Company "forgot" to payroll deduct loan payments

[maverick]

Plan loan granted w/first payment due 2/20/02. The company forgot to start payroll loan deduction payments, and it took the participant 6+ months to ask why. I think we'll be okay if the loan is paid back by the end of the payment period (3 years), but I'm wondering how to handle the approx 600 in back principal and interest. Our loan notes are worded to not allow partial payments (you either make each periodic payment, or can pay the entire loan off early) Any ideas?

I know there was a post similar to this, but I could not locate it in the distributions and loans area.

Thanks. Maverick

[mbozek]

Well since the loan is in default under Reg. 1.72p-1 Q-10 because the first installment should have been made not later than 6/30/02, your only option is to consider recession of the loan agreement on the grounds that it was never legally put into effect because of the failure to commence withholding as required under the terms of the loan agreement. Then reissue the loan with a new effective date or old effective date and higher mo. payments. You will need to get an opinion of counsel as to why the contract can be rescinded under the tax law and the participant may have to repay the loan proceeds but it is better than a default on inception of the loan.

[R. Butler]

I don't necessarily agree that you can rescind the loan and start over. You possibly could argue that there was no bona fide loan (repayments never began and were never demanded), but as mbozek suggests you should contact counsel to this issue.

If you determine that there wasn't a bona fide loan then the entire amount should be treated as an actual distribution. If there wasn't a distributable event, than I suppose you would treat the same as any improper distribution.

[mbozek]

Why not? Employees have been permitted to recind and repay compensation previously paid duing the tax year without incurring taxation. See Clark v. Comm. 11 TC 672.; rev rule 79-311.The loan can be rescinded on the grounds that the plan admin failed to provide for witholding of the loan as required by the terms of the note.

[R. Butler]

I am not familiar with Clark v. Community, but from the brief facts set forth a tax-qualified plan was not involved, that is a significant factor here.

You may still end up with the same result. The correction for an improper distribution is for the participant to return the proceeds. A new loan may be issued, but it would be totally unrelated to the first loan.

Again, as mbozek points out, consult counsel. An argument may be made that there isn't a bona fide loan, but its not clear to me that thats the case. There are several factors to consider, including evidence of a loan agreement, whether security was provided, etc.

[mbozek]

Application of recession is a judical doctrine not IRS procedure. It is not limited to compensation matters but can apply in any tax situation. Problem is that counsel has to be able to construct argument as to why it applies-- e.g, must be able show substantial authority where there is no precedent. It is not for the risk adverse or faint of heart. It is also expensive.

Recesssion theory is the only way to avoid the taxation of the loan proceeds as a deemed distribution for failure to make loan payments under IRS regs. Otherwise loan is treated as a taxable distribution. If loan is not bona fide then distribution occurs when participant receives funds. I am open to any other ways to avoid taxation of participant for failure to remit loan payments.

[R. Butler]

If the loan was not bona fide it is considered distribution. If the distribution would not have been allowed under the terms of the Plan it is an improper distribution. If the participant repays the improper distribution in full there would be no taxation. A lot of "ifs" though.

[Sandra Pearce]

Since this was an administrative error why can't the correct payment and interest be brought current - no harm, no foul?

[R. Butler]

Probably could have corrected if caught before June 30, 2002, but now we are beyond the cure period. Although Plan Sponsor should have started payroll deductions ultimately some responsibility does lie with the Participant. He/she knew the payments were not being withheld and did not mention anything for 6 months.

[maverick]

Thanks for all your responses. I'll be in Chicago Wed - Fri for Corbel's advanced pension conference, and will talk to an ERISA attorney.

Lesson learned: make sure the company starts taking loan payments.

Thanks again.

[R. Butler]

If you don't mind let me know what they tell you. Its an issue that doesn't arise frequently and always helpful to have as many ideas as possible if and when it does come up.

[mbozek]

rb: Employee has no responsibility for payroll withholding and many payroll services do not make it easy for emplyees to figure out the withholdings.

[R. Butler]

mbozek,

I would disagree that the Participant bears no responsibility, but its irrelevant to the question. Sandra Pearce's question asked whether the loan could just be brought current. I don't see any thing in case law or regs that would allow her suggestion. Even your initial post to this thread suggests that just resuming payments is not an option at this point.

[Gruegen]

The guidance in the Treasury Regulations at 1.72(p)-1, Q&A 10 regarding deemed distributions assume:

1) The 1st and subsequent payments on the loan were made timely;

2) The participant was "mailing in" monthly checks to the plan;

3) The participant made a conscious decision to stop making loan repayments.

However, my understand of the fact pattern of this thread is that:

1) The 1st scheduled payment was never started due to administrative error or oversight;

2) The participant's loan payments were to be made via payroll deduction;

3) It was the failure of the recordkeeper or the administrator to set up the payroll deductions, NOT the participant.

I feel that the participant is essentially an innocent party for a period of time - - the participant has to realize at some point that loan payments were never being withheld from his paycheck, but that could easily be after the cure period has ended.

In my opinion, the consequence of deeming / taxing the loan to the participant is appropriate given the assumptions implicit in the Regulations because it was the participant's decision to stop making repayments. But for purposes of this thread, the remedy of deeming the loan does not seem to "fit" the administrative error of the recordkeeper or administrator.

Although I agree that the Regulations to do not provide alternative remedies other than deeming the loan, I am wondering if anyone has discussed this with the IRS or had any experience with a situation like this under audit. I would imagine that the kindler, gentler IRS would not want to punish participants for the sins of the recordkeeper or administrator.

[maverick]

I asked around at Corbel's Adv. Pension conference last month; no bright ideas for fixing this. Right or wrong, here's what I did (had the plan sponsor direct me to do):

- Prepared a new amort schedule and loan note for the original loan amount.

- Used the same date for the last payment, so the loan will be paid off when the original one should have been.

The participant didn't have the funds to bring the payments up to date, but could afford the higher payments under the new amort.

Based on a couple recent IRS audits, I feel the same way Gruegen does about the new kinder and gentler IRS. One plan was top heavy, but contributions were not made in the past two years. The firm was not in a position to make the top heavy contributions (couldn't even get a loan). The IRS allowed the keys to "remove" their 401k deferrals, thus eliminating the need for top heavy contributions. No penalty/disqualification. Go figure.

Thanks for your responses. Maverick