A participant with an outstanding loan files for bankruptcy and the pl

[k man]

A participant with an outstanding loan files for bankruptcy and the plan has received a proof of claim. how do we treat the loan this point?

[pjkoehler]

You should review the participant's promissory note and the plan's loan policy to determine the timing of an event of default and whether or not default triggers acceleration of the total unpaid principal balance. If, as seems likely in this case, the participant has been or shortly will be in default, most loan policies provide for a grace period to cure the loan. The proposed regs under Code Section 72(p) regarding "deemed distributions" permit a grace period not to exceed the last day of the calendar quarter following the calendar quarter in which the default occurs. If the default is not cured by the end of the grace period, the proposed regulations require the plan to regard the amount in default as a "deemed distribution" in that tax year, which will require reporting the amount on a Form 1099R. The "deemed distribution" will be includible in gross income and subject to the 10% penalty on premature distributions under Code section 72(t). Q&A 12 of the proposed regs provide that any amount treated as a "plan loan offset," the amount by which the account balance is reduced to offset the loan in default, will be treated as an actual distributions. If the participant remains employed by the plan sponsor and the loan was secured by the participant's salary deferrals under a 401(k) plan, such a "plan loan offset" would violate the 401(k) regulations prohibition on distributions. Accordingly, for administrative purposes the plan cannot treat the loan as paid off by the equivalent of executing on the collateral and reducing the employee's account balance. It must continue to track the loan as a nonperforming asset of the account, until the participant terminates employment. At that time, if the participant elects a lump sum, it will cashout the account and distribute the "plan loan offset," with respect to which the employee will have a tax basis equal to the deemed distribution.

[MoJo]

The approach I've seen taken (although have no specific authority for) is to deem the loan uncollectible (by virtue of the bankruptcy stay), but nonetheless a taxable deemed distribution. The tax consequences of which, are then the "forgiveness of debt" rules under IRC Section 108 (I think).

[Guest FREE401k]

We have a similar situation where a 401(K) participant with an outstanding loan has filed bankruptcy, and the court has ordered that the Plan Sponsor "discontinue that deduction from the Debtor's payroll and refund to her all such deductions since the date on which this case was commenced, July 17, 2000." We are trying to figure out if the Plan Sponsor should stop the deduction (we think yes) and if deductions since July 17th should be refunded (we think no - these deductions have been remitted to the Trustee and cannot be taken out of the Plan unless a distributable event occurs). Any thoughts?