What should happen with loans when participant comes out of bankruptcy

[John A]

When a participant with an outstanding loan from a 401(k) plan discontinues loan payments because of

1) bankruptcy (bankruptcy court not allowing loan payments to be made to plan), or

2) approved leave of absence,

what are acceptable choices when the participant

1) is out of bankruptcy, or

2) returns from leave of absence?

Should of can loan payments be "doubled up" to "catch up" on the loan so the loan is repaid within the amortization schedule? Should or can the loan be considered in default? Should or can the loan be reamortized? Can participants coming out of bankruptcy be treated differently from participants returning from leave of absence?

[k man]

I am faced with a similar issue and I believe that once the grace period passes, the loan must be declared in default and the participant should receive a 1099 for the deemed distribution.

[Guest Bob Collins]

K Man has a point. Once the loan goes into default the plan should treat the loan as a taxable event and then a 1099R should be issued. Generally the requirement to pay the loan off will no longer exist. If the participant makes loan payments after a deemed distribution, the money should be treated as going into an after-tax account. This will cause administrative problems for the plan.

[pjkoehler]

To properly analyze this you'll have to understand the difference between a "deemed distribution" and a "plan loan offset," which are concepts covered in the proposed regs sec. 1.72(p)-1 et seq. In this case, it sounds like the employee has not separated from service and persumably doesn't otherwise qualify for a distribution under the 401(k) distribution restrictions. For tax purposes, the plan will have failed the level amortization requirement at the expiration of the grace period and, therefore, the outstanding principal plus accrued unpaid interest is includible in the employee's gross income and reported on 1099R as a "deemed distribution" but not as an actual distribution. See Prop. Reg. Sec. 1.72(p)-1, Q&A-9 and Q&A-13. However, because this is a 401(k) plan, assuming the loan was secured by the employee's elective deferrals, the plan cannot payoff the loan by executing upon the collateral, viz. the participant's deferral account. That is treated as the distribution of a "Plan loan offset," i.e. an actual distribution that violates 401(k)'s distribution restrictions. You'll have to maintain the loan as a nonperforming asset of the participant's account until he becomes entitled to a distribution under the plan, at which time he will receive, in the case of a lump sum distribuiton, cash plus the nonperforming note, with respect to which he has tax basis to the extent of the prior deemed distribution (i.e. it's a wash).

[This message has been edited by PJK (edited 04-27-2000).]

[Guest EDS]

For leave of absences, you should look at the proposed reg to see how it applies to your situation. Generally, with respect to an unpaid (or paid, if paid at a rate less than the amount of the installment payments) leave of absence, see Q&A 9 in Prop. Reg. 1.72(p)-1. Payments may be suspended, then reamortized after a leave of no longer than one year, or made up in a lump sum at the end of the loan's term. But the loan may not extend beyond the statutory max period. There is an example under that Q&A

[k man]

I think it is critical to understand that leave of absences and military service are treated differently than bankruptcies.