Failure of Plan to deduct loan repayments from employees pay

[Guest tscher]

A participant receives a loan from from his 401(k) Plan 2001.

The loan re-payments were to commence for 120 pay periods (5 years).

However, the Plan has not deducted the repayment amount from the individual's payroll until 2 years after the loan re-payments were to commence.

In this case, should the Plan receive the total repayment amount and interest amount for the period from the participant?

Should the Plan receive the only repayment amount for the period from the participant?

Or is there another alternative?

[FundeK]

The loan needs to be deemed and a 1099-R mailed to the participant. Any payments the participant makes on the deemed loan are after tax and will create basis.

[Brian Gallagher]

Plus, the participant must pay back the loan plus imputed interest (even after it was deemed) should she/he would like to take another loan from the plan.

[Harwood]

Is the employer at fault for not making deductions? Some prior thread discussed possibilities in that scenario.

[Brian Gallagher]

I thouhgt I remembered reading something recently that a court judged that it is a two-way street. The participant should have noticed that the loan payments were not taken. The court upheld that the loan should have been deemed.

[FundeK]

TAX COURT REFUSES TO ACCEPT EXCUSES FOR NOT REPAYING PARTICIPANT LOAN

[Leonard v. Comm'r, T.C. Summary Opinion 2004-11 (2004)]

For a copy: http://www.ustaxcourt.gov/InOpHistoric/Leonard.SUM.WPD.pdf

The participant in this case received a loan from a qualified plan in

June 2000. Due to a transfer that same month to a different operating

division of his employer, no loan payments were ever taken out of his

paychecks. Because no payments had been made by the end of the year,

the loan was declared to be in default and a Form 1099-R was issued,

reporting the entire amount of the loan as a taxable distribution. (As

a general rule, a participant loan from a qualified plan will be

treated as a taxable distribution unless the loan complies with the

requirements of Code Section 72(p). Among other things, the loan must

be repaid within five years unless used to purchase a principal

residence, and substantially equal payments must be made at least

quarterly.) When the participant failed to include the amount of the

loan in his taxable income for the year, the IRS issued a notice of

deficiency and assessed additional taxes against the participant,

including a 10% early distribution penalty under Code Section 72(t).

The participant argued in tax court that he had not received a "deemed

distribution" because he had not received the quarterly plan account

statements that were mailed to him after his transfer, a letter that

requested him to remit the delinquent loan payments, or the Form 1099-R

that was later issued to him. (For a time, the participant's address

was not correctly recorded in the plan's records.) But the tax court

held that none of this mattered. The participant had not made any loan

payments from the time he received the loan through the end of the

year, more than two quarters later. As a result, the quarterly

repayment requirement had been violated, and the loan therefore

constituted a deemed distribution. Furthermore, on the facts of the

case, there was no exception that would prevent the application of the

10% early distribution penalty.

[mbozek]

How do you reconcile the payments that have been made for the last year with the taxation of the loan as of a date two years previous? Taxing employee will expose employer to claim for tax liability of employee as well as claims under state labor law for back wages and penalities because payments were not made to pay a loan under ERISA. The ct case can be ignored because it is not precedent under tax law. Best case is to continue accepting the loan repayments and take the audit risk. Statute of limitation for taxes on loan may expire as early as 4/14/05.

[R. Butler]

mbozek,

I follow the tax claim against the employer, but what possible basis is there for back pay? The employee got paid, it just went to him instead of the plan.

I've debated this before on prior threads. I strongly disgree that there is any basis for not defaulting this loan.

[FundeK]

How do you reconcile the payments that have been made for the last year with the taxation of the loan as of a date two years previous? Taxing employee will expose employer to claim for tax liability of employee as well as claims under state labor law for back wages and penalities because payments were not made to pay a loan under ERISA.

I am sorry, but I am confused by the question.

The loan should be deemed now and issue a 1099-R for 2004. The payments that have been made should be reclassified as after-tax because they are now payments made to a deemed loan. Just because the "deeming of the loan" was not processed on the recordkeeping system doesn't mean the loan didn't fall into a "deemed status". The participant took the loan, signed the agreement to repay, and never paid. They have some liability here. Did they think they hit the jackpot, got money out of the plan, and would never have to repay it?

