Loans, Deemed Distributions and Offset

[Gadgetfreak]

From the EOB:

With a deemed distribution, the participant is taxed as if he received a distribution, but he still owes the plan the borrowed proceeds because the transaction was a loan, not an actual distribution.

No withholding (which is obvious since we are not sending any money)

A deemed distribution under §72(p) is reported on Form 1099-R, as if the plan actually made a distribution. The distribution is coded in Box 7 as either a regular distribution, or a distribution that is a premature distribution, depending on whether the participant is under age 59½. The 1997 Form 1099-R introduced code “L” which is also included in Box 7 to identify the distribution as a deemed distribution under §72(p).

The distribution is reported to the IRS like other distributions (see 2. above), and any later offset of the defaulted loan (including accrued interest) is not reported again at the time of the offset.

When the offset later occurs, the account balance will be reduced at that time, and the rules in 3.b. above are applied by treating the offset as an actual distribution.

Since the deemed distribution treatment under §72(p) is solely a tax rule, and is not treated as an actual distribution for other purposes (see 3. above), the deemed distribution does not affect the participant's continued obligation to repay the loan. The loan obligation is not extinguished until the loan is repaid, either by the participant through a resumption of loan payments, or by offset against the participant's accrued benefit.

From Relius:

If a participant defaults on a loan when the participant does not have a distributable event, the plan may not offset the loan but must report the defaulted loan as a deemed distribution. The plan reports the deemed distribution on a Form 1099-R with a code “L” in box 7 and a code “1” if the participant is subject to the 10% premature distribution tax. For purposes of the Form 5500, the plan will report the deemed distribution on line 2g of Schedule H or I, and will reduce the plan assets as of the end of the year by the amount of the deemed distribution (Sch. H, line 1c(8); Sch. I, lines 1a and 3(e)). Even though the deemed distribution no longer is part of the plan assets for Form 5500 reporting purposes, the defaulted loan continues to be a plan asset for purposes of vesting, top heavy and qualification for future loans. Accordingly, the plan must continue to accrue interest (“phantom” interest) on the loan until the plan offsets the loan. The additional interest, however, is not reported on a Form 1099-R or on the Form 5500.

Later, when the participant incurs a distributable event, the plan will offset the loan. However, when the deemed distribution precedes the loan offset, the plan does not report the later offset on a Form 1099-R nor on the Form 5500. The plan merely reduces the account balance paid to the participant by the amount of the loan.

Does this mean that, until the loan is offset, our 5500 assets and loan balance will not match the trust reports from the custodian? That could be years of irregularity. I understand the above reasoning that the 5500 should match the 1099s. So, if a 1099 was issued in 2012 (for example) the 5500 should reflect the deemed distribution then. But the fact that it is staying as a loan balance on the recordkeeping system is going to cause enormous confusion for future years.

Does anyone have any advice? Thanks.

[Lou S.]

You have it correct.

As for advice I suppose not allowing loans or at least loan defualts is out of the question.

[GMK]

^ but it is good advice.

[BG5150]

Does anyone have any advice? Thanks.

Keep a sheet of paper in with the 5500 files and keep track of the defaulted, but not offset, loans.

Cross them off when they get offset.

[Bird]

We prepare a balance sheet including the defaulted loans and show an adustment to reconcile it to the 5500.