Really Old Loan

[ak2ary]

Participant took a loan in 1997, several years after terminating employment. Made a few payments and stopped. In mid 1998 received a letter from plan administrator that the loan was about to default unless brought up to date immediately and would be includable in 1998 taxable income. No additional payments were made. Outstanding balance of the loan was $3500 in 1998. Not clear if participant reported taxable income from loan in 1998 and not clear if 1099 was issued.

Participant left his account in plan. In 2007 plan terminated. Third recordkeeper since 1998 was on the job. Claimed loan default in 2007 and prepared a 2007 1099 with income from defaulted loan of over $7000 (3500 plus nine yeras of accumulated interest). Participant is claiming that the loan defaulted in 1998 and offers letter from plan administrator as proof. Recordkeeper claims no 1099 was issued and without 1099 there is no default. Participant counters that DOL rules required the default in 1998 and just cause the plan admin/trustee made a reporting mistake, he should not be penalized. Participant claims that he believes that he reported the loan default as income in 1998, but whether he did his taxes right or not is none of the plan's concern.

Thoughts?

[Mike Preston]

Interesting. At one level, I agree with the participant. At another level, I don't.

The TPA's job is to recommend that the Plan Sponsor do things such that the Plan Sponsor does not incur liability with the action taken. For this purpose, losing the plan's qualified status would qualify as liability.

Would not reporting a loan properly result in the plan losing its qualified status? If so, and if the TPA believes that there was no 1099 issued and, at the same time, the participant didn't report the income, then the TPA should stick to its guns and recommend to the Plan Sponsor that the loan be treated properly. Now, I'm not saying that the 2007 1099 is the way to go. Maybe it requires EPCRS. But I'll leave that to others.

There are a couple of ways that the above might be short-circuited.

First, the participant could volunteer to present a tax return showing the income claimed. Certainly, the plan can't force the participant to present such a tax return. But without it, in the absence of other proof, the Plan Sponsor may take an action the participant is not fond of (like issuing a recent 1099).

Second, the Plan Sponsor might be comfortable having the participant execute a hold harmless agreement. This would expose the participant to significant liability and is unlikely to be something the participant wants to do (and may not be something the Plan Sponsor is comfortable with in the first place). But, if the Plan Sponsor *IS* comfortable with this and so is the participant, I can see this as a reasonable compromise.

Let us know what happens.

[ak2ary]

Interestingly, the participant is threatening to go to the DOL and IRS about this, but has offered a comprimise...Re-issue the 1099 for the outstanding balance at the 1998 default date and he will shut up. He claims that then,if he is later audited he will produce his 1998 return for the IRS which will show a distribution of that amount

[masteff]

Just for the sake of being devils advocate...

not clear if 1099 was issued

if the TPA believes that there was no 1099 issued

Not having evidence that a 1099 was issued is not the same as knowing it wasn't issued.

I'd like to know more about the evidence the TPA has to base their position on. After all, certain records are not subject to permanent retention and with 2-3 changes in TPA, they might well have fallen to the side. Does the current TPA have 1099's for other distributions for 1998? Saying here are the 1099's and John Doe isn't in them is more clear cut than not having any 1099's at all.

Personally, given the plan was diligent enough to send the warning letter, unless there's reasonable evidence to the contrary, I'd have a tough time assuming the plan failed to follow thru on the default. They obviously had a procedure in place and the presumption should be that it was followed entirely.

PS - It's because he knows he can't be audited for 1998. It's generally a 3 year limit on individuals.

[ak2ary]

The participant seems most upset about the continued accrual of interest through 2007 on a loan he was told defaulted in 1998

[Mike Preston]

As well he should be if he claimed it as income.

Perhaps yet another compromise. Allow the participant to stipulate, under oath and penalty of perjury, that the amount was claimed on the 1998 return. Perhaps have that statement attached to a redacted copy of the tax return showing only the line in question where the amount was claimed. Have the stipulation recognize that making a false statement about a tax return is fraud. If the participant is willing to do all that, I'd be inclined to go recommend to the Plan Sponsor to go along with it.

