Loan treatment in Chapter 7 Bankruptcy

[jaemmons]

A participant in a plan my office administers has been afforded debt elimination under Chapter 7 Bankruptcy. He has an outstanding plan loan and I have a couple of questions on what should happen:

1) Is the outstanding loan taken off the "books" pursuant to the court order?

2) If so, does it become a deemed distribution to the participant and is it exempt from the 10% early distribution penalty

I believe that the loan is an allowable debt to be listed on the petition for bankruptcy but I am not exactly sure what if any tax implications result from this action.

[QDROphile]

You are likely to get other answers, in part because of contradictory positions of bankrutcy courts about whether or not a plan loan is a debt that can be discharged in bankruptcy.

A chapter 7 bankruptcy discharges the loan (meaning that the plan cannot collect and payroll deduction must stop). It may be possible for the loan to be excluded from the discharge, but the effect of exclusion is available to the participant because the participant may voluntarily continue to make payments after the filing (in this respect, different from chapter 13) or may formally reaffirm the debt. I have not considered if the plan can refuse to accept the voluntary payment unless the participant formally reaffirms.

The participant suffers a deemed distribution if the payments are not made in time, no matter what the reason. The loan regulations define the outer limits of "in time." The plan terms can probably provide for less grace.

Q&A 11(B) of Treas Reg section 1.72(p) says that the 10% tax applies to deemed distributions.

I think that the better answer is that if the loan is discharged and not reaffirmed, it is removed from the books and does not count as an outstanding loan for purposes of future loans, but I am not aware of any authority that has addressed the issue. Richard Wickersham was once induced to say so, but it was a very tentative statement. The alternative is that the loan remains on the books and may interfere with later loans. If the participant continues to pay without reaffirmation, I don't know. I suspect that the plan can't take loan payments without taking the position that the account has a loan. The plan may wish to require a reaffirmation of the loan to help resolve the question.

Loan payments after a deemed distribution create an after-tax account.

[jpod]

Look at the bankruptcy documentation. I have to wonder, why on earth would the bankruptcy court treat the plan loan as a real debt? Did the plan, either through the employer, the plan administrator, or the trustee(s), receive any formal notice in the proceeding as "creditors" are supposed to receive?

[mbozek]

Bankruptcy is a voluntary procedure which is initiated by the employee by filing a petition under Ch 7 to be discharged from all debts which are dischargeable (e.g. student loans are not discharged). An employee is not required to list the plan loan on the schedule of creditors and may continue to make payament on the loan. If the plan is listed as a creditor then it will recieve a copy of the bkcy ct order notifiying all creditors of the filing of the bkcy petition and ordering the creditor (plan) to cease collecting the debt. Plan Admin notifies the employee of the receipt of the order and that all witholding of repayment will stop unless the employee agrees to continue repayment. If repayments stop the loan goes into default under the IRS rules. The sole purpose of filing the Bkcy petition is to allow the plan admin. to cease mandatory withholding of loan payments. While several people have advocated that the plan admin can oppose the filing of the petition on the grounds that it is not a valid loan under bkcy law there is no reason for the PA to incur such legal costs just to force the part. to continue payments. I really dont know what the significance of a discharge is to the participant other than that the outstanding loan is no longer owed to the plan- but the outstanding balance is still a deemed distribution.

[JanetM]

If the participant does not repay the loan - even after the default - it is still a loan on the PA books and counts in the calculation of available loan dollars in the future.

[QDROphile]

JanetM:

Does the discharge of the loan in the bankruptcy proceeding change your observation? One of the purposes of bankruptcy is to give the debtor a clean slate and generally it is improper to hold a discharged loan against a debtor, directly or indirectly. Seems like counting the discharged loan (with ever accruing interest) directly against future borrowing capacity is inconsistent with the purposes and rules of bankruptcy. The bankruptcy code is on the same level as other federal laws, and all have to be reconciled in some way. I don't think we have seen any authoritative recognition or reconciliation.

[JanetM]

Whith no distributable event how can you offset the loan from the account balance? You can't have a deemed distribution offset the balance. Offset only occurs at distribution. The loan stays on the books for active employees - there are just no payments made on the loan. If the ee wants new loan - outstanding defaulted loan is used in determining the amount that can be barrowed.

This is my understanding of the rules - you can't distribute until there is an event listed under IRC 401(k)2B

[jaemmons]

The plan administrator received a "Discharge of Debtor" from the court with respect to the plan loan (which they listed on their filing as outstanding debt). As such, we have taken the loan off of our books (offset) and deemed the loan as a distribution to the participant. It doesn't make any sense to me to keep a receivable in the plan which has no chance of being paid off. Plus the court ordered that payment stop on the loan. With that in mind, does anyone see any reason why the loan couldn't be deemed and offset simultaneously?

[JanetM]

Will cut and paste the reason - no distributable event. Under your policy - I borrow 50% of my balance and declare bankruptcy. As soon as bankruptcy is done - I borrow 50% of what my balance is because I don't have loan.

