Prohibited Transaction or Ordinary Loan Default?

[Guest LHart]

Participant was a 31% partner in a law firm in 2009, and took out a retirement plan loan while employed. At the end of 2009 he left the firm and (as often happens) had the best of intentions to continue making payments on his outstanding loan in order to avoid a distributable event.

He made payments through January 2010, and then stopped. He was notified in May that his loan would be in default effective June 30 unless he brought his payments current. He made a few token loan payments, but did not even remotely correct, and his loan was in default effective June 30, 2010.

Because he was a partner in the firm at the time the loan was taken, and under lookback rules would be considered a 5% owner in 2010, would his default fall under the prohibited transaction rules, or, because he was a terminated employee at the time he went into default would this default be treated in the same manner any ordinary employee's loan default would be treated?