plan distribution, while A gets only $75k. This is why, IMHO, it is better to individually allocate the loan as an investment SOLELY of the participant who takes it.

Thanks, spiritrider. That is very helpful.

Larry, on the loss issue, you may or may not be right, depending on how you handle the default. Assume plan has pooled investments and 2 participants, A and B. Each has 100k account. Plan is invested in mutual funds at time 0, so $200k in mutual funds. At time 1, B takes a loan for $50,000, so immediately after, A and B each have $75k in mutual funds and $25k of B's loan allocated to their accounts. Assume that at time 2, the $150k in mutual funds has not changed value, but B is complete deadbeat and does not repay loan, so 100% loss there. B then terminates employment and requests a distribution. What happens to the $75k of mutual funds in B's account? Do you move $25k of it from B's account to A's to insulate A from the total loss on B's loan?

austin3515, the issue is whether the interest rate is reasonable. Because the plan uses prime + 1 for everyone else, and intended for this participant, prime is, at least arguably, per se unreasonable. This is not a qualification error or a 72(p) problem, but if the interest rate is unreasonable it is a PT for IRC 4975 and ERISA 406(a). Therefore you would need to correct in accordance with those provisions. The amount of tax owed under 4975 (15% of 1% of the loan amount, divided by 12 and multiplied by the number of months the loan has been outstanding) will almost certainly be too small to actually file the 5330. Probably just a few dollars. The DOL won't want you to do VFCP for such a small amount either. So just get the participant to agree to change the rate and your done. Participant can make up the lost interest in next payment, which again will probably only be a few dollars.

justanotheradmin, totally agree with Doghouse, except why bother with anything other than the reg cites. They flat-out prohibit if you are SH.

Thanks, Bird. I think that is probably the right answer, even though it seems not to be one's first impression.

Sole proprietor adopts SEP, contributes in compliant manner for a few years. Has no employees. Later ceases to operate as a sole proprietor and becomes member of partnership and gets K-1. Keeps contributing to SEP as if K-1 were Schedule C income for several years. His only business income after joining the partnership is from the partnership, reported on the K-1 (i.e., individual does not have any non-partnership related Schedule C income after joins partnership). Assume partnership had no qualified plan and no non-5% owner employees. Partnership (i.e., other partners in their capacity as such) had no knowledge of SEP or that sole proprietor turned partner had continued to contribute to it. Assume also that SEP documents show individual's sole proprietorship as only adopting employer. A couple of other practitioners have looked at this and opined that the contributions based on the K-1 income are simply excess contributions to an IRA (i.e., they exceed the individual's contribution limit), IRC sec. 4973 6% excise tax is owed, contributions must be withdrawn to stop further excise tax, individual will owe ordinary income tax on distributions reportable on 1099-R, and will be subject to 10% premature distributions tax under IRC sec. 72(t) because under 59-1/2, and IRC sec. 4972 tax on nondeductible contributions also applies. However, EPCRS seems generally to treat SEPs analogously to qualified plans, and it seems that there has been a violation of 415(c) and we have excess amounts that under EPCRS need to be distributed to employer (which, admittedly, is the same individual) as a return of an excess amount, and that the returns for prior years should be amended to reflect nondeductibility, and the 1099-R will show "$0" as the distribution amount to individual. The IRC sec. 4972 tax would still need to be paid. See Section 6.11(5) of Rev. Proc. 2019-19. I don't see why the rule would apply differently just because a single participant sole proprietor SEP is involved. VCP would be required, since SEPs qualify for SCP only for insignificant failures, and anyway this is more than two full plan years old. Anyone ever dealt with IRS on this or a very similar issue? Any other thoughts?

Larry, (a) there is a theoretical risk of loss to participants other than the borrower where not individually allocated (if value of portion of borrowing participant's account other than portion invested in note declines below outstanding amount of note), and (b) optics. Re (b), if you are making a loan that a reasonable person (e.g. the reasonable folks in the employers HR and payroll dept(s)) would think is very iffy, the optics are better if you know that only the participant is invested in that loan.

Assuming the loan is allocated to the individual's account as his/her own self-directed investment (100%), then the worst that happens is that the loan defaults and he gets a 1099-R and, if under 59-1/2, has to pay 10% premature distribution tax in addition to regular income tax. The IRS will not be impeded in any collection efforts that it then eventually takes. Not much of an issue for the plan sponsor or administrator. Of course, they could talk to the guy to make sure he understands the consequences.

Would really depend on plan documents, SPD, etc. Of course, you can have a payroll match with true-up at end, including discretionary true-up, which is what we normally recommend.

No further comments, Jakyasar. Good luck.

He is increasing "to" get to maximum, just doesn't make enough to get there. I practiced baseball as a kid "to" play for the SF Giants, just didn't make it. Obviously, without seeing the language I can't be sure, but generally agree with others that it should be OK.

