S corp shareholder takes participant loan

[Dawn Hafner]

If an S corp shareholder takes a participant loan, what is the correction?

At the time the loan was taken it was not a loan due to not meeting the participant loan exemption rules, so it was a distribution at that time.

This is also a prohibited transaction. The fact that the transaction was taxable does not fix the prohibited transaction. The "loan" should also be repaid to the plan, creating basis for the taxpayer. Each year the "loan" is outstanding the 15% exise tax applies to the interest.

Comments on my short anaysis? Anyone dealt with fixing this type of transaction?

[Guest RJM]

Good summary. Our experience is only with respect to the 5330 loan. Excise Tax rate increased from 10% to 15% on 8/5/97. Tax is assessed against loan interest, not the loan amount or balance. Sticker is that tax is reapplied until transaction corrected. For instance, 1997 5330 applied tax to 1997 interest; 1998 5330 applied tax to 1997 and 1998 interest; 1999 5330 (this guy was stubborn) applied tax to 1997, 1998 and 1999 interest.

[Kirk Maldonado]

You should check whether this must be reported on the Form 5500.

[KJohnson]

I agree on the PT excise tax issue.

I am not so sure on the income tax aspects. Since you are correcting an error under APRSC and putting the plan back to where it should be (i.e. no loan was made) could you simply have the participant repay the loan amount plus interest/earnings. Particpant would have no taxable event (and of course would have no basis in future payments received). Obviously, your method also works, but tracking the basis and then the rules on recovery of basis would seem to add a level of complexity that I am not sure the IRS would require. Any thoughts?

[M R Bernardin]

I used to think this would be taxable income to the borrower, but the preambles to the 72(p) regulations (I think that's the right cite) suggest that this is not taxable, as long as the amount is not in excess of the dollar limits, even though the participant was not entitled to take a loan. You may also have a problem under 401(a)(13) because only loans which are exempt under 4975(d)(1) do not cause a violation of the anti-assignment rules. The loans are reportable on the 5500. It should be repaid to correct.

[Dawn Hafner]

Thankfully, this was just in process and was stopped in time, but it has come up in the past. It seems there are administrators that forget their client is an S corporation.

I did work on a VCR request for a client a few years ago and the IRS did view it as a taxable event at the time of the loan withdrawal unless their view has changed since then.

[Guest randitoman]

I have a similar situation where a member in an LLC later became an owner. He did not pay back the loan prior to his becoming an owner/partner. This happened in 1995. We are outside the 2 year limit...What should he do? The loan amount is $10,000. What are the tax consequences.