cure period

[Guest Kelly T.]

Date of loan = 3/30/2005. For whatever reason, the participant was behind on payments but has been doubling up to catch up (he was getting "default danger" notices). Final payments have been withheld from pay (prior to 3/30) but not yet submitted to the recordkeeper. Recordkeeper states the loan has defaulted. I argue the cure period applies and the default is not until 6/30 (quarter-end folllowing). Recordkeeper argues that would be the case if this were simply for missed payments, however, because we're beyond 5 years different rules apply.

I imagine this wouldn't be an issue if he weren't already blacklisted. Surely they're not immediately defaulting anyone whose final payment is not received by exactly 5 years post-issue.

Thanks,

Kelly

[Bird]

I agree with you. Yes, I think the code says it has to be repaid within 5 years, but I've always taken that to mean it has to be amortized over 5 years, not that it defaults if not fully paid off within 5 years. It's kinda silly if you ask me.

[Kevin C]

The loan becomes a deemed distribution when either the actual or scheduled repayment schedule extends beyond 5 years. See 1.72(p)-1, Q&A 4. The five year requirement is in Section 72(p)2)(B). The cure period only applies if the loan payments are not satisfying Section 72(p)(2)©'s level amortization requirement. See 1.72(p)-1, Q&A 10.

But, you said

Final payments have been withheld from pay (prior to 3/30) but not yet submitted to the recordkeeper.

The payments are made when they were withheld from the paycheck. If the final payments were made before 3/30/2010, the participant did not exceed the five year period.

If the recordkeeper insists on issuing a 1099-R for the loan even though the payments were made within the 5 year period, you might want to refer them to Section O (Penalties) starting on page 12 of the general 1099 instructions. Make sure you highlight the paragraph about willful violations.

[Bird]

Kevin, I've always been impressed by your ability to provide on-point cites when I thought something wasn't necessarily clear. But in this case, I don't see Q&A 4 directly saying that the loan defaults when an actual payment is made after the five year period; it references Q&A 10 for timing and I don't see it saying that there either.

Good point about the payments being withheld before the end of the period; I missed that, which should clinch it anyway.

[Kevin C]

Here is what I'm looking at:

Q-4: If a loan from a qualified employer plan to a participant or beneficiary fails to satisfy the requirements of Q&A-3 of this section, when does a deemed distribution occur?

A-4: (a) Deemed distribution. For purposes of section 72, a deemed distribution occurs at the first time that the requirements of Q&A-3 of this section are not satisfied, in form or in operation. This may occur at the time the loan is made or at a later date. If the terms of the loan do not require repayments that satisfy the repayment term requirement of section 72(p)(2)(B) or the level amortization requirement of section 72(p)(2)©, or the loan is not evidenced by an enforceable agreement satisfying the requirements of paragraph (b) of Q&A-3 of this section, the entire amount of the loan is a deemed distribution under section 72(p) at the time the loan is made. If the loan satisfies the requirements of Q&A-3 of this section except that the amount loaned exceeds the limitations of section 72(p)(2)(A), the amount of the loan in excess of the applicable limitation is a deemed distribution under section 72(p) at the time the loan is made. If the loan initially satisfies the requirements of section 72(p)(2)(A), (B) and © and the enforceable agreement requirement of paragraph (b) of Q&A-3 of this section, but payments are not made in accordance with the terms applicable to the loan, a deemed distribution occurs as a result of the failure to make such payments. See Q&A-10 of this section regarding when such a deemed distribution occurs and the amount thereof and Q&A-11 of this section regarding the tax treatment of a deemed distribution.

Q-3: What requirements must be satisfied in order for a loan to a participant or beneficiary from a qualified employer plan not to be a deemed distribution?

A-3: (a) In general. A loan to a participant or beneficiary from a qualified employer plan will not be a deemed distribution to the participant or beneficiary if the loan satisfies the repayment term requirement of section 72(p)(2)(B), the level amortization requirement of section 72(p)(2)©, and the enforceable agreement requirement of paragraph (b) of this Q&A-3, but only to the extent the loan satisfies the amount limitations of section 72(p)(2)(A).

...

When you put them together, I read it as saying the outstanding loan balance becomes a deemed distribution when the loan, in form or in operation, no longer satisfies the repayment term requirement of 72(p)(2)(B).

72(p)(2)(B) REQUIREMENT THAT LOAN BE REPAYABLE WITHIN 5 YEARS. --

72(p)(2)(B)(i) IN GENERAL. --Subparagraph (A) shall not apply to any loan unless such loan, by its terms, is required to be repaid within 5 years.

72(p)(2)(B)(ii) EXCEPTION FOR HOME LOANS. --Clause (i) shall not apply to any loan used to acquire any dwelling unit which within a reasonable time is to be used (determined at the time the loan is made) as the principal residence of the participant.

The cure period is only in Q&A 10 of the regs.

Q-10: If a participant fails to make the installment payments required under the terms of a loan that satisfied the requirements of Q&A-3 of this section when made, when does a deemed distribution occur and what is the amount of the deemed distribution?

A-10: (a) Timing of deemed distribution. Failure to make any installment payment when due in accordance with the terms of the loan violates section 72(p)(2)© and, accordingly, results in a deemed distribution at the time of such failure. However, the plan administrator may allow a cure period and section 72(p)(2)© will not be considered to have been violated if the installment payment is made not later than the end of the cure period, which period cannot continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.

With the specific references to 72(p)(2)© and no mention of 72(p)(2)(B), I don't see how the cure period could apply when you are exceeding the maximum 5 year repayment period.

[Bird]

Thanks for the detailed explanation. I understand what you're saying, but there's enough lack of specificity for me to not default after 5 years.

[PLAN MAN]

I found this from 2003:

Q1. §72(p) – Taxation of Plan Loans

Employer maintains a defined contribution plan that provides loans to its participants. The plan provides for a sixty-day cure period for missed installment payments. An employee takes out a five-year plan loan, and fails to make his last installment payment. Would permitting the employee to cure the missed payment after the five-year term but within the cure period for the loan violate the requirement of §72(p)(2)(B)?

Proposed response: No. Curing a missed payment after the term of the plan loan but within the cure period provided by the plan and within the limitations prescribed by Treas. Reg. 1.72(p)-1, Q&A-10 would not violate the requirement of §72(p)(2)(B) of the Code. Payments made within the cure period are deemed to relate back and considered made on the day the installment payment was due.

IRS response: The IRS agrees with the proposed answer. The plan can use a cure period even at the end of the sixty-month period.

AMERICAN BAR ASSOCIATION

SECTION OF TAXATION

MAY MEETING 2003

___________________________

COMMITTEE ON

EMPLOYEE BENEFITS

JOINT COMMITTEE ON EMPLOYEE BENEFITS

INTERNAL REVENUE SERVICE

QUESTIONS AND ANSWERS

May 9, 2003

[Bird]

That's a great find, thanks for posting!