Prohibited Transaction--or fixed by EGTRRA

[Guest CRC02]

An owner-employee who owns more than 5% of an S corporation takes a plan loan in 2001. Although EGTRRA revised the code to permit plan loans to owner-employees, the provision permitting such loans wasn't effective until 1/1/02. Therefore, the loan is a prohibited transaction from the date it was made in 2001 until December 31, 2001.

The loan has not been repaid as of this date. Therefore, what are we dealing with: (a) an ongoing prohibited transaction that was not cured by the EGTRRA change; (B) a prohibited transaction for the applicable part of 2001, but no prohibited transaction during 2002; or © no prohibited transaction for either year because you can't retroactively correct prohibited transaction and as of 1/1/02 it was no longer an ongoing PT?

I haven't been able to find any guidance on this. Anyone have any thoughts?

[lkpittman]

I think the IRS would assert that you've got a PT in 2001 and since it has not been "corrected" under the PT rules (correction is achieved by "undoing" the transaction to the extent possible--placing the plan in a financial position no worse than the position it would have been in had the transaction not occurred). I think you have a PT for the portion of 2002 during which the loan is not repaid or otherwise "corrected." I don't think that EGTRRA "corrects" your PT. I think you need to get the loan repaid and then start over. Participant is now allowed to have a loan under EGTRRA, so a new loan in 2002 would be fine. It should be a separate transaction, however (not a refinance or replacement, since the 2001 transaction is not really considered a valid participant loan).

You also have the other issue of an "operational error" (not following terms of the plan in 2001 by allowing shareholder/employee to receive a loan) and potential disqualification if not corrected under EPCRS (separate from PT correction).

Good luck!

[Mary Kay Foss]

Did the loan qualify under 72p so it wasn't treated as a distribution? I don't know if the loan being a PT in 2001 would give you any break under 72p as to the maximum amout of loan that could be taken.

If 72p is going to limit the amount of the loan or treat it as a taxable distribution, consider taking a distribution to pay off the loan.

[Guest mcw]

I have the exact problem. However, it was 2003 before we discovered the improper loan. Any additional thoughts?

[imchipbrown]

I don't know what this means, but for what its worth....

Conference Agreement

The Treasury and the Secretary of Labor will waive any penalty or excise tax in situations where a loan made prior to the effective date of the provision was exempt when initially made (treating any refinancing as a new loan) and the loan would have been exempt throughout the period of the loan if the provision had been in effect during the period of the loan.