Loan failure withholding issue

[Guest EBcounsel]

Ok gents and ladies, this is my predicament:

I have a client who recently realized that he has about 7 plan participants who (originally participants made loan payments through payroll withholding which were inadvertently stopped after the employer switched payroll systems) have defaulted their loans. To make matters worse, these 7 loans have lapsed their 5 year payment term. Thus, correction under Rev. Proc. 2008-50 Sec. 6.07 is limited to the following remedy:

General rule for loans.

Unless correction is made in accordance with this section 6.07(2) or (3), a deemed

distribution under § 72(p)(1) in connection with a failure relating to a loan to a participant

made from a plan must be reported on Form 1099-R with respect to the affected

participant and any applicable income tax withholding amount that was required to be

paid in connection with the failure (see § 1.72(p)-1, Q&A-15) must be paid by the

employer.

Now, my boss is of the opinion that the withholding requirement imposed to the employer is a penalty. In other words, he is of the opinion that the withholding is required and be paid by the employer regardless of whether or not the participant received a transfer of property or cash from the plan at the same time the deemed distribution occurred.

I took a look at Q&A 15 and it says that the 20% withholding that would be applicable to the deemed distribution that occurred in a date later than the date the loan was made (as in this case) is only required if the the participant received a transfer of property or cash from the plan at the same time the deemed distribution occurred (not the case for any of the affected participants here). My take on it is that withholding is not required in any of these cases as per Q&A 15 language.

My question is: Is the withholding requirement compulsory for the purposes of the VCP correction procedure as a penalty to the employer (trumping the Q&A language) or is it only required if the participant received a transfer of property as per Q&A 15?