Can a loan be sold from 401(k) account to Profit Sharing Account?

[Guest Dave Danziger]

I've got a participant (still employed) with a defaulted loan in his 401(k) account. He's suffered a deemed distribution already, and now, he would like to have the loan written-off entirely. The problem is - the participant has not experienced a 'distributable event' with respect to the 401(k) account.

On the other hand, the plan allows a defaulted loan held in a profit sharing account to be written off via a 'setoff distribution'.

Can any one think of a reason why the participant could not sell the loan from the 401(k) account to the profit sharing account, and thereby open the door to a setoff distribution without violating the distribution restrictions that are applicable to 401(k) amounts?

There's nothing prohibiting it under the plan document or procedures. I, also, don't think it constitutes a 'prohibited transaction' because it is not a sale to a prohibited party.

What do you think?

Thank you very much.

[KIP KRAUS]

What do you mean by selling the defaulted 401(k) loan to the profit sharing plan? What value you would you put on the defaulted loan?

Seems to me that a qualified plan would have no interest in acquiring a worthless document of any kind.

Could this be a breach of fiduciary responsibility under the profit sharing plan?

[Guest Dave Danziger]

The value of the loan (in my proposed sale/transfer) would be it's outstanding balance, plus all interest accrued through the date on which a deemed distribution occured. (Under the section 72(p) regs, interest continues to accrue, but only for limited purposes. I wouldn't consider such additional interest to be part of the value of the note because it is not counted in determining the value of vested benefits under the plan.)

I'm confident there isn't a fiduciary violation here, since the plan already owns the note. Under my fact pattern, the note is an earmarked investment attributable to a participant's 401(k) account. Under the proposed transaction, the same participant would transfer funds from his profit sharing account (in an amount equal to the value described above) to his 401(k) account. The value of both accounts remain the same after the transaction. The difference, after the transaction, is that the participant's 401(k) now consists exclusively of cash and securities, while his profit sharing account includes an earmarked investment consisting of the non-performing loan that was previously titled to the 401(k) account.

Once this transaction is completed, the profit sharing account can distribute the non-performing note to the participant. (This is a non-taxable distribution according to the 72(p) regs.) The participant's profit sharing account balance is then reduced by the value of the note.

Ultimately, plan assets are less, but they've been reduced as a result of a permissable in-service distribution. Neither the plan, nor the participant suffers any loss as a result of the transaction. (The loss occured when the participant defaulted on his loan and suffered a deemed distribution. The subsequent transfer and distribution only resulted in a cleaning up of the balance sheet, by writing off the non-performing loan.)

I think my real question is whether this is a prohibited transaction. Or, does anyone know of any other rule that would prohibit a plan from using this approach to clean up its balance sheet?

[Guest b2kates]

David, you do not state if the participant is also a fiduciary to plan. This may impact the result.

[Guest Dave Danziger]

That's an interesting point! Let's assume the participant is a fiduciary. Let's also assume that the participant is an officer and owns 50% of the stock of the sponsor. That'll really make the participant a "disqualified person" (for excise tax purposes) and a "disqualified person" (for ERISA purposes).

I still don't see a fiduciary violation, and I would still question whether the transaction would be prohibited. In arguing that it is not prohibited, I would note:

1. The transaction is taking place within the plan. I don't think this constitutes an "indirect" transaction between the plan and a prohibited party.

2. I suppose the plan's trust could be a prohibited party, if the participant's interest in the plan represents 50% or more of total plan assets (which, conveniently, is not the case). I do not believe that a self-directed accounts would be treated as separate trusts. If that were the case, the participant would hold 100% of the beneficial interest in his accounts.

3. The transaction could be structured as a refinancing of a loan, and as such, covered by the PT exemption for participant loan programs. I don't think there is a restriction against refinancing a loan in one account using funds in another account. I imagine this happens all the time in big platform cases. (This approach wouldn't work, under section 72, if the participant's account is worth more than $100,000 and the loan balance is greater than $25,000.)

Thanks for the continuing feedback!

[R. Butler]

I may be getting lost in the facts, but is this one plan or two separate plans? I am assuming that this is actually one plan with both a profit sharing and 401(k) source. I am also assuming the document does provide for offsets, you just you can't use the 401(k) source because participant is under 59 1/2. If my assumptions are correct there isn't any reason you can't offset. The default triggers the distributable event.

If this actually two separate plans (although I would question why two plans), then I would not feel comforatble using an offset. Although you call it a purchase, really you have distributed money from the profit sharing plan when there is no distributable event.

I don't see any fiduciary issues, it really is just a matter of whether or not there is a distributable event.

