Loan initiated at incorrect rate

[Guest Holly Foster]

The Loan Policy indicates loans should be written with a rate of Prime +1%. A loan was accidentally written at a rate of Prime. This error was discovered 6 months later. What is the corrective procedure? I think the corrective action would be to deposit the missing peice of the payments (the difference in the payments to date if the loan rate was correct and the payments to date at the incorrect loan rate). If that is the case, who should make up these payments, the employee or employer or trustee?

[Guest Sieve]

I would first make sure that the interest rate, whatever it is, fits within the requirements of a "reasonable rate of interest" under DOL Reg. Section 2550.408b-1(e). If not, then fix the interest rate before correcting.

Because this loan will not have been amortized on a level basis (IRC Section 72(p)(2)©), then it must be corrected under VCP (most easily, I would think, by reamortizing). (See Rev. Proc. 2008-50, Section 6.07.)

[Guest Iwonder]

I have the opposite problem. Loans were given at Prime + 1 and should have been at prime (loan policy).

Assuming rates in the locality are at prime + 1, would the response be the same? Reamortization?

Would a VCP filing also be necessary, do you think? Because this has been done consistently because the company has been remiss in revising its policy, would a retroactive amendment to the policy be an option?

[Guest Sieve]

Of course, check the documents. I would think that the Plan's loan policy (or plan document) probably specifically requires that loans be made at a reasonable rate of interest (to prevent partcipant loans from being PTs). So prime +1% may actually be the appropriate rate pursuant to plan (loan policy) terms--even though the rate may be specified somewhere as being prime--and therefore, in that case, there would not be an operational violation to correct. If this kind of provision is not in the loan policy, the loan policy is deficient but I don't think you have a violation since the interest rate must be reasonable to comply with the PT rules--so, just change the policy for future loans.

However, if the proper rate should, in fact, be prime, and if prime + 1% is not "reasonable", then you have a PT and a potential operational violation. I say "potential" operational violation because you will have established a repayment schedule that is faster than level amortization (after correction has been made), and I'm not sure whether or not that's an amortization violation. If it is, then you ought to go in under VCP (and VFCP is handled through the VCP application--see VFCP, Section 7.3(a)); if it's not an amortizatin violation, then you only have a PT (i.e., no VCP/VFCP correctable failure), and the PT can be corrected by changing the interest rate, reamortizing and paying the necessary excise tax.

[J Simmons]

If the interest rate is not commercially reasonable, the loan is a PT when made. You'd need to correct and file a Form 5330.

If the interest rate does not comport with what the loan policy specifies, then you have a breach of fiduciary duty for not following the written plan terms. You'd need to correct per DoL's VFCP.

The loan policy ought to be re-written to simply provide that the interest rate will be commercially reasonable. This will avoid Catch-22 situations from developing in the future.