Prohibited Transaction?

[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?

[Tom Poje]

The last notes I had on it (from the ASPA conference inOct) was that "The Conference Agreement expects the IRS to waive excise taxes on a loan made prior to the effective date that, had the new law been in effect for the term of the loan, would have been an exempt loan."

(I guess you could apply for a waiver and see what happens)

[actuarysmith]

I wonder if there might be some way to self-correct this problem.

Let's suppose that the rules had not changed (EGTRRA) and you discovered that a loan had been granted to a shareholder employee by accident.

You probably could have attempted to self- correct by documenting it - and then had the shareholder employee repay the loan immediately. (I am not sure whether it would be the outstanding amount, or the full original loan - probably outstanding amount). Finally, you would make note of whatever process you were putting in place to assure that this mistake did not happen again.

Using the same logic, have the shareholder employee "Repay" the outstanding loan and then turn around and take out a new loan for the same amount. The amort period and interest rate may or may not be different. (I think that you would need to make the amort period the same as whatever was left on the original loan, rather than starting a new 5 year (or whatever) amort period).

However, you would have a loan origination date that is post-EGTRRA. The shareholder-employee would have the use of the same amount of money. If the interest rates have changed, you may have a modified payment amount prospectively.

One pitfall may be that if the prior loan was very large, the amount available for a new loan might not be large enough to meet the need.

Any other thoughts on this approach?

[Guest CRC02]

Actuarysmith--

I don't think that the method you suggest would work. The Eight Circuit has held that retroactive correction of prohibited transactions is not permitted. The court reasoned that the first tier of Section 4975's two tier excise tax would never be applied if participants to a prohibited transaction loan were allowed to simply self-correct the transaction. Therefore, the court found the idea of self-correction was contrary to the legislative intent behind Section 4975.