Missed loan payments; when does deemed distribution occur?

[LCARUSI]

I am working with two clients with a similar problem. They both have a 401(k) Plan with a loan provision. They have both made isolated errors in that they neglected to take loan repayments for a couple of participants. The periods of nonpayment vary from 2 months to almost one year.

Counsel for one sponsor has said it is not necessary to default the loans as long as they can get the participant caught up on repayments within a five year period (measured from the original loan date).

Counsel for the other sponsor says failure to make repayments is a default - regardless of how or why it happened.

I would really appreciate anyone else's thoughts or comments on this issue.

[Dave Baker]

By default, do you mean treating the loans as a taxable distribution?

The 1995 proposed regulations on plan loans are on BenefitsLink at http://www.benefitslink.com/taxregs/72p.shtml (click) -- here's da bad news for the participant who's a year overdue, from the "preamble" to those regs:

quote:

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If the repayment terms of a loan are not satisfied after the loan has been made due to a failure to make a scheduled loan repayment, the proposed regulations provide for the balance then due under the loan to be deemed to be distributed. The proposed regulations permit a grace period, to the extent the grace period does not extend beyond the end of the calendar quarter next following the calendar quarter in which the repayment was scheduled to be made.

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The participant who's only 2 months behind needs to move quickly!

[This message has been edited by Dave Baker (edited 08-26-98).]

[This message has been edited by Dave Baker (edited 08-26-98).]

[david shipp]

What position do service providers take when the plan sponsor says "even though we are past the grace period for nonpayment, reamortize the payment amount so that it is paid off within the original 5 yr. period from this point forward."

Is the answer different if the service provider is responsible for 1099Rs on benefit payments?

[Casey]

I am dealing with the same issue. I had concluded I would need to default those loans that were over the grace period late, but what amount gets defaulted for those really late loans, like the first writer mentions [one year late...]?

Can someone clarify the date on which to stop counting interest in the example below. Thanks.

Example: A takes a loan from a 401(k) plan on 1/1/96 and begins making weekly payments, but

then stops on 8/1/96. A's grace period is over on 12/31/96 at which time his outstanding balance is

$5000, but the administrator takes no action. On 8/1/98, administrator decides to issue a Form

1099 for the "deemed distribution". Should administrator issue a Form 1099 for the $5000 [amount

which was in default on 12/31/97]OR should administrator accrue and add the amount interest from

12/31/97 to the date administrator issues the Form 1099?

If you think the answer is $5000, would your From 1099what year would it be [1998 or 1996].

All thoughts appreciated

[LCARUSI]

This is in response to Casey's message:

My response is based on the proposed loan reg 1.72(p)-1:

1) The participant should receive a 1099-R for $5,000. Interest that accrues after the deemed distribution is disregarded for tax reporting purposes.

2) Interest should accrue on the loan for other purposes - such as calculating the maximum loan amount available for future loans.

3) I'm not sure what year the 1099-R should be issued for. I would make an argument for 1997. The grace period ends on 12/31/96, so you default the loan on January 1, 1997. This seems reasonable - and creates less havoc for the participant than issuing a 1996 1099-R. I guess the participant would prefer a 1998 1099-R but I can't justify doing that.

[Casey]

Thanks for you response, LCarusi. I still feel a bit uncertain about when a "deemed distribution" occurs. Is there anything in the regs or elsewhere that makes it clear that "deemed distribution" means the date that the loan is past due (and grace period is over) rather than the date the plan sponsor takes action to treat the loan balance as taxable distribution?

Thanks,

[LCARUSI]

Casey, I think it's pretty clear from either 1.72(p) or 1.72(p)-1 that a deemed dsitribution occurs as a result of failure to make timely repayments. So, it is based on the end of the grace period and not when the Sponsor gets around to taking action. That would imply the sponsor could control timing of the deemed distribution.

[This message has been edited by LCARUSI (edited 09-01-98).]

[Guest TMRobinson]

I agree that 72(p) defines when a deemed distribution has occurred. I would caution all administrators on relying on the IRS "grace period". The application of the grace period works ONLY if the language has been adopted (amended) into your plan document. Otherwise, PAs must follow the plan documents default provisions.