At what point is the "substantially level" loan repayment re

[John A]

I've talked with some other TPAs and there seems to be some disagreement over what would be a violation of the "substantially level" loan requirement. Would any of the following be a violation:

1) A person making loan payments of $200 per month decides to start making loan payments of $400 per month to pay the loan off faster.

2) A person making loan payments of $200 per month makes a one-time additional payment of $2000 and then resumes making payments of $200 per month until the loan is paid off.

3) The promissory note and amortization schedule are written to provide that payments will be $200 per month for 3 years and $500 per month for the final year.

Are there court cases or other guidance that show instances where there has been a violation?

What are the consequences if there is a violation?

[pjkoehler]

Code Section 72(p) governs the tax treatment of the proceeds of a loan from a "qualified employer plan." One of the requirements is that the form of the loan (i.e. the terms of the promissory note) must provide for "substantially level amortization." A loan that by its terms did not satisfy all of the exception requirements to the general rule set forth in section 72(p) is treated as an actual taxable distribution of the entire loan proceeds, regardless of whether the loan is respected as a binding contract by the parties (plan/lender and participant/borrower)and a default has not occurred. As such it can be a disqualifying defect in the operation of the plan. Level amortization is a form requirement imposed by Code Section 72(p) as an exemption requirement. On other hand, a loan that by its terms met the level amortization requirement (and all others at the time it was made), will be treated as a "deemed distribution" in the taxable year in which the participant/borrower fails to cure a previous default in accordance with the terms of the note, because this violates the level amortization requirement in operation. The proposed regs provide a special exception in the case of leaves of absence. See Prop. Reg. Sec. 1.72(p)-1, Q&A-9.

Cases #1 and #2 of your question turn on whether the note itself permitted this accelerated payoff. So long as the loan documents required level amortization, but permitted such prepayments, it certainly wasn't an actual distribution, i.e. a bad loan from day one, and you can reasonably argue that it's not a "deemed distribution" either merely because of the accelerated payoff. However, if the loan documents don't provide this, then, in addition to a "deemed distribution" to the participant, you have a new problem. The loan and the loan policy under which it was issued are generally treated as governing instruments of the plan. Any deviation from them raises plan qualification issues, regarding the operation of the plan in accordance with its terms. Case #3 appears to be a slam dunk violation of the level amortization requirement, i.e. a bad loan from day one and therefore, it would be treated as an actual distribution when the proceeds are made available.

[This message has been edited by PJK (edited 05-04-2000).]

[This message has been edited by PJK (edited 05-04-2000).]