[Guest b2kates]

David, in your shareholder scenario if foresee the exposure to violating the exclusive benefit rule. i.e. utilizing plan assets for his personal benefit.

Further, if the participant had defaulted what then makes him a good credit risk for the plan to authorize a refinance of the loan.

Lastly might not the refinance violate the 5 year rule.

[JanetM]

I may be missing some thing in this - but here is my two cents anyway.

My take is that you can only move (transfer, sell, distribute - sematic games we play) assets between plans if triggerd by a distributable event in the case of a single participant. Only exception to that is a plan merger/ plan spin-off that effects all participants.

I do not see how you can distribute the assets at this time unless the plan allows inservice.

[pjkoehler]

Dan: If the plan were to permit the participant to modify the security agreement to replace the plan's security interest in his 401(k) account balance with an interest in his nonelective profit sharing account balance only, then the plan should automatically treat the loan as an earmarked investment of the profit sharing account. Assuming the profit sharing account balance is adequate for this purpose and there's no contrary plan language, it's a no-harm-no-foul fiduciary act under the PT plan loan exemption because the loan remains "adequately secured." You could probably make a reasonable argument that it's in the plan's interests to clean this up to avoid the ongoing admininstrative cost of servicing a nonperforming loan.

The concern about engaging in a plan loan offset of a loan secured by the participant's 401(k) interest is, of course, the violation of the 401(k) distribution limitations regarding in-service distributions. But that concern is the result of the effect of the trustee's executing upon the collateral, i.e. a debit to the 401(k) plan account, in order to cure the default. If the plan doesn't have a security interest in the 401(k) plan account, because the security agreement limits the plan's security interest to the participant's non-CODA originated account(s), the 401(k) distribution limitations would no longer govern the plan's execution upon the collateral.

[maverick]

Dave, please don't take this as a criticism of you personally, I know you're just trying to help a participant. Now, having said that, here's my opinion on plan loans -- they don't belong in retirement plans. People (employers, tpa's) spend an inordinate amount of time on various loan "issues" and "problems" that could be better spent on other things. This discussion thread is a good example one of those "problems."

I have a client with weekly payrolls and a 1k minimum loan. Over the past couple months I've spoken with a participant 7 or 8 times re: how can I (when can I) get a loan? Account balance was less then 2k, so he called the vru every week until his balance finally went over 2,000; then a 1,000 loan representing 50% of his vesting balance was available. After processing the loan this ee called several more times looking for his check, after I told him when to expect the $$. The admin person at his plant even called wondering the same thing. And, this person was willing to pay a $100 loan fee, which probably does not cover our processing costs, to get a 1,000 loan (my problem, we should increase the fee).

The bottom line: Don't expect your 401(k) plan to be a loan company/credit union/bank. You might want to consider deferring a little less and putting the difference in a savings account for easy access. That's my 2 cents, and yes, I feel much better now. Maverick.

[Guest Dave Danziger]

You're not alone in hating loans Maverick.

We always recommend against the creation of loan programs. The few programs that remain, nowadays, always require payroll deductions. This has helped reduce, but not eliminate, our hassles with loans.

The final 'Deemed Distribution' regs under Code section 72 increase administrative burdens by requiring plans to continue accruing interest even though the accruals are not part of the assets of the plan.

My objective in starting this discussion, is to find ways to further reduce the burden on plans, and service providers. This burden is great when loans come from 401(k) accounts because defaulted loans cannot be written off without a 'distributable event.' I understand that the 72 regs cannot authorize a distribution that is not permitted under 401(k), but they also don't prohibit a plan (or participant) from taking reasonable steps (as described in my original question). Those steps would preserve the value of the 401(k) account. They do not change the true value of the participant's total benefit, and they allow fiduciaries to operate their plans at reasonable cost.

You and I are on the same page Maverick! How about we, and others in our community, work on a solution. The IRS understands this administrative burden and (reasonably) note that they can't provide a solution without Congressional action amending 401(k). Fear of the open-endedness of DOL pronouncements, I believe, is causing us to worry about fiduciary, exclusive benefit, and prohibited transaction issues, etc. I respect the law, and the DOL, but I'm not convinced that the proposed transaction would violate anything, as long as the participant voluntarily agrees that s/he will never pay off the loan, and therefore, the loan should be written off. This is a "commercially reasonable practice" - which is the foundation on which the PT exemption for loans is founded.

[Guest b2kates]

david, i do have a comment on writing off the loan. What efforts did the trustee undertake to enforce the loan. i.e. collection suit. No action and simply writing off the loan would appear to be a fiduciary violation.