Participant w/plan loan files for bankruptcy

[Guest Reneeg]

When a participant with a plan loan files bankruptcy, I understand that their plan loan payments stop. How is this handled administratively? Does interest still accrue? Does it stay on the books as a loan until there is a discharge of the bankruptcy? Is there any other option to the participant to start repaying the loan again after the discharge or do they only have the 30 days to pay? Etc.Etc!

[Guest Connie]

I was under the impression that bankruptcy had no effect on plan loans. That only separation from employment would affect repayments.

[Guest]

I also think that a bankruptcy would not affect a participant's loan repayments. Depending on the loan language though, the participant may be able to discontinue the payroll deduction.

[MoJo]

I think the bankruptcy will discharge the participant's obligation to repay the loan (i.e. the creditor plan cannot enforce the loan or attempt to collect it), but that the tax consequences of failing to pay would still occur (it can be deemed a distribution, and then the tax consequences will depend on the debtors situation). Some would say a bankrupt participant would have no tax consequences because the discharge of indebtedness provisions of the Code exempt income from a debt discharged when the participant is bankrupt. Others say the taxation of distributions from plans rules apply, and the deemed distribution is taxable.

The participant could, in the bankruptcy proceeding, reaffirm the debt, and continue to make payments.

[Wessex]

I have very limited knowledge of bankruptcy matters, but my understanding with respect to plan participant loans is as follows:

Once a plan sponsor is aware that the participant has filed a petition in bankruptcy, loan repayments must cease.

The loan will be a deemed distribution for tax purposes once the loan is in default beyond any applicable grace period. The particpiant will be taxed on the deemed distribution, and may be subject also to the additional 10% early distribution tax.

Plan assets are not part of the bankruptcy estate, so the participant is no longer PERSONALLY liable for the debt, but the plan or trustee is still a secured creditor. The loan does not just disappear, it is still an outstanding, defaulted loan under the plan. The participant's account balance remains subject to offset of the outstanding loan balance, generally when there is a distributable event.

The participant could reaffirm the debt in the bankruptcy proceeding, but this is unlikely. After the bankrupty is final, the participant could also voluntarily repay the loan. If the voluntary repayment occurred after a deemed distribution, those repayments would be like after-tax amounts in the plan and not subject to tax upon a subsequent distribution.

[Guest GregSelf]

This may not be of any relevance to this particular issue, but I thought I'd mention it. There has been at least one documented court case (California) in which the court ruled that plan loan proceeds are not exempt from bankruptcy estate. See 'Friedman v. Broach, 220 B.R. 670 (9th Cir. 1998)'.

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[Wessex]

I agree with the court's holding. Once distributed, loan proceeds are not plan assets. I believe there are a number of other cases holding that the Code and ERISA anti-alienation provisions are not applicable to amounts that have been distributed (including monthly pension payments).

[Guest Scizz3]

Is a “Voluntary Petition” enough to stop loan deductions?

[mbozek]

Once the plan administrator has received notice of the petition in bankruptcy by an employee and the plan is listed as an unsaecured creditor the plan must cease taking out payroll deductions as required by the bankrutcy code. However, the cessation of loan payments will result in a default of the loan and a taxable event to the participant. HR should inform the employee of the tax consequences of ceasing loan repayment.

[Mike Preston]

But aren't most plan loans secured? In that case, is there still a requirement to cease payroll reductions?

[KIP KRAUS]

It has always been my understanding (unless something has changed) that plan assets are not attachable by creditors so why would a plan loan that is secured by plan assets in most cases be related in any way to a personnel bankruptcy?

[mbozek]

Because the plan loan is a debt that is owed by the employee to the plan as a creditor under the bankruptcy law and is subject to discharge by the Bkcy ct. Bkcy law is not preempted by ERISA. It is not a question of attachment of the assets which remain in the plan- under the bkcy law the employee can be discharged from having to pay back the loan to the plan. If the employee stops paying off the loan the outstanding balance is subject to taxation.

[jpod]

I do not have the citations in front of me, but the bankruptcy courts have reached the "correct" result when it comes to outstanding plan loans (although they have arrived there by different routes). Namely, the courts will not allow someone to pour money back into his or her plan account through "loan" repayments at the expense of creditors, whether it is an involuntary proceeding or a voluntary proceeding. And, to the extent that anyone would try to defend the economic integrity of a plan loan and argue that the plan is a "secured" creditor, the courts' response, figuratively, is to have a good laugh.

[KIP KRAUS]

Thanks folks.

[Mike Preston]

Jpod, mbozek, do you have any cites for your position? I don't disagree with it on a theoretical level, but I'm having a bit of difficulty on a practical level. What would the trigger be for cessation of payroll withholding? Would the bankruptcy court formally notifying the plan of being an unsecured creditor be required? That is, in the absence of the bankruptcy court formally notifying the plan that the loan is not to be repaid, can the plan stop payroll withholding just because the plan administrator is "aware" of a bankruptcy filing? I would think not.

If my conclusion is correct and the bankruptcy court doesn't formally notify the plan, then the loan continues to be paid.