IRC, PEN-CODE-VOL, SEC. 401. QUALIFIED PENSION, PROFIT-SHARING, AND STOCK BONUS PLANS.

401(k)(1) General rule.--A profit-sharing or stock bonus plan, a pre-ERISA money purchase plan, or a rural cooperative plan shall

not be considered as not satisfying the requirements of subsection (a) merely because the plan includes a qualified cash or deferred

arrangement.

401(k)(2) Qualified cash or deferred arrangement.--A qualified cash or deferred arrangement is any arrangement which is part

of a profit-sharing or stock bonus plan, a pre-ERISA money purchase plan, or a rural cooperative plan which meets the requirements of

subsection (a)--

401(k)(2)(A) under which a covered employee may elect to have the employer make payments as contributions to a trust under the

plan on behalf of the employee, or to the employee directly in cash;

401(k)(2)(B) under which amounts held by the trust which are attributable to employer contributions made pursuant to the

employee’s election--

401(k)(2)(B)(i)(IV) in the case of contributions to a profit-sharing or stock bonus plan to which section 402(e)(3) applies,

upon hardship of the employee, and

401(k)(2)(B)(ii) will not be distributable merely by reason of the completion of a stated period of participation or the lapse of a

fixed number of years;

401(k)(2)© which provides that an employee’s right to his accrued benefit derived from employer contributions made to the trust

pursuant to his election is nonforfeitable, and

401(k)(2)(D) which does not require, as a condition of participation in the arrangement, that an employee complete a period of

service with the employer (or employers) maintaining the plan extending beyond the period permitted under section 410(a)(1)

(determined without regard to subparagraph (B)(i) thereof).

[RTK]

In the few active participant bankruptcies we have handled, the participant loan was not considered "debt" and the loan was not discharged in bankruptcy. Thus, the loan was handled in accordance with normal plan procedures. The deemed distribution was reported to the IRS and a plan loan offset taken at the participant's termination of employment.

My concern would be that the IRS would take the postion that a discharge of a participant loan in bankruptcy does not permit the plan loan offset under the IRC (i.e., does not permit the loan to be taken off the books). I have not seen any guidance on this. At this point, I would be inclined to leave the loan on the books until a distributable event occurs, but not attempt any collection in the interim.

[mbozek]

Janet M: what is being distributed after default? Only thing left is the loan note which has been defaulted on.

RTK: even if the loan is not considered debt and not discharged the result is the same- participant stops making payments by salary deduction and loan is in default. Failure to get bkcy discharge is significant only if plan will require employee to continue to make repayments after default on loan. I do not understand why plan admin would oppose filing of plan loan as debt under bkcy law since it provides legal basis for PA to cease withholding via salary deduction and opposing filing of bkcy petition requries filing of legal documents. If PA prevents inclusion of plan loan as debt for bkcy purposes then participant must continue to make repayments every pay period in accordance with note and there will be no default. IRS prop reg 1.72(p)-1 Q/A-19(B) considers defaulted loan to be outstanding loan for purposes of applying the maximum amount of any subsequent laon.

[RTK]

Actually, the participants (or attorney) did not schedule the participant loans as debt in the few cases we handled. Thus, the plan took no action with respect to the bankruptcy action. In any case, I have been advised by the bankruptcy folk that most bankruptcy courts would not consider a participant loan to be a debt under bankruptcy law, but I am not sure of the basis.

What I consider most significant about the bankruptcy discharge is whether this would require the plan to offset the discharged loan at that time, and whether the IRS would then treat that as a disqualifying distribution (assuming no distributable event permitting the offset). This has the qualification and 72(p) maximum loan issues noted above.

The bankruptcy discharge would be helpful with respect to the issue of the steps a plan administrator must take to collect a delinquent loan for both ERISA (fiduciary) and Code (bona fide loan) purpose.

In the loans we handled, even though the loans were not discharged, repayments stopped and they went into default. In one case, salary reduction was not required for repayment. In the other, the participant elected to revoke salary reduction (which was its own event of default). One of the cases may have been a chapter 13, and payments stopped on that basis.

[mbozek]

A debt must be listed on the petition for bankruptcy in order to be discharged. If it not listed as an unsecured loan the Plan admin will not get notice of the filing and will not recieve the order to cease withholding of repayments. A participant is not required to list the loan on the petition for bankruptcy. If the loan is not listed on the petition then the participant must continue repayments. If the loan is listed on the petition for bankruptcy and there is no objection the loan will be discharged. The discharge of the loan by the bkcy ct has no impact on the defaulted loan under the tax law since discharge releases the participant from the obligation to repay the debt. A loan in defaut is deemed distributed. Q/A-10. See prop. reg. 1.72(p)-1 Q 19(a)- a loan that is deemed distributed under 72(p) ceases to be an outstanding loan for Section 72, but is not deemed to be an actual distribution for qualification purposes under Q-12. A defaulted loan must be taken into account in determining the amount of any future loans. Q-19(B).