Can participant loans be forgiven?

[pbarrett]

We have a plan with numerous participant loan in it. The employer asked that we "forgive" one loan that an active participant has on the books. (The participant is having financial difficulties.) The loan has been paid via payroll deduction. Can we just write off the loan and report it as a distribution? If in-service distributions were permitted (they are not in this plan), would that make a difference?

Any help would be appreciated.

Thank you.

[bzorc]

You can certainly write the loan off and create a taxable distribution for the participant. However, the loan cannot be written "off the books". The participant can (however unlikely)come back and repay the loan in the future. The loan is essentially in default.

The only time the loan can be physically taken off the books is when the participant has a "distributable event", e.g. termination.

Also, you may want to look at the instructions to the 1999 Form 5500. The reporting of a defaulted loan is quite ugly.

[KIP KRAUS]

I'm no sure that we would allow an employee to stop having payroll deductions made on a plan loan. This would be the only way the loan could ultimately be in default under our plan.

I would check with legal council before doing anything to adversely affect the tax status of the plan.

[Kirk Maldonado]

Does your plan document expressly authorize the "forgiveness" of loans?

[This message has been edited by Kirk Maldonado (edited 06-06-2000).]

[MoJo]

Be careful as well about state wage and hour laws. Many state will allow an employee to cease payroll deduction (nothing in ERISA mandates payroll deduction, and presumably ERISA does not preempt these state wage and hour laws as it relates to loan repayments). If that is the case in your state - the participant may be able to cause a default on the loan by demanding the cessation of payroll deductions.

[pjkoehler]

Please define what the employer means by "forgiveness" of the loan. I gather what is meant is that the employer would like to enter into an accord and satisfaction with the employee terminating the payroll deduction agreement by which the employee was obligated to repay the loan. This would then permit the employee to default by simply failing to make a scheduled payment by any other means. The tax consequences of this are two-fold, both of which are discussed in the proposed regulations under Code Section 72(p). Essentially, assuming that the promissory note does not otherwise provide, the outstanding principal balance of the loan will be a taxable "deemed distribution" at the expiration of the plan's grace period for curing the default. You will, of course, need to observe the impact of Code Sec. 72(t) (10% excise tax on premature distributions).

Unless this is a 401(k) plan with respect to which the loan was secured by the participant's elective deferrals, the plan will follow a procedure analogous to execution on the secured property, by making a distribution (reducing plan benefit liabilities) in the form of a "Plan Loan Offset" in the same taxable year as the "deemed distribution." If the loan was secured by elective deferrals under a CODA, the plan will have to maintain the nonperforming loan as a plan asset until the employee becomes eligible for an actual distribution.

You will also need to analyze this "forgiveness" procedure under the prohibited transactions exemption requirements for participant loans. See Code Section 4975(d)(1). Of particular concern would be whether "forgiveness" (1) is made available to all employees on a "reasonably equivalent basis" and (2) is made in accordance with specific plan provisions (i.e. the plan document, loan policy and promissory note).

[This message has been edited by PJK (edited 06-07-2000).]