Loan payments - stopping payroll deduction

[Guest MaryMac]

Hello,

Any advice regarding the ability to stop loan payment deductions from payroll at the request of a participant?

Our loan policy says that payments will be made from payroll deduction, so the thought is that as long as there is payroll to deduct from, the payment should be made. However, that is a hard message to deliver when someone is in financial trouble, so we are looking for an alternative.

Perhaps there is a way around this that I am not aware of.

Thanks in advance for any suggestions, links.

[QDROphile]

Depends on:

1. Whether or not the plan has an assigment of pay.

2. Whether or not the payroll deduction authorization is irrevocable.

3. State law concerning payroll deductions (the pre-emption of state law is the subject of some debate).

4. What the plan and loan documents say.

The plan administrator cannot simply let the participant off the hook because of unpleasant circumstances, nor can the plan administrator walk away from easy collection of loan payments. If the participant does not have the right to cancel payroll deductions, the administrator can't let them be cancelled simply because the participant would like it. The loan must be enforced. The plan administrator can decide whether or not extraordinary collection efforts are warranted under the circumstances if the particpant is able to cut off the easy money because of a right to cancel the payroll deductions.

[Kirk Maldonado]

I think that there could be serious consequences to the plan if it allows participants to stop making loan repayments simply because of financial hardship.

This could result in loans being treated as taxable distributions and/or the loans being prohibited transactions.

Think of it this way, if the employee had borrowed the money from a bank, could the employee go to the bank and say "I'm having financial trouble, so I've decided that I'm just not going to repay your loan."

Could the employee apply for a hardship distribution to get the funds to pay off the loan?

[mbozek]

I have alwys understood that the point behind making the loan a legally enforceable agreement to repay was to prevent the loan being treated as a distribution. This requires that the loan agreement provide for a repayment schedule. See reg. 1.72(p)-1 Q-#,4. If there is no enforceable repayment schedule then the loan is a distribution. Plan admin require repayment of the loan by salary deduction a condition of the loan and also as a plan provision to avoid state labor laws which permit employees to terminate withholding at will. If the employee cannot pay the laon he/she can always file for bankruptcy and the plan admin. can stop withholding pursuant to the order of the bkcy ct. If the loan repayments stop the employee will have a taxable distribution at the end of the quarter following the last qtr in which a payment was made.

[Guest MaryMac]

Thank you for your comments. The participant was willing to take on the taxable event, but the administrator has decided it is not worth the risk to the plan.

We did have a bankruptcy court force us to stop withholding loan payments for a participant a few years back.

Thanks again.

[DR]

On 8/5/2002 at 8:45 PM, QDROphile said:

"The plan administrator cannot simply let the participant off the hook because of unpleasant circumstances, nor can the plan administrator walk away from easy collection of loan payments. If the participant does not have the right to cancel payroll deductions, the administrator can't let them be cancelled simply because the participant would like it. The loan must be enforced. The plan administrator can decide whether or not extraordinary collection efforts are warranted under the circumstances if the particpant is able to cut off the easy money because of a right to cancel the payroll deductions."

I realize the law is the law but this comment makes it sound like the employee is trying to get off easy.....but it's money they earned and it is they who suffer the consequences if they choose not to pay back to the loan.  

[DR]

On 8/7/2002 at 11:36 AM, Guest MaryMac said:

Thank you for your comments. The participant was willing to take on the taxable event, but the administrator has decided it is not worth the risk to the plan.

We did have a bankruptcy court force us to stop withholding loan payments for a participant a few years back.

Thanks again.

I'm probably asking a stupid question but indulge me.  What is the risk to the plan in the employee opts to take the money as a distribution?  Thanks!

[QDROphile]

If the participant is not eligible for a distribution under the terms of the plan, a distribution would be grounds for disqualification (failure to follow plan terms) and the fiduciary could have liability (same reason).

[Bird]

Wow, pulling up a thread from 2002?!  

Just FYI, there are many later discussions on this, and some/many, myself included, do not think you can force someone to continue payroll withholding for a loan if they don't want it.  It might depend on state law but I have yet to see someone prove that you can continue to force such payments in XYZ state.  

