Risk in accepting a loan payoff (pre-tax) for a loan that should have been deemed?

[FundeK]

Scenario: Participant's loan fell behind in payments, and is past the cure period. Loan has not been "deemed" on the recordkeeping system. The participant would like to payoff the loan, without paying it back as an after tax payment. The employer does not want the participant to face the tax consequences, so asks that the pre tax loan payment be accepted. In most cases like this that I encounter, the employer made an error and stopped the payments too early, or stopped payments in the middle of the loan.

What is the risk in accepting a loan payoff (pre-tax) for a loan that should have been deemed? I realize that it is an operational failure, but what position do you think the IRS/DOL would take? They do want participant's balances to remain pre-tax don't they? Especially if it is the fault of the employer?

Thanks

[QDROphile]

I imagine that the IRS would like to see compliance with section 72(p), especially since the regulations for cure of late payment are very generous. I think neither the IRS nor the DOL and IRS are fond of loans and view compliance with the exceptions that allow them as important. Your fate with any particular agent is unpredictable and probably depends on all facts and circumstances. For example, if the borrower is the owner of the sponsor, I would be worried. I did not check, but I think the penalty for willful failure to issue a Form 1099-R is outside the otherwise small penalties.

Why are you trying so hard to do what is wrong?

[FundeK]

Why are you trying so hard to do what is wrong?

Personally, I think the loan regs are very clear and don't have much wiggle room. They certainly don't allow for "correction due to administrative error". I believe that if the Plan Sponsor is adamant not have the participant face the taxation, they (Plan Sponsor) should pay the taxes and have the loan deemed.

However, I was asked to define the risks in accepting a pre tax payment on a loan that is in a deemed status.

[maverick]

Maybe I'm missing something here, but since when are loan payments made on a pre-tax basis?

[FundeK]

I am sorry, I am miscommunicating. I meant that the loan payments are applied to the loan to maintain it's pre-tax status. The participant is actually using after tax funds, but the loan payments do not create basis. If the loan payments were applied to a deemed loan, they would create basis.

[Guest hyper]

We have approached the IRS on an anonymous basis with the scenario you describe. ER incorrectly stopped withholding loan repayments and participant is beyond cure period. ER explained the error was not the EE's fault and ER proposed restarting loan repayments again to pay off the loan.

IRS said tough noogies, EE has a responsiblity to keep track of the loan and ER has responsiblity as well. Must deem the loan defaulted and EE must be taxed.

Your results may vary.

[david rigby]

Scenario: Participant's loan fell behind in payments, and is past the cure period. Loan has not been "deemed" on the recordkeeping system.

So what if not "deemed" on the recordkeeping system. Is the loan "deemed" by the terms of the plan?

[Guest 401der]

Remember, it's not the employer or the employee who "deems" the loan a taxable distribution - it is the IRS. Just as with the plan asset rules where the IRS "deems" amounts as trust assets subject to fiduciary standards at a certain point regardless of whether or not they have been formally deposited into the trust account, the IRS "deems" a loan as a taxable distribution at the end of the cure period. Failure of the plan to prudently administer loans and report such taxable events jeopardizes the plan's loan program and ultimately its qualification and could subject the plan fiduciaries to additional scrutiny.