Loan Default Prohibited Transaction?

[Guest NiceGuyMike46205]

I've had a couple of situations in which a participant decides to just stop making payments on the loan, recognizing that it will be considered a deemed distribution.

What I'm not sure about is whether it is also a prohibited transaction.

Does it make a difference if the plan does not permit in-service withdrawals?

Does it make a difference if the participant is not a party-in-interest?

I'd been taught previously that this would be a prohibited transaction because (a) they are no longer following the loan provisions by not making payments quarterly, and (b) the plan does not permit in-service withdrawals, so it can't be recharacterized/offset. My co-worker says differently.

Which of us is correct?

[namealreadyinuse]

It is a deemed dist., not an actual dist.

There should not be any prohibited transaction or violation of plan terms if the offset is not made until a distribution event.

[E as in ERISA]

I think it's essentially a PT but the only thing that is done about it is that the fiduciary continue to try and collect it. I think it used to be reportable on an audit chedule as a non-exempt transaction. But I don't think that's done anymore.

[Disco Stu]

...but the only thing that is done about it is that the fiduciary continue to try and collect it.

Most loan programs I've seen require repayment via payroll deduction. If this is the case in this instance, what leverage does this employee have to make his employer cease the payroll deduction for the loan repayment?

[Belgarath]

I do not believe it is a prohibited transaction. The PT exemption requires only that the loan be a bona fide loan when made. The fact that it subsequently defaults should not, IMHO, give rise to PT status.

Now, if it is to a "disqualified person" I expect it might be scrutinized more carefully to determine if it is a bona fide loan in the first place, particularly if no payments at all were made. And the regulations provide that if it isn't a bona fide loan, it isn't a deemed distribution but an actual distribution, and then the PT comes into play. But, for example, assuming everything clean, and payments made regularly for 2 years, then his business goes sour and he can't pay and defaults on the loan, I don't see that this is a PT. It's funny, because I had this precise question yesterday, so just spent some time looking into it yesterday morning.

[namealreadyinuse]

what leverage does this employee have to make his employer cease the payroll deduction for the loan repayment?

I don't think that the DOL (or court) has ruled on preemption of state payday laws. I have always assumed that a participant could withdraw or repudiate her written authorization for payroll deductions and, depending on what state they are in, the employer would really have to look at the preemption vs. payday law issue carefully.

[QDROphile]

Assignment of wages avoids the payroll deduction question, but most plans consider it too much trouble, if they ever thought about it in the first place.

[Kirk Maldonado]

Belgarath:

Am I interpreting your post as indicating that you believe if the person had no intention of repaying the loan when he or see obtained the funds from the plan, then it would be a prohibited transaction?

(That is my position, without doing any research on this point.)

[Belgarath]

Kirk - yes, that is my position. 1.72(p)-1, Q&A-17 is pretty clear on this issue. Now, presumably the determination of whether or not there is a bona fide loan is quite subjective and subject to a facts and circumstances determination, but I'm guessing that a loan to a "disqualified person" is likely to be scrutinized more closely than to a regular rank and file employee.

[Kirk Maldonado]

Belgarath:

To be hyper-technical, the language you cited only specifically relates to the taxability of the loan; not to whether or not it is a prohibited transaction. But I agree that it is a prohibited transaction in these circumstances and that language is indirect support for that position. Here is the language you referenced:

Q-17. What are the income tax consequences if an amount is transferred from a qualified employer plan to a participant or beneficiary as a loan, but there is an express or tacit understanding that the loan will not be repaid?

A-17. If there is an express or tacit understanding that the loan will not be repaid or, for any reason, the transaction does not create a debtor-creditor relationship or is otherwise not a bona fide loan, then the amount transferred is treated as an actual distribution from the plan for purposes of the Internal Revenue Code, and is not treated as a loan or as a deemed distribution under section 72(p).

[Belgarath]

Kirk - good point, and I agree with your observation.

[Guest NiceGuyMike46205]

Many thanks to those who answered. It's been a while (before lately) that I've had to deal with it, so it's likely I had to report this kind of thing before. We ended up not considering it a PT and telling the sponsor that they are technically still responsible to collect until there's a distributable event. Also, they can consider this if/when the participant applies for a new loan, since creditworthiness is one of the bases of availability under their plan. If someone can't afford to make the payments, they're probably not creditworthy.