Plan Loans in Bankruptcy

[Guest kjk]

Are participant plan loans dischargeable in bankruptcy? If not, what is the authority? Is it because they are not technically "debts"? Or is it because they are considered plan assets and qualified plan assets are excludable from the bankruptcy estate?

[mbozek]

Plan loans are debts owed by the participant to the plan which is evidenced by the promissory note signed by the employee. Therefore it is an unsecured loan subject to fed bankruptcy law which is not preempted by ERISA. When a participant files for bankruptcy the plan loan is listed on the schedule of unsecured creditors and the plan admin. gets a notice of the filing and a statement that payments by the participant are stayed by bkcy ct order. If the participant files for straight bkcy ( ch 7) then the participant's assets will be liquidated and the unsecured creditors will receive very little, of any, of the part. assets. When the payments are stayed the part. should be notified that the loan will go into default and the outstanding balance will be taxed if no further payments are made. The part. usually doesnt care because the payments from payroll are stopped. Part. can elect to go into ch 13 wage repayment whereby some debts are continued at a reduced amount but the Bkcy ct must approve the repayment schedule. A part can not elect to go into Ch 13 and repay only the plan loan and cancel all other debts.

[Guest Bud]

I don't think there is a straight forward answer to this. I could not find one BK case that held a 401(k) loan is a debt. I think it is settled common law that a participant loan is not debt for purposes of bankruptcy. I wish participant would stop listing them as a debt. The reasoning that is a plan does not have a right of repayment, therefore there is no claim and without a claim there is no debt. Therefore, the arrangement under which the participant pays the plan is not dischargeable by the BK. The way I see it, the BK court treats the loan payments like 401(k) deferrals.

In a Ch 7 BK, it's my understanding that the court does not require that 401(k) deferrals stop. Therefore, in my company, we ask the participant whether he or she wants to stop loan payments.

In a Ch 13 BK, the courts have generally held that the 401(k) loan is not debt; however, they (in particular, the 6th Circuit) generally hold that payments must stop because the payments should be going to creditors through the payment plan of the bankruptcy estate, instead of the participant. In a Ch 13 BK, 401(k) deferrals stop because all disposable income is supposed to go to the bankruptcy estate.

The legally enforceable promissory note as required under Code Section 72(p) isn't enough for the BK courts to treat the 401(k) loan as a true debt. It's going to take an act of Congress and Presidential signature to change that.

I hope a long thread develops on this. I'd like to read more.

[mbozek]

Participants who declare bankruptcy list the plan loan as a debt because they want to the loan repayment to stop. Bkcy ct order stays repayment of all loans during bkcy proceeding. Participant can elect to continue to pay loan provided that bkcy ct approves. Appreciate any cites you have which support your claims. Promissory note is a legal debt because it is is between two separate parties the plan and the participant which do not have an identity of interet.

[Guest Bud]

I know there is an agreement, but all I'm saying is that in a bankruptcy, the loan is viewed as loan from oneself and payments to oneself (kind of smells like Enron).

I think participants should be able to stop payments and revoke payroll deduction elections whenever they like. I don't think a plan needs to be listed as a debtor for the plan to stop payments. Communication from the participant and perhaps a copy of the bankruptcy petition should suffice.

If a partiicpant can pay on a loan and cure any missed payments after a Ch 7 is done, why not continue loan payments so a participant can avoid the risk of default.

Here are a couple of cases that shaped my view and one I found as I looked up the cites. Thanks for the discussion.

In re Villarie, 648 F.2d 810 (2nd Cir 1981) the Second Circuit held when a person borrows from his own retirement account, it does not create a true loan in the sense of a legally enforceable debt or claim by a third party claimant or debtor.

In re Harshbarger, 66 F.3d 775 (6th Cir.1995), the Sixth Circuit held that in a Ch 13 loan payments should stop because they are disposable income that should be paid to creditors of the BK estate.

In Re Guild, 269 B.R. 470 (D. Mass. 2001), the bankruptcy court said what I said, which as, "I conclude that there is no meaningful difference between 401(k) loan repayment and contribution."

[Guest kjk]

There is a decent article on this subject in the February 1999 American Bankruptcy Institute Journal, titled "Qualified Loans in Bankruptcy." I think Bud is right on target with his research.

[mbozek]

Under applicable law the plan must provide for repayment which can be required by salary deduction. A participant does not have the right to stop loan repayment if the plan requires repayment by salary deduction and state labor laws requiring the employees permission to withhold salary are preempted. DOL opinion 97-24. The sole purpose in listing the plan as a debt is to permit the plan admin to stop witholding the loan repayments in accordance with a lawful order of the bkcy ct. Otherwise the plan is obligated to continue withholding the repayments. Employees who file for bankruptcy want to stop making repayments and filing for bkcy is the only way to halt witholding. In my prior post I indicated that a participant can elect to continue repayment of a plan loan after filing a bkcy petition if ct. approves.