[mbozek]

The issue is not whether the participant has some liability for not notifying the employer because payments were not withheld. The issue is how the plan can retain the payments made by the employee since a loan that has been deemed in default is considered to be distribuated and the employee is taxed on the balance as of inception. Assume that the 5000 ee borrows is deemed in default. Employee makes payments of 1000 to pay off the loan. Since the loan is in default and the 5000 is taxed the 1000 is not a payment under the loan hence the employer has violated state labor laws. The payments cannot be counted as after tax contribution to the plan because the employee never agreed to make such after tax contributons.

[E as in ERISA]

ERISA requires a plan administrator to collect a loan -- regardless of whether the loan has been deemed under IRC 72(p) or not.

[R. Butler]

The issue is not whether the participant has some liability for not notifying the employer because payments were not withheld. The issue is how the plan can retain the payments made by the employee since a loan that has been deemed in default is considered to be distribuated and the employee is taxed on the balance as of inception. Assume that the 5000 ee borrows is deemed in default. Employee makes payments of 1000 to pay off the loan. Since the loan is in default and the 5000 is taxed the 1000 is not a payment under the loan hence the employer has violated state labor laws. The payments cannot be counted as after tax contribution to the plan because the employee never agreed to make such after tax contributons.

Thank you for the explanation. I still say its a stretch to argue a state labor law violation. The $1,000 would still be a loan repayment, just a repayment on a defaulted loan. Although the end result is the similar, the employee is not making an after-tax contribution; he is repaying the loan. The employee agreed to repay the loan. The employee is repaying that loan late, as a result its deemed after-tax money. I'm skeptical that a court would give the employee a windfall.

I'm curious if the original poster would be willing to tell is the amount the initial loan amount. Unless this just a very large loan, I'd be surprised if the employee will consider litigating issue.

[E as in ERISA]

From footnote 3 to the 2000 proposed loan regulations:

\3\ The Department of Labor (DOL) has advised the IRS that... the administration of a participant loan program involves the management of plan assets. Therefore, fiduciary conduct undertaken in the administration of such a loan program must conform to the rules that govern transactions involving plan assets. In particular, a loan program must be administered in a prudent manner, solely in the interest of the participants and beneficiaries, and for the exclusive purpose of providing benefits to participants and beneficiaries. ...In the view of DOL, it is questionable whether a participant loan program of a plan covered by Title I of ERISA that does not provide for timely repayment of loans (through payroll withholding or otherwise), REGULAR AND EFFECTIVE COLLECTION EFFORTS FOLLOWING A DEFAULT, and adequate security for the plan in the event of default would be in compliance with the rules applicable under Title I of ERISA to transactions involving plan assets. In the view of DOL, it is also questionable whether such a program would qualify for the relief provided under section 408(b)(1) of ERISA. See Preamble to 29 CFR 2550.408b-1.... A fiduciary must take steps to ensure, inter alia, that such a loan is bona fide and not a mere transfer of plan assets, that the loan is adequately secured, and that the plan's assets will be preserved in the event of default. See Preamble to 29 CFR 2550.408b-1, (54 FR at 30521).

[Harwood]

http://benefitslink.com/boards/index.php?act=ST&f=20&t=25199

[FundeK]

The issue is not whether the participant has some liability for not notifying the employer because payments were not withheld. The issue is how the plan can retain the payments made by the employee since a loan that has been deemed in default is considered to be distribuated and the employee is taxed on the balance as of inception.

I would have to respectfully disagree. The issue is that the participant did not commence payments, therefore, under IRS regulations, the loan must be considered a taxable distribution.

a loan that has been deemed in default is considered to be distribuated

The treatment of a loan as a deemed distribution is solely for tax purposes, and the loan obligation is not satisfied until the participant repays the loan or the loan is offset, which can only occur if there is a distributable event. The outstanding deemed loan continues to accrue interest, and is taken into account for purposes of applying 72(p)(2)(A) loan limits (See Treas Reg 72(2)-1, Q19)

the employee is taxed on the balance as of inception.

2004 ERISA Outline Book, Chapter 15: Tables, Checklists, and Quick Reference Guides -Section VI (Plan disqualification and IRS resolution options): Part B.¶1 (EPCRS: general information)

Failures involving participant loans. Section 6.07 of the EPCRS Procedure provides that, as part of VCP, a plan may correct failures relating to participant loans from a qualified plan or section 403(b) plan. If the loan is to be treated as a deemed distribution, pursuant to IRC §72(p), the distribution may be reported on Form 1099-R for the year of correction with respect to the affected participant.

[R. Butler]

That is a well organized reply FundeK

[Guest tscher]

Re: RButler's Question: The initial loan amount was $6,698.00