Jakyasar, I think the income from the LLC he retired from is good self-employment income for purposes of 401(a) plan contributions, but the plan has to be of the LLC from which he retired, i.e., the trade or business that gave rise to the income. See Code sec. 401(c)(2)(A)(I) and related reg. Also, for 415(c) purposes it probably has to be paid within 2-1/2 months after termination of active service, although I'm not sure there's any guidance on application of the "severance from employment" phrase to a retiring Subchapter K partner. See Treas. reg. 1.415(c)-2(e)(3). He can't establish a plan of his own just for that income, or use the income to fund contributions to a plan of his sole proprietorship/Schedule C business, if he establishes a plan for that. Note that the plan of the LLC that he retired from should contain a provision to effect that a partner who receives trailing receivables payments after retirement under 736(a), but who does not currently work for the partnership, is not eligible to participate in the plan immediately upon cessation of active membership as a service provider, assuming that's what they want to do, which most do. If the plan document does not specifically address, they may have a difficult interpretational issue as for tax purposes, he is still a partner, but they probably do not consider him as such, e.g. he may not have a capital account, has no rights to participate in control of firm, etc.

Would really need to see the documents. Not just plan document, but any resolution or communications regarding the match instituted 4/1/2019. Also, when you say they started match, do you mean they made the contributions, or just told people they'd match starting 4/1/19? Obviously, if it's discretionary they could just cut the rate in half. Unless they have really high turnover, should be about the same for most employees. But if they are locked in by prior communications and contributions that of course probably would not work.

Larry, some of this is terminology, but based on your most recent, we may have misunderstood each other. Example: Plan has two participants, A and B. Each has $100k account. Total $200k invested in mutual funds, whether pooled or self-directed for investment purposes. Plan permits loans. A borrows $50k, B does not borrow. Obviously, immediately after the loan and overlooking daily fluctuations in value, the plan has $150k in mutual funds and holds a $50k note, again whether pooled or self-directed for investment purposes. In the system you are advocating/defending/whatever, does A have $50k in mutual funds and a $50k note allocated to his/her account for investment return purposes, and B still $100k in mutual funds, or do both A and B have $75k in mutual funds and $25k A promissory note for investment purposes?

Bottom line, I think in a DC plan if a participant borrows, say, $50k from a $100k + account (just as an example), it makes more sense and is safer from a fiduciary perspective to say to the borrowing participant and all the nonborrowing participants that (1) the borrowing participant's account funds 100% of the loan, (2) his/her account's, and only his/her account's, investment in other assets (whether as part of a pooled fund or individually directed) is diminished by the outstanding amount of the loan at any time, and (3) only his or her account is at risk of default.

I think for those that are now > $5,000, you can no longer require distribution. For those < $5,000, you can, late, and that is correction. Whether insignificant so as to permit self-correction, or not so as to require VCP, depends on facts and circumstances. You might go out to those with > $5,000 and tell them that they can take their money if they want, assuming that is consistent with plan document.

You might be able to do an ICHRA.

401(k)athryn, I assume this is for a 501(c)(3), and not a government. If you meet the election timing rules of 1.457-7(c)(2)(ii) (which it sounds like you are assuming), then you are essentially on the cash basis. somewhat like a qualified plan, except reported on W-2, as you note, not 1099-R. The reg expresses this by saying that if you meet the rules, then the amount(s) are not considered "available" until the elected payment date(s). So bottom line, (a) yes, it could be 10 years, subject to 401(a)(9) RMD rules, and (b) if installments are appropriately elected, the income occurs when the installments are paid, limited to the amount of the installment. See 1.457-7(c)(3), Example 2.

Sure, but in a DB plan, a low interest rate or default would not impact benefits, just employer funding. Re Larry's points, are you saying Larry that you set up loans such that for rate of return purposes (other than the negative rate of a return of a default), the loan is a pooled investment of all accounts, but if there is a default, you take the amount of the default out of the borrowing participant's account? Again, I think you can do that, but I think most plans, maybe nearly all, make the borrowing participant's loan an investment of his/her account for all purposes, so that (1) if equities outperform the loan (which they likely will over a five-year period) the "hit" is on the borrowing participant, (2) you can tell the participant that he or she is paying interest to him/herself, and (3) if there is a default, the loss is borne solely by the participant (which I understand is still the case in the system you describe, if I understand it correctly). And you don't see a fiduciary issue if (1) the owner takes a loan at prime + 1, (2) equities outperform prime + 1 over 5 years, and (3) because all of the investment characteristics of the loan (other than default) are allocated proportionally over all accounts the owner gets some of the equity return on the money he or she has borrowed, and conversely the non-borrowers get some of the loan interest even though some of their mutual funds were cashed out to fund the loan? It doesn't have to be just the owner or a small plan situation. People feel comfortable based on informal guidance and on the security of the loan and market rates in saying that a relatively low interest rate (e.g., prime + 1 or 2%) is OK for participant loans, but no one would want to invest the rest of their plan assets with a hope of just getting prime + 1 or 2% for five years.

Agree with all of above, especially carving out loans as self-directed even if nothing else is, but if you don't do that I think there is fiduciary exposure. First, to be adequately secured under DOL reg. sec. 2550.408b-1(f), the loan must be secured by the participant's account balance. I guess you can do that without also having the loan wholly allocated to that participant's account as an investment, but I have never seen it done that way in the last 35 years. The documents always say that the loan is an investment of the borrowing participant's account for purposes of rate of return (loan interest) and default. Moreover, if the loan is considered to be a pooled investment for purposes of rate of return, this puts a lot of pressure on the interest rate and security to protect the plan as a whole. ERISA 408(b)(1) and regs thereunder protect you from having a PT (ERISA 406), but do not protect on fiduciary duties (ERISA 404).