[Guest Bud]

I don't think ERISA Opinion Letter 97-24 holds that such state laws are preempted. In addition, the plan doesn't withhold payments from paychecks because the plan does not issue paychecks. Paychecks and withholdings (and deductions or deferrals) is payroll. A plan may require salary deduction while setting up a loan, but a salary deduction agreement is outside of the plan. Even though an agreement says it is irrevocable, it really is revocable (probably) under state law. In addition, the parties to the agreement (the employer and employee) can mutually revoke that term of the deduction agreement.

I think we give the plan's right to loan payments too much weight. A loan payment doesn't have the weight of child support payments or a tax levy. It's just a loan payment to oneself.

A plan should be able to take the position that the plan loan is not a debt for purposes of BK. I assume 401(k) deferrals must stop when a participant files for BK. How the BK court stops it should be the same way it stops loan payments. There is no need to list the plan as creditor and the plan won't have the hassles of dealing with BK notices.

In a Chapter 7, once debts have been discharged, a participant doesn't need court approval to continue repayment because future income is not within the BK court's control. Court approval would be necessary only in a Chapter 13 after debts have been discharged.

[Guest Do]

I agree with Bud. Participant loans are not debts in a bankruptcy. I can't even find Op Ltr 97-24, which would only be the opinion of the DOL anyway. So, I think payments can stop whenever a participant chooses and listing the participant loan as a debt would not be necessary.

If the bankruptcy court tells a participant to stop deferring into the plan, the participant will stop. If the court tells the participant to stop making payments on a participant loan, the participant should be able to stop payments by telling the payroll to stop deductions. I don't know how the court stops a participant from deferring into a plan, but that should be the same way it tells a participant to stop payments to a plan. Listing the plan as a creditor shouldn't be required. It just creates more work for plan administrators by having to respond as a creditor.

[k man]

this is an old thread but i have a comment/question to add. after the plan adminstrator follows the court ordered stay, does the clock start running with respect to default and 1099? i would say that it does even if the Court subsequently allows the petetioner to commence repayments. it may already be too late if the cure period has passed. do you all agree or disagree?

[Guest Bud]

I think the clock starts running when a payment is missed. If an order comes in mid week and the payment would have been made on the upcoming Friday payroll, the clock would start on that Friday. If the cure period has passed, the missed payment cannot be cured. I agree that loan is in default.

[mbozek]

I think that there has been some miscommunications here. The purpose of filing a bkcy petition is to get relief from repaying debts. If the loan is not listed as a debt then the implication is that the loan is not a debt for which repyment can be suspended because the participant does not reqard the loan as a debt. There is no requirement that the plan respond to a petition in bkcy filed by a participant-- the plan adm is notified that the petition is filed and the plan is listed as an unsecured creditor. The purpose of the filing is to permit the plan admin to stop witholding of loan repayments from salary which the participant agreed to as a condition of the loan to comply with the requirement that there be a repayment schedule in order for the loan not to be deemed a distribution. See reg. 1.72(p)-1, Q-3(B) and Q-4. The loan may be a fiction but repayment procedure is a necessary fiction to prevent distribution. I dont know of any way that a participant can stop withholding on a plan loan other than by termination of employment if repayment by salary deduction is a condition of the loan-- State labor laws requiring the consent of a participant to withholding are preempted under both Dol ruling 94-27A (NY labor law) as well as federal case law, Hewlett Packer Co v. Barnes, 425 F Supp 1294, aff 571 F2d 502 (state laws which affect how a plan operates are preempted by ERISA), even if the state law applies to the employer instead of the plan. see Ingersoll Rand v. McClendon, 498 US 133. You can agree or disagree with following the procedure listing a plan loan in filing a bkcy petition but ther are not many plan admin who would want to hear that state law permits plan participants to voluntarily stop their loans at any time.

[RTK]

I looked at this issue a few years back in connection with an anticipated participant bankruptcy that never happened. My preliminary conclusions were:

1. A majority of courts would not consider the loan to be a "debt" under bankruptcy law. Thus, the loan would not be discharged and the plan could foreclose on the defautled loan.

2. Once bankruptcy case closes, plan could accept repayments and take collection actions. Before then, the automatic stay provisions would be at issue. If Ch. 7, the plan could generally accept repayments. If Ch 13, the repayments should stop.

Some related comments:

1. I once had a bankruptcy trustee try to seize the participant's account as part of the bankruptcy estate. She did so by contending the ERISA qualified plan must (among other things) be tax qualified and asked to the bankruptcy court to rule that the plan was not qualified under the Internal Revenue Code.

2. Whether ERISA preempts state law on payroll deductions I think is a close call (and with the Sup. Ct. decisions, who could tell). The DOL Op Ltr is 94-27. Rather than forcing the issue, I typically require payroll deduction as a condition of eligibility for a loan make the revocation of the order an event of default.

3. I do not think that a bankruptcy stay on loan repayments changes the income tax consequences. Thus, I believe the deemed distribution rules, 1099R reporting requirements, etc. would apply.