If my conclusion is correct and the bankruptcy court is intending to formally notify the plan, then it is up to the bankrupt's lawyer to convince the court to exclude the plan from being on the list.

I've known of quite a few bankruptcies and the court has never included the plan loan on any formal list. Hence, the loans have been continued, at the option of the participant, of course. Here, in California, if the employee withdraws their authorization for payroll withholding, most employers will go along with that request, even if it means that the loan is defaulted.

[jpod]

If I can dig out the citations later, I'll post them.

A plan loan is not treated as a debt for bankruptcy law purposes. On the other hand, the individual cannot be permitted to continue to pay money to his or her plan where it would then enjoy the status as excluded property (although most likely a good argument could be made that loan payments made after the bankruptcy filing are not excluded from the debtor's estate).

Obviously, the bankruptcy trustee or the court has to find out out about the outstanding plan loan, but this usually will happen after the trustee gets a look at the individual's pay stubs. Once it becomes known, the employer is directed to stop withholding loan repayments.

Insofar as the adverse tax consequences of a default may be concerned, the bankruptcy courts couldn't care less.

[mbozek]

I have reviewed Ch 7 bankruptcy petitions which list a plan loan as a scheduled unsecured debt. The debtor ( ee)' s atty sends a notice of the filing of the petition to all creditors along with a direction that the creditors are to cease collection of the dept until the bkcy ct hears the case and decides on the settlement of the estate as required under th bkcy law. When the Plan admin gets such a notice I advise suspension of payroll withholding of the loan and notify the ee of the fact the loan default will result in taxation of the outstanding balance. The ee doesn't care about default because he/she no longer has to make payment. Failure to comply with bankrupcty notice to cease collection could be deemed a contempt of ct. Bkcy law is not preempted by ERISA.

I would like to hear explanation of why the loan is not a debt subject to bkcy law since it is an obligation that the emplyee must pay back.

Jpod: in order for the debt to be subject to discharge and ct jurisdiction it must be listed on the schedule of unsecured creditors. The languae of the notice to creditors requires a suspension of the collection of the debt under bkcy law.

Mike I have no list of citations- -- the language of the notice to creditors which is issued in the name of the bkcy ct is enough for me. Remember bkcy law is not premepted by ERISA. Also I have conferred with bkcy attys who concur.

Also only loans listed on the schedule of unsecured creditors are suspended. I once had an employee take out a second loan after filing the bkcy petition. Only the withholding on the first loan was suspended because the second loan was not on the schedule. Was that ee suprised.

I would like to know what other advicie is given to plan admin.

[Mike Preston]

Thanks for the detailed explanation. Everything seems consistent with my understandings. I think the key to this whole thing is that the loan has to be listed and the notice from the bankrupt needs to find its way to the plan administrator. Just having the participant tell the plan administrator that they are going through a bankruptcy isn't enough to automatically cease payroll withholdings.

There must be something about 9th Circuit bankruptcies because I've never had a plan sponsor receive a formal notice.

[Guest ckolodziej]

It is my understanding that the participant is still obligated to pay regardless of the bankruptcy. I am assuming the loan was secured with his vested balance as collateral. If so, if the loan has been in default for 90 days you can issue him a 1099R for the amount of the loan as a deemed distribution - Code L. It will be fully taxable with a possible 10% penalty depending on his age.

When there is an actual distributable event his actual payment will be reduced by the amount of the loan since it is due back to the plan. He will be paid his vested balance less the outstanding balance of the loan - with no accrued interest, I think. It will not be taxed twice so make sure the loan amount is not reported as taxable a second time when he is actually paid out.

WESSEX actually stated the law very well if you haven't already read his or her response. You might want to check that out.

Thanks.

[Guest CMC]

Looks to me like some of this discussion may be out of date. My understanding is that under the Bankruptcy Abuse Prevention and Consumer Protection act of 2005, plan loans are not discharged in bankruptcy and loan repayments can continue.

I'm trying to determine whether a participant that has declared bankruptcy can nevertheless (and notwithstanding the tax and penalties triggered by the resulting default) instruct the plan sponsor to stop withholding loan payments from his paycheck.

(Another way to stop the payments might involving allowing the participant to take a hardship distribution from the part of his account that does not secure the loan, assuming he otherwise qualifies. Seems like he could use that to repay the loan and end up in the same position economically.)

[mbozek]

Looks to me like some of this discussion may be out of date. My understanding is that under the Bankruptcy Abuse Prevention and Consumer Protection act of 2005, plan loans are not discharged in bankruptcy and loan repayments can continue.

I'm trying to determine whether a participant that has declared bankruptcy can nevertheless (and notwithstanding the tax and penalties triggered by the resulting default) instruct the plan sponsor to stop withholding loan payments from his paycheck.

(Another way to stop the payments might involving allowing the participant to take a hardship distribution from the part of his account that does not secure the loan, assuming he otherwise qualifies. Seems like he could use that to repay the loan and end up in the same position economically.)

The bankruptcy amendments act removed plan loans from discharge under the bankruptcy law. There are some special conditions for participants who file under Chapter 13.