[ak2ary]

Mike-

I guess I don't understand. Under IRS and DOL rules the loan HAD TO default no later than 1998. Since the participant is not taxed on the interest that accrues for repayment purposes after default {1.72(p)-1 Q&A 19}. I can see the plan argue that it should have cut a 1099 in 1998 and cut one now reporting it for 1998 or alternatively cut one now for the amount that should have appeared on the 1998 1099 but I see no justification for what they are doing.

In short the plan should have cut a $3500 1099 in 1998, how does that justify cutting a 1099 for $7000 in 2007?

[masteff]

What proof do you have that a 1099 wasn't written in 1998? Do you the 1099s from that year and this person isn't among them?

[ak2ary]

The recordkeeper (Wachovia) told the participant that the plan sponsor "has no record" of a 1099 having been prepared. But had no further info

[Mike Preston]

Tom, I'm not sure what you are saying is correct. I don't recall when the loan regulations were finalized, but I thought it was significantly later than 1998. As such, I think there was ample opportunity for random results during that time period. I also believe that loans originated before the regs were finalized were left untouched by the final regulations.

Since you have the paying client, I'll let you look that stuff up and let me know whether my memory is faulty. If it isn't, then the result might be that a default occurs when the Trustees say it does, and not one minute before. Even if said default takes place, oh, 9 years after the last payment.

[four01kman]

Mr recollection of the rules is that a default occurs when the "loan procedures" say a default occurs. Prior to the DOl regulations, there was significant controversy over when a default occurred, and what happened in the event of a default. TRI Pension Services published "Defaults on Participant Loans" (in their Summer 1996 Newsletter - Issue #2); and then published "Loan Defaults And Loan Offsets Under The Final 72(p) Regulations" (in their Winter 2000/2001 Newsletter- Issue #20), suggesting to us the final rules came out after the "default" in question.

For what its worth, in my practice, plans had adopted loan procedures which called for a default as of the first day of a calendar quarter, following two calendar quarters of non-payment.

[four01kman]

Just found this:

Full Version: When is a loan in default?

BenefitsLink Message Boards > Retirement Plans > 401(k) Plans

DWARD

Sep 13 2000, 10:38 AM

Does the IRS or the DOL have any definitive regulations (guidance)for a Loan Default? Does a specific amount of time have to pass before the loan is in default? Is a Plan Administrator the only person who can deem a loan in default? Thanks to all who can give guidance on this issue. DSW

MWeddell

Sep 13 2000, 03:00 PM

The promissory note or loan agreement when the loan was issued will state when a loan is in default.

The DOL does not have any specific guidance.

The IRS on 7/31/2000 issued final and proposed regulations under Code Section 72(p) on when a loan is deemed to be a distribution for tax purposes, which is similar to your question. Although plans may set stricter rules, the loan is treated as a taxable distribution when there's a whole calendar quarter with no payments. The first year of unpaid leave may be ignored and payments aren't required if the participant is on leave because of U.S. military duty.

R. Butler

Sep 13 2000, 03:18 PM

I agree with MWeddell. Failure to make a payment when due in accordance with the terms of the loan is generally considred a default at the time of the missed payment. However, the plan administrator may allow a grace period, and the default will not occur until the last day of that grace period. The grace period cannot extend beyond the last day of the calendar quarter following the quarter in which the payment was due.

You should start with the loan document and perhaps the loan agreement signed by the participant. Does the loan program or loan agreement provide a grace period? If it does use that grace period. If the document and/or agreement is silent then the plan administrator may use grace period set forth in IRS Reg. §1.72(p)-a,Q-10.

I would reccomend defining the grace period in the loan document just to avoid confusion.

Dave Baker

Sep 14 2000, 02:16 AM

The 2000 final regs are here: http://www.benefitslink.com/taxregs/72p-final.shtml

card

Apr 18 2001, 08:28 AM

Additional question on this issue: What if the 5 year limit intervenes before the grace period ends? Which controls? That is, can the grace period be used to avoid the 5 year limit for immediate taxation of the outstanding balance?

card

MWeddell

Apr 18 2001, 08:40 AM

IRS regulations under Section 72(p) provide that the 5-year limit still applies even if loan payments weren't made due to a grace period (unless of course the the loan was for the participant's prinicipal residence so that the 5-year limit didn't apply in the first place).