Loans default, all the time.  Sure, a Plan Administrator who regularly (or perhaps even once) permitted loans and then collected no payments could indeed jeopardize the plan's status, as this would certainly look like a work-around for an otherwise impermissible distribution(s).  But I don't think setting up a loan, collecting payments for some period of time, and then stopping payments at the participant's request, puts the plan in any danger at all.  Payments by payroll deduction is an administrative policy that does not, in my opinion, give rise to a higher level of duty to collect.

[RatherBeGolfing]

I agree with @Bird that you cannot force someone to continue payroll withholding for loan payments.  Simply having loan defaults does not put the plan in danger, even if it is because the participant withdrew consent for payroll withholding. 

That said, if the plan admin or fiduciary responsible for approving loans knows that the participant does not intend on making loan payments, the loan should not be approved.  I would argue that in that case, it is a distribution rather than a loan and what @QDROphile said above applies.  

[QDROphile]

Bird:

Here is one way it works, which is not required by federal law, but is consistent:

The loan program requires assignment of pay as part of the loan conditions as security for loans.  This is done under state law, but assignment of pay is a feature of most or all state commercial codes.  Community property states might require the spouse to consent to the assignment.  A payroll deduction authorization can be part of the picture as well, but the assignment of pay avoids the issue about whether or not the payroll deduction can be irrevocable under state law.  If the payroll deduction authorization is revoked, the plan (as lender and secured party) relies on the assignment of pay to have the employer continue to set aside the payment amount each period and deliver it to the plan to cover the loan payment obligation.

[Bird]

16 hours ago, QDROphile said:

The loan program requires assignment of pay as part of the loan conditions as security for loans.  This is done under state law, but assignment of pay is a feature of most or all state commercial codes.  Community property states might require the spouse to consent to the assignment.  A payroll deduction authorization can be part of the picture as well, but the assignment of pay avoids the issue about whether or not the payroll deduction can be irrevocable under state law.  If the payroll deduction authorization is revoked, the plan (as lender and secured party) relies on the assignment of pay to have the employer continue to set aside the payment amount each period and deliver it to the plan to cover the loan payment obligation.

I'm not sure I want to drag this out, because it's not something that concerns me on a practical level, but where did this come from?  Are you explaining the tie-ins, or is this in a loan program/procedure?  I've never seen anything so rigid/handcuffing.  In our (FTW) procedures, the method of loan payment is just a checkbox (another alternative being the participant writes a personal check).  IMO it's not even a compliance issue, it's just something you show the participant, that that's how it's going to be done as an administrative convenience.  

[QDROphile]

Of course this is irrelevant in a check-the-box document world that is populated by automatic, machine-processed, and on-line administration.  I was merely offering you an example of how one can "force" payment of a plan loan when the participant is still employed.

I prefer not to look at it as "forcing" anything.  Instead, it is a way of assuring that the plan and its fiduciary come out on the correct side of compliance without having to face various issues involving state payroll law and expectation of payment at the time the loan is initiated (which is based on qualification rules, in particular the rules against in service distributions, and prohibited transaction rules).  To elaborate, let's start with the legal requirement that the loan is not to be made unless payment is reasonably expected.   This requirement is based on the limitations on in-service distributions.  If the loan is not paid because of elective termination of the payroll deduction,  an in-service distribution will occur.  Having adequate security for the loan is an assurance of payment.  Fiduciaries do not want to through the same drill as commercial lenders in reaching a conclusion that the loan will not go bad, including credit checks and having some security that requires expense and effort to foreclose on the security (like repossessing a car for car loans).

A common requirement for a loan is a payroll deduction authorization.  Payroll deduction gives the fiduciary some assurance that the loan can be expected to be paid as long as the participant is employed (and the restriction on in-service distributions is in effect).  On that basis, the fiduciary does not have to check credit/finances of the participant, which would be annoying to everyone.  Because of realities and doubts about state law on irrevocability of payroll deduction authorization, payroll deduction is weak.  If the participant can simply cancel it, the fiduciary can then be in a bind and will be faced with decisions about if and how to enforce the loan contract by some extraordinary means. Defaulted loans also complicate administration of loans and may result in the plan having to account for basis if loan payments are made after a taxable deemed distribution.

