Participant Loan in default

[Brenda Wren]

Participant took a loan in March 2008. Although payments were supposed to be withheld from paychecks, it didn't happen and no one noticed until the plan changed recordkeepers in December 2008. The original recordkeeper defaulted the loan in June 2008 and issued a 1099-R to the participant in January 2009.

It appears that the employer still has an obligation to institute the loan repayments from payroll.

Questions:

1. Is it possible to void the 1099-R, i.e. taxation to the participant, since this could be argued that the employer was at fault? If so, is it recommended?

2. Are there any prescribed methods of correction from IRS in this situation?

[Guest Sieve]

If a loan is deemed distributed, there is no longer any requirement to repay (or to withhold, for that matter)--but, if repayment does not occur, the loan continues to accrue interest for purposes of determining the maximum amount of any subsequent loan and additional security may be required for a subsequent loan. (Treas. Reg. Section 1.72(p)-1, Q&A-19.)

As for correction of loan failure due to employer error, including potential 1099-R issuance in a subsequent year or reamortization, see EPCRS (Rev. Proc. 2008-50). If you choose to correct under EPCRS, then you would propose to eliminate the issuance of the prior 1099-R as part of the correction process.

[J Simmons]

If a loan is deemed distributed, there is no longer any requirement to repay (or to withhold, for that matter)--but, if repayment does not occur, the loan continues to accrue interest for purposes of determining the maximum amount of any subsequent loan and additional security may be required for a subsequent loan. (Treas. Reg. Section 1.72(p)-1, Q&A-19.)

As for correction of loan failure due to employer error, including potential 1099-R issuance in a subsequent year or reamortization, see EPCRS (Rev. Proc. 2008-50). If you choose to correct under EPCRS, then you would propose to eliminate the issuance of the prior 1099-R as part of the correction process.

Larry, I thought that there would yet be an obligation to repay (which would after the deemed distribution and taxation) would be treated like after-tax contributions as to which the employee would acquire basis against otherwise future taxation. I also though a trustee would have a fiduciary duty to try to collect on the defaulted loan.

[Guest Sieve]

John --

Reg. 1.72(p)-1, Q&A-19 indicates that a deemed distributed loan "ceases to be an outstanding loan for purposes of section 72 . . ." The rest of Q&A-19 contemplates that a loan may not be repaid, although it leaves open the possibility that it will be repaid. Q&A-21 discusses the basis in the account if a deemed distributed loan is, in fact, repaid. If the plan permits loans to be repaid only through payroll withholding, and/or defaults the loan upon termination of employment, there may be no way to repay a deemed distributed loan pursuant to plan terms (especially after employment terminates) unless the plan is appropriately amended.

Don't kinow about the fiduciary obligation to obtain repayment.