[ak2ary]

Never considered the "when were the regs written angle" thats a good point and I'll have to do the leg work but not today because somehow a 2 hour conference call got scheduled for 5 Oclock. Have you ever heard of such a thing , Mike? The client is a cheap so and so

[masteff]

Prop regs in 1995: "Proposed §1.72(p)–1 (EE–106–82) was published in the Federal Register (60 F.R. 66233) on December 21, 1995."

Prop regs in 1998: http://www.irs.gov/pub/irs-irbs/irb98-08.pdf

Final regs in 2000: http://www.irs.gov/pub/irs-irbs/irb00-33.pdf

[Mike Preston]

I have NEVER heard of such a thing!

[Blinky the 3-eyed Fish]

Even if the TPA issues a 1099 in 2007, why can't the participant have his CPA create a corrected 1099 that effectively wipes it out? Then everyone is happy.

[Mike Preston]

I'm not sure the participant wants to be known as a troublemaker in all of this, but if he (she?) does, it seems like the plan has made ample disclosure that its procedures required a default in or about 1998. Failure to follow those procedures is clearly a violation of the plan's terms and subjects the plan to EPCRS.

So, the plan appears to have a choice, treat the default as having taken place in 1998 and let sleeping dogs lie or suffer the slings and arrows of an EPCRS filing. Can the participant start the process by identifying the operational error in a draft letter to the IRS?

There is a part of me, though, cold hearted actuary that I am, which says that if the participant has been receiving statements 'lo these many years showing a loan balance in his/her account, is there some joint responsibility here?

[ak2ary]

Participant could have addressed this about a year ago....but prior to that the statements were being sent to his ex wifes house

[masteff]

But... just because a loan has been deemed as a distribution doesn't make the loan disappear. The loan is still outstanding, merely in default. The loan remains until it is offset which typically doesn't happen until full distribution of the account. So how would seeing the loan on the statement raise any flags to the part?

[GMK]

We like to include a friendly reminder in mailings to participants (account statements, SAR, etc.) that it is the participant's responsibility to keep the Plan Administrator informed of changes of address, marital status, etc. I think we'll keep doing it.

[Mike Preston]

We need a poll. How many people think that this is the participant's fault? Now that we know he was divorced maybe we cut him a little slack? OK, what is this participant's IQ? Curious minds want to know!

[Guest mjb]

Why is the participant to blame if the plan does not have records of whether the participant recieved a 1099? Under IRC 72(p) taxation of the loan occurred in year when the loan went into default, not when a 1099 issued. Since the participant is a cash basis taxpayer he was taxed in year of default, 1998 or at the latest, 1999. Does any one seriously think that the participant should be taxed on the default in 2007? If so please provide a cite.

Issue 1099 for 98 or 99 and move on.

[Blinky the 3-eyed Fish]

Issue 1099 for 98 or 99 and move on.

That ship has sailed.

[Guest mjb]

Issue 1099 for 98 or 99 and move on.

That ship has sailed.

sorry wrong button was pressed.

I will leave it to you to determine the IQ.

[Kimberly S]

Issue 1099 for 98 or 99 and move on.

That ship has sailed.

I generally agree, but with the potential late filing penalties triggered by filing a 1099 now, I'd be more inclined to let sleeping dogs lie until someone proved that it was NOT filed years ago.

[401(k)guru]

What do the promissory note and plan loan rules say about the provisions for default? Usually these documents are written so that if the money is distributable to the participant the loan will be offset against the participant's account balance and the loan will be paid off.

If the documents allowed the plan balance ("the collateral") to be used to pay off the loan the issue is not just whether the 1099R was produced but whether the account balance (not including the loan) should have been reduced to pay off the loan. If the documents allowed this, then the participant's earnings in the account would have been reduced by the amount that should have been deducted.

[Mike Preston]

Guru, I'm sure you meant well, but I certainly don't understand what you are getting at. You seem to be saying that if the account balance (not including the loan) was $50,000 and the loan was $10,000 (so the total was $60,000) you would then "reduce the account balance (not including the loan)" (which is $50,000) by the loan. Did you really mean that?