If the plan requires an assignment of pay, all of the issues relating to participant discretion over payroll deduction and possible consequential default are avoided.  The assignment of pay is a much stronger basis for expecting payment (no longer at the whim of the participant), assurance of compliance with qualification requirements and fiduciary duty, and avoidance of administrative complications arising out of in-service defaults.  Also, assignment of pay is a feature that is more like what is found in commercial lending and the regulatory agencies operate (in appearance, but not in effect) on the idea that plan loans are supposed to look like commercial loans (witness all the discussion and fretting over interest rates).  The aspect of the regulatory agencies is another matter.

[Bird]

Thanks for taking the time...I will agree to disagree.  

[QDROphile]

I know I have dragged you beyond your interest level at this point, but I am curious about what "disagreement" there may be.  I do not say the the plan design (or loan policy design, if that is how one views the loan provisions of the plan ) must be as I described and I acknowledge that prototype plan documents will not provide the option.  The protocol does increase administrative burden up front at loan initiation.  Are you saying it is not legally permissible?  Your use of "handcuffing" suggests that you think "forcing" the participant to repay the loan from employer compensation is unwise.  Is that the disagreement?

[Bird]

Mmm, I think the very concept that an employer could or should worry about allowing a participant to stop loan payments is not valid (except in the case where the loan is a sham*).  I have no grasp whatsoever of why an employer would want to have a policy of mandatory loan withholding forever, even if it is permitted.

On a legal level, I've heard that it goes to state law.  I don't pretend to know much about state law in general, let alone the laws of all 50 states, but as I said earlier, I have yet to see someone prove that you can continue to force loan payments in XYZ state.  

On a practical level...no concerns whatsoever.  If you or anyone torturing themselves by reading this is aware of a case where the IRS raised questions about the validity of a loan program because the sponsor allowed participants to stop their loan payments through the payroll system, please let me know.

*Whether the loan program is a sham or not has nothing to do with whether payments are made by payroll deduction or otherwise, IMO.

[MoJo]

On 11/29/2018 at 9:03 AM, Bird said:

Thanks for taking the time...I will agree to disagree.  

And I would agree with Bird.  State law has something to say about wage assignments - and being revocable is usually one of the conditions....

[DR]

"If the participant is not eligible for a distribution under the terms of the plan, a distribution would be grounds for disqualification (failure to follow plan terms) and the fiduciary could have liability (same reason)."

Being eligible for a distribution and defaulting on a loan are not exactly the same thing (unless, as previously mentioned, a loan was taken and not a single payment was made) I found myself in a situation where I had to default on my loan that I had been paying for three years. I simply asked my payroll person to stop withholding payments and it was done immediately  and without question.  I figured I would be given a scolding but they spared me that, perhaps because I was upfront about my understanding of the consequences of such.  I also read my loan paperwork which explicitly stated that I could revoke permission to withhold funds.

[shERPA]

First time this came up with one of our plans BITD (maybe 20 years ago?), we checked with our attorney.  She said the participant had the right to stop the loan withholding from payroll under California law governing payroll deductions.  I doubt this has changed under CA law since then.  Other states may differ. 

[RatherBeGolfing]

17 hours ago, DR said:

"If the participant is not eligible for a distribution under the terms of the plan, a distribution would be grounds for disqualification (failure to follow plan terms) and the fiduciary could have liability (same reason)."

Being eligible for a distribution and defaulting on a loan are not exactly the same thing (unless, as previously mentioned, a loan was taken and not a single payment was made) I found myself in a situation where I had to default on my loan that I had been paying for three years. I simply asked my payroll person to stop withholding payments and it was done immediately  and without question.  I figured I would be given a scolding but they spared me that, perhaps because I was upfront about my understanding of the consequences of such.  I also read my loan paperwork which explicitly stated that I could revoke permission to withhold funds.

The argument is that without an enforceable agreement to repay the loan, the participant can cease loan payments for any reason.  If the participant is not required to make loan payments, it is no longer a loan, it is a distribution.  If the participant is not eligible for a distribution,  there has been a failure to follow plan terms which is a problem for the plan.

The counter argument is that simply defaulting on the loan, even if it is at the request of the participant, does not invalidate the the original loan transaction.  That said, it would still be a distribution rather than a loan if the participant never intended to pay back the loan.