Loan limit exceeded, what to do?

[FundeK]

Can anyone provide a cite or a reference that would detail how to handle a error where the participant's # of outstanding loans exceed the terms of the loan policy? For example, loan policy allows 2 loans, participant recevies 3.

I am trying to type up acceptable correction methods for various scenarios, but would like to provide cites and/or PLR or something to support my policies.

I have posted about this issue in a prior post and in that situation decided to deem the third loan. Would you view each scenario differently and either consolidate, allow the participant to pay off the extra loan, or deem the loan? Or, is there one correction method that should apply in all circumstances?

[QDROphile]

Please explain.

I infer that "deem the loan" means that you treat the balance as a distribution for tax purposes. Section 72(p) governs tax consequences. I don't recall seeing an excess number of loans as failure under section 72(p). The loan amounts are another matter.

If you take the position that the loan policy terms are effectively plan terms (see ERISA Reg. section 2550.408b-1(d)), you may have plan disqualification and a prohibited transaction if the terms are violated. Disqualification of the plan has tax consequences, but not specifically with respect to the errant loan. Prohibited transactions ultimately have tax consequences, but I don't think treating the loan as distributed is one of them.

[Mike Preston]

I don't have time to look this up, but if a loan fails to operate under the terms of the plan and therefore is a prohibited transaction, doesn't it also lose deferral under 72(p)? Hence, wouldn't it be the same tax consequences for the individual as if a non-problematic in the prohibited transaction sense was defaulted?

[FundeK]

Please explain.

I infer that "deem the loan" means that you treat the balance as a distribution for tax purposes

Yes, I meant that we treated the balance as a taxable distribution. In the situation I had before, the third loan actually caused the participant to exceed the 50% limit as well as the # of plan loans allowed. In that case, I felt comfortable that the proper correction was to "deem" the loan.

Now, as I am creating procedures and policies, I am not sure how to handle a loan that exceeds the maximum number allowed, but does not exceed the 72(p) limits. I thought maybe I could use the same logic that when a limit had been exceeded, whatever amount that caused the limit to be exceeded should be treated as a "deemed distribution".

I do think the additional loan is a prohibited transaction, and I am not sure how it would be corrected. I read in Trea. Reg. 1-72(p)-1, Q&A 16 that deeming a loan does not correct the prohibited transaction. This of course makes sense in this situation because a deemed loan is considered an outstanding loan for all loan limit purposes so deeming the third loan wouldn't solve anything as you would still have 3 loans outstanding! Can you consolidate with another loan if the loan policy allows? Can you "reclassify" as a distribution if the document allows?

Do you think a plan should file indicating there is a prohibited transaction if a participant accidently recieves one too many loans?

[No Name]

I've always regarded a loan policy or procedure as outside the four corners of the plan document.

[Mike Preston]

Even if they put it in the document?

[Harwood]

Isn't the policy considered to "forming part of the plan," no matter where it is?

2550.408(b)-1(d)

(2) For participant loans granted or renewed on or after the last day of the first plan year beginning on or after January 1, 1989, the participant loan program which is contained in the plan or in a written document forming part of the plan includes, . . .

[TBob]

Our prototype document says that " A Loan Policy the Plan Administrator adopts under this Section XX.XX is part of the Plan...". I have always understood this to be a part of the plan document.

[Guest M. Martin]

http://benefitslink.com/modperl/qa.cgi?db=qa_plan_defects&id=113

APRSC Correction of Improper Participant Loan

Question 113: A reader asks: "What is the correction under APRSC for a 401(k) plan that, pursuant to its written loan policy, limits participants to no more than two outstanding loans at one time, but the plan administrator in fact allowed several participants to have three loans outstanding at one time?"

Answer: Making loans contrary to a plan's written loan policy is a failure to operate the plan in accordance with its terms and, as such, is an operational failure described in Section 5.01(2) of Rev. Proc. 98-22. If the IRS were to audit the plan and discover this error, it could seek to disqualify the plan on the basis that the failure violates the definite written program requirements of Code §401(a) and Treasury Regulations §1.401-1(a).

Under Parts IV and V of Rev. Proc. 98-22, operational failures can be voluntarily corrected under APRSC without IRS involvement, assuming the plan meets the eligibility requirements of that program (see Q&A #90 for a discussion of those requirements).

The most conservative and, therefore, safest approach to correction under APRSC would be to ask the participants to repay the third loan. The repayment should be documented, preferably in plan committee minutes, as a correction under APRSC; the documentation should also state the steps which the plan administrator has implemented to insure future compliance with the plan's loan policy.

For any participant who refuses or otherwise fails to repay the loan, then, if the plan provides for in-service distributions and one of the circumstances allowing for in-service distributions has occurred (e.g., the participant has participated for a fixed number of years, reached a stated age, become disabled, retired or died), the plan could correct under APRSC by distributing the loan to the participant as an in-service distribution. (Of course, proper consent would be required if the present value of the participant's vested account balance exceeds $5,000.) To the extent the loan consists of elective deferral amounts, the in-service distribution could be made only upon the occurrence of the events indicated in Code §401(k)(2)(B), including hardship, if the participant's circumstances qualify for hardship under both the Code and the plan's hardship provisions. (NOTE: It is possible that the IRS would be willing to allow the plan to treat the loan as an in-service distribution, even in the absence of a plan provision allowing for such distributions. This is true because to require otherwise might put the plan sponsor in a position of having to correct by contributing to the plan the amount necessary to pay off the loan, which would result in a windfall to the participant. However, because of the uncertainty regarding this approach to correction, we suggest that it be pursued in conjunction with the filing of a VCR application.)

As an alternative to correction under APRSC, the plan sponsor could file an application under Walk-in CAP and request that the plan be retroactively amended ("reformed") to provide for three outstanding loans, rather than two. Support for this method of correction is found in Rev. Proc. 98-22, §4.05(2). However, correction of this defect under Walk-in CAP is by no means guaranteed, since it may be that the IRS would require the plan sponsor to establish that three outstanding loans were always intended under the plan and/or the equities of the case justify correction by "reformation." In addition, the plan sponsor would have to establish that the retroactive amendment satisfies Code §401(a) on a current and retroactive basis, which includes making certain that no participant had ever been denied a third loan. (See Rev. Proc. 98-22, §4.05.) As a word of caution, the initial contact with the IRS under reformation Walk-in CAP should always be made on a "John Doe" or anonymous basis, since the IRS reserves broad discretion for granting — or not granting — relief under that program

[FundeK]

M. Martin - This is great!!!! This is exactly what I was looking for. I did a search in the Q&A columns, but I did not read them back to 1999. I am so glad you did! Thanks!

One more question for all of you experts.....

If a participant receives a third loan (loan policy only allows 2) and that loan causes the total outstanding loan balance (1+2+3) to exceed 50% of the account balance, which correction method would be appropriate? 72(p), or the one M. Martin posted?

[QDROphile]

If the loan violates the limits under 72(p), the loan is taxable in accordance with section 72(p) and probably is a prohibited transaction. If it violates plan terms, then it becomes a qualification problem. Each is a separate matter. You can have all three and have to deal with the consequences of all three. One correction does not solve all problems.