Defaulted loan loses 4975(d)(1) prohibited transanction exemption?

[AndrewZ]

We have a 401(k) plan being audited by the IRS, where one of the owners defaulted on his loan. We issued a 1099-R in 2003 in accordance with 72(p), but kept the loan on the books as there was no distributable event (the participant is still employed and is under age 59 1/2). IRS agents are telling me that they treat participant loans lose the P/T exemption under 4975(d)(1) once they go into default. However, I can't find anything to support this in the regs--4975(d)(1)(E) says the loan must be "made in accordance with the plan's terms" which it was - the participant just didn't comply with the loan terms. Our agent directed me to 1.72(p) Q&A 16 stating that taxation of a defaulted loan that is a P/T doesn't correct the P/T, but that doesn't state that the default status creates a P/T.

The agent is requiring that the loan principal and accrued interest be repaid in order to fix the P/T. What happens when a participant refuses to make payments - would the employer be subject to P/T excise taxes each year forever? This case is different, because the participant is an owner and will be partly responsible for P/T taxes, but there's no distinction in 4975(d)(1) between owner and non-owner participants.

Does anyone have experience dealing with the IRS on this issue?

Thanks

[Additional clarification]

Payments were originally made in accordance with the loan's terms, then stopped due to financial difficulty. Additionally, the loan fully complied with the plan's loan program and was bonafide when issued.

[namealreadyinuse]

If no payments were never made, or if circumstances indicated that there was no intent by participant to treat loan as a vaild debt, the PT sounds possible. Otherwise, they may be confusing the Section 72 repayment requirments with 4575.

[Belgarath]

I agree that a bona fide loan where there is a subsequent default does not, in and of itself, create a PT. If this is what the IRS agent is saying, then you need to push back.

However, not having all the facts at hand, it is possible that the IRS agent is really asserting that there was no "bona fide" loan - just as an example, if an owner takes a loan without proper documentation, or there's no effort to repay it, etc. - which leaves some discretion to the agent - then it is possible that there's a legitimate PT here.

Well, Ok, I hadn't seen Name's reply, which I just noticed. Yup.

[J Simmons]

I don't think it would be the employer that would be subject to the P/T excise taxes, but if anyone is, it would be the owner who defaulted on the loan. That's the disqualified person dealing with the plan (without an exemption, at least per the IRS stance you describe). IRC sec 4975(a).