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?

[My 2 cents]

I am not involved in any way with plan loans, but if the initial loan transaction was a legitimate, permissible loan, made under the rules of the plan and applicable regulations, how could a later default possibly be considered a prohibited transaction, especially if the person was no longer an employee of the sponsor?

[Guest LHart]

I am not involved in any way with plan loans, but if the initial loan transaction was a legitimate, permissible loan, made under the rules of the plan and applicable regulations, how could a later default possibly be considered a prohibited transaction, especially if the person was no longer an employee of the sponsor?

He was an owner of the business. Owners are held to a higher standard where retirement plan loans are concerned. A loan default by an ordinary employee is simply a default. A loan default by an owner is a prohibited transaction, and the plan is at risk for disqualification unless very specific, and rather stringent steps are taken.

If, due to this owner's termination, he is no longer considered a "disqualified person," I simply deem his loan a distribution. But if, due to ownership as recently as the prior year, he is still considered a disqualified person at the time of default, the employer and the former employee have a rather structured and painful set of corrective measures to undertake.

I'm wondering if anyone has an idea as to where this former employee falls in the pecking order.

[Guest Sieve]

I'm learning something here. On what basis is a defaulted loan a PT to anyone?

(If he was not a party-in-interest when the loan defaulted, then I do not see a PT when the default occurred. And, he was not.)

[Belgarath]

"A loan default by an owner is a prohibited transaction..."

That's a pretty strong statement. EGTRRA added IRC 4975(f)(6)(B)(iii) to allow participant loans to shareholder-employees and owner employees to rely on the normal prohibited transaction exemption for participant loans. I think a mere default, in and of itself, does NOT necessarily rise to the PT level. However, if under 1.72(p)-1, Q&A-17, it was not a "bona fide" loan, then it could be deemed prohibited transaction from the beginning. Based upon the fact pattern you give, I think this is a very unlikely result. Personally, I would never suggest to ta client that they treat this/correct it as a prohibited transaction.

[mbozek]

I am not involved in any way with plan loans, but if the initial loan transaction was a legitimate, permissible loan, made under the rules of the plan and applicable regulations, how could a later default possibly be considered a prohibited transaction, especially if the person was no longer an employee of the sponsor?

He was an owner of the business. Owners are held to a higher standard where retirement plan loans are concerned. A loan default by an ordinary employee is simply a default. A loan default by an owner is a prohibited transaction, and the plan is at risk for disqualification unless very specific, and rather stringent steps are taken.

If, due to this owner's termination, he is no longer considered a "disqualified person," I simply deem his loan a distribution. But if, due to ownership as recently as the prior year, he is still considered a disqualified person at the time of default, the employer and the former employee have a rather structured and painful set of corrective measures to undertake.

I'm wondering if anyone has an idea as to where this former employee falls in the pecking order.

What is the basis for your contention that owners are held to a higher standards where plan loans are concerned. The Legislative history of the EGTRRA amendment allowing loans to owners of unicorporated businesses and S-Corps noted the purpose of the amendment was to eliminate discrimination against self employed persons and S corp owners, e.g., prior law allowed a 100% owner of a C Corp to have a plan loan but not a self employed owner. The Committee report notes that the general statutory provisions for loans will apply to loans by owners.

[Guest LHart]

What is the basis for your contention that owners are held to a higher standards where plan loans are concerned. The Legislative history of the EGTRRA amendment allowing loans to owners of unicorporated businesses and S-Corps noted the purpose of the amendment was to eliminate discrimination against self employed persons and S corp owners, e.g., prior law allowed a 100% owner of a C Corp to have a plan loan but not a self employed owner. The Committee report notes that the general statutory provisions for loans will apply to loans by owners.

I am not so sure that relying on the relief afforded by section 408(b)(1) means that under all circumstances an owner gets a free pass in a loan default. If facts and circumstances indicate that this person did not intend to repay the loan (he took it out about a month before he left the firm, and payments were token from the start), I am concerned that this set of circumstances could be construed in an audit as a prohibited transaction. So, while EGTRRA eliminated "discrimination" against owners where plan loans are concerned, should I be concerned that this person was a 31% owner at the time of the loan? Maybe, based on the response to my question the answer is no . . .