[Belgarath]

I have a marginally related question regarding how long the IRS can "reach back" to make you pay tax on a distribution. Let's suppose it was a simple distribution, not a loan. In 1998 the plan pays you $5,000. Never issues a 1099. So you don't report it. 10 years later this comes to light. Since 1998 is presumably a "closed" year, can the participant be forced to even pay income tax?

I really don't know the answer to this, but it might have a bearing on what the plan does, and whether the participant cares, in an ancient loan default scenario.

[Guest mjb]

I have a marginally related question regarding how long the IRS can "reach back" to make you pay tax on a distribution. Let's suppose it was a simple distribution, not a loan. In 1998 the plan pays you $5,000. Never issues a 1099. So you don't report it. 10 years later this comes to light. Since 1998 is presumably a "closed" year, can the participant be forced to even pay income tax?

I really don't know the answer to this, but it might have a bearing on what the plan does, and whether the participant cares, in an ancient loan default scenario.

I thought the question was about the s/l. If a taxpayer files a tax return, the S/l for collecting taxes on an amount that was distributed but not reported is generally 3 years from the date the return is due or 6 years if the amount omitted exceeds 25% of gross income. If the loan defaulted in 1998, the time for the IRS to collect back taxes expired on 4/15/2002. If the plan issues a 1099 for 1998 showing taxation of the loan as a default the taxpayer will not owe any tax.

[401(k)guru]

Guru, I'm sure you meant well, but I certainly don't understand what you are getting at. You seem to be saying that if the account balance (not including the loan) was $50,000 and the loan was $10,000 (so the total was $60,000) you would then "reduce the account balance (not including the loan)" (which is $50,000) by the loan. Did you really mean that?

Sorry Mike, I did not say it correctly. What I meant was that if the total value of the account was $60,000 (and this amount includes an outstanding loan balance of $10,000) then (if the loan procedures and promissory note allow) the account would be reduced by $10,000, the loan balance would become $0 and and the loan would be repaid in full. The amount remaining in the participant's account would be $50,000.

[Mike Preston]

Guru, now we are on the same page. In this case, it appears the participant was terminated and entitled to a distribution long before 2007, although not necessarily in 1998. In any event, assuming the plan's procedures provided for a default and assuming the participant was entitled to a distribution, we then look to the procedures one last time to see whether they provide for a reduction of the account balance to reflect the defaulted loan. If they do, then the right thing for the plan would have been to show a participant statement with the loan nowhere in sight. This participant, admittedly kept out of the loop by an ex-spouse that was not kind enough to notify the plan that statements were being sent to the wrong address for years, nonetheless admitted receiving a statement about a year ago with the loan still firmly in place. That would have been the time to raise the red flag. Perhaps that WAS the time that the participant raised the red flag.

[masteff]

Guru, now we are on the same page. In this case, it appears the participant was terminated and entitled to a distribution long before 2007, although not necessarily in 1998. In any event, assuming the plan's procedures provided for a default and assuming the participant was entitled to a distribution, we then look to the procedures one last time to see whether they provide for a reduction of the account balance to reflect the defaulted loan. If they do, then the right thing for the plan would have been to show a participant statement with the loan nowhere in sight. This participant, admittedly kept out of the loop by an ex-spouse that was not kind enough to notify the plan that statements were being sent to the wrong address for years, nonetheless admitted receiving a statement about a year ago with the loan still firmly in place. That would have been the time to raise the red flag. Perhaps that WAS the time that the participant raised the red flag.

But... if the plan merely provided for deemed distribution in accordance with 72(p) then your assumptions collapse. The 72(p) regs differentiate between deemed distribution and offset. Under the regs you can have a taxable event and not have an offset until full distribution. Offset is not an absolute and foregone conclusion.

[Mike Preston]

Masteff, I don't think anybody disagrees with you. Guru was just laying out another possibility if the documents were in accordance with his assumptions. If you find out that the documents are not in accordance with his assumptions, his rationale has no applicability.