Bankruptcy Extending loan beyond 5 years

[Guest Do]

A participant is in Ch 13 bankruptcy. The BK plan is to pay back the loan, but under the terms of the BK plan. The participant's bankruptcy attorney asserts the bk court can modify the terms of the loan by making smaller payments and extending the length of the loan. Our position (I'm counsel to the plan) is that the smaller payments cause the loan to default immediately because payments are no longer substantially equal or default at the end of 5th year by the oustanding amount.

Does anyone know whether BK code prevails or the IRC (that is, 72(p)) prevails? Do you think we need a private letter ruling that says going beyond 5 years does not violate 72(p)?

[QDROphile]

72(p) is absolute. Bankruptcy may be able do whatever it wants with the economic obligation of the borrower to the lender, but tax consequences can't be changed.

Perhaps the word "default" is causing confusion.

[Guest Do]

No, the word default isn't causing the confusion. Lack of legal authority is causing confusion. I need a case or statute that says the BK Code cannot cause a violation of the Tax Code or Treasury Regulations.

[QDROphile]

The changes to the debt payment obligation that can be required under the bankruptcy code can cause the loan to be treated as a deemed or offset distribution for tax purposes.

You will not find any authority that says that the bankruptcy reorganization is restrained by 72(p) and you will not find any authority that gives relief from 72(p) because of a bankruptcy reorganization. Both statutory schemes can operate. The tax consequence to the borrower is unfortunate, but that does not mean one scheme has to yield to another. The unfortunate consequence to the borrower is an argument to have the loan treated differently in bankruptcy, but the bankruptcy courts are almost never swayed.

[Guest Do]

Thanks QDROPhile. I'll stop looking for authority.

I thought of something last night. At the end of the 5th year, the outstanding amount is defaulted, treated as a deemed distribution and the participant gets a 1099. Even though the outstanding amount is defaulted, the participant can still make payments on the outstanding amount. The participant's attorney can seek an agreement with the IRS whereby the IRS allows the participant to ignore the 1099.

I know the IRS makes exceptions to the income tax rules for bk situations all the time. This way, the plan does what it is supposed to do and the IRS makes a deal with the participant that doesn't involve the plan.

How's that sound?

[QDROphile]

Generally I agree with the outcome you describe, except I have nothing to say about what the individual can do to get relief from the income reported on Form 1099. Taxation of the particpant is not the plan's concern. Proper reporting of distributions is the plan's concern. Compliance with the bankruptcy order is the plan's concern.

I still go back to the term "default." Because the debt obligation is reformed, as long as the particpant makes payments on the loan under the reformed schedule, the loan is not in default. Once the payments fail to comply with section 72(p), for example because they fail to pay the loan completely within five years, there is a distribution for tax purposes. The particpant can go on paying the loan and the plan cannot accelerate the obligation. Watch out for basis in the plan because of the later payments.

I am surprised that the particpant has not already had a deemed distribution. Usually loan payments are stayed upon filing of the bankruptcy and the loan fails to comply with the quarterly payment requirements before the debt is reorganized.

[Guest Bud]

The other side understands that the default/deemed distribution occurs at the end of 5 years. That the reason for extending the period. No deemed distribution yet because some payments are coming in. It continues to be in arrears and the amount that he is behind continues to grow.

[jquazza]

Bud, I disagree, if the payments are not in concordance with the amortization schedule, the default could occur much sooner because 72(p) requires level amortization payments. So, unless the participant refinances the loan, he will not meet the exemption of 72(p).

Now, if the laon is deemed distributed (and not distributed,) you should be able to apply the Bankruptcy payments to the defaulted loan which would create a basis for the participant.