Loan Repayment After Deemed Distribution

[mming]

A participant defaulted on a loan and though it was a deemed distribution, a 1099-R was not filed to report it. He went on to repay the entire outstanding balance afterwards which I understand should be considered an after-tax amount within the plan. Are the repayments still considered to be after-tax amounts if the defaulted loan was not reported as a taxable event when it became a deemed distribution?

If the repayments are to be treated as after-tax amounts, I presume that when it's time to distribute them that earnings on those amounts are taxable.

[MoJo]

I think the "taxable" event occurred at the point in time the default occurred. The filing of the 1099 is merely reporting of the event, and it's timing is irrelevant to the issue of tax being due. Hence, the participant now has basis in his account equal to the amount repaid (after-tax).

[Bird]

I'd argue that if a 1099-R wasn't filed then the loan didn't default and there was no deemed distribution - nothing happened. Given the very ugly fact pattern, and forced to accept it, I'd just treat 100% of the money coming out of the plan later as taxable (assuming no Roth or after-tax contributions).

How could one possibly not issue a 1099-R and give credit for basis?!

[Belgarath]

Seems to me there are two separate issues.

The failure to do 1099 reporting is, as MoJo mentioned, irrelevant to the question of subsequent loan repayment. The deemed distribution occurred, and if a 1099 wasn't produced properly, then that is an error that needs to be corrected. Failure to report such a distribution is subject to all the appropriate penalties.

Then the subsequent repayment to the plan is basis, and should be treated as such upon later distribution.

[MoJo]

Thanks Belgarath. I think there is a major misunderstanding here (and amongst others) that the "deeming" of a loan is something that has to be done - and even that it occurs only with the filing of the appropriate 1099. Aloan is "deemed" by operation of law when certain conditions exist - whether one takes action on it or not. The "deeming" of the loan is a taxable event - and as with many taxable events, there is a reporting requirement OF THE FACT THAT A TAXABLE EVENT HAS OCCURRED - and not as an indispensable part of the act of deeming the loan in the first place.

[Bird]

I get that deeming a loan and reporting it are two separate events. But the deeming is merely bookkeeping, where the reporting/taxation is what really matters for all practical purposes. If you're not going to report it, then you can't create basis just because it should have been reported.

[MoJo]

Bird said: "If you're not going to report it, then you can't create basis just because it should have been reported."

No offense, but I could not disagree more. First, "deeming" is NOT a bookkeeping issue - it is an operational issue that has both qualification ramifications (failure to abide by the terms of the written plan document) AND fiduciary implication. In addition, there is an income tax consequence to the participant WHETHER OR NOT A 1099 FORM WAS ISSUED. Failure to account for "income" at the personal level is both a civil violation and possibly criminal and it is NOT AT ALL dependent on receipt of a 1099 form (just as non-receipt of a 1099 form by an independent contractor does NOT excuse payment of tax on monies received as such - you are PERSONALLY responsible for ALWAYS paying tax due, whether or not you get a slip of paper indicating so).

The loan is DEEMED by operation of law whether or not the plan records reflect it - and failure of the plan records to properly reflect it is another problem. Filing of a 1099 form is ministerial in nature - and has separate (non-plan related) penalties attached to it - under the failure to report timely provisions of the Internal Revenue Code (just as if your bank failed to timely give you a 1099-INT, or your employer failed to give you a timely W-2).

Not considering the loan "deemed" just because the 1099 hasn't been properly issued is just wrong - and the fix is not to ignore it and not properly recordkeep the repayment with a basis attached to it, but rather the fix is to remedy the failure to file the 1099 form (and paying associated penalties) by filing it - albeit late.

Will the plan get caught? Who knows - but if the plan is large enough to get an annual audit for the 5500 and there is a good chance that they will find it (the auditors I routinely work with certainly would) and if the plan gets a regulatory audit, then it could be an even bigger problem.

[Bird]

No offense taken. You are right on the technicalities. On the practicalities, I think it is safe to assume that the participant didn't report it. I'm not going to reward that failure by giving him basis. If you want to insist that a 1099-R be issued now, that's reasonable. But I can't ignore the fact that it wasn't reported.

[MoJo]

Bird: I wouldn't ignore the fact that a 1099 wasn't filed either. If you look at the penalties - they accrue DAILY until the report is actually filed. Wait at your own peril. It's one of those things where the risk of getting caught may be perceived to be small - but the consequences can be catastrophic.

And as far as being right on the "technicalities" - well, isn't that what keeps us in business? This is a "technical" industry that is highly regulated, and not really susceptible to short-cuts (especially in an area (loans) that has very explicit regulations governing how to handle the situation)....

[Tom Poje]

the loan failure should have been reported,

under VCP of EPCRS 6.07(1) ...As part of VCP the deemed distribution may be reported on Form 1099-R with respect to the affected participant for the year of correction (instead of the year of failure)

I think the fee is only $300 under the new rules. so issue the 1099 now and be done with it.

now, since the person has paid back the loan there is a basis.

this is really not much different than if the 1099 had been issued when it should have been, and then later the person paid it back. I don't see how that is a 'reward'.

to do nothing is rewarding the individual by permitting a loan payback time more than what is permitted.

[mming]

Thank you all for the helpful perspectives. Regarding the late penalties for the 1099-R, all I could find in the IRS instructions was mention of a flat $100 fee per form if it's filed after the August 1st following the filing deadline for it. I, too, originally thought there would be daily penalties, but I guess that's not the case.

[Tom Poje]

Interestingly enough (or perhaps I should say coincidently), a similar type question popped up at the IRS Q and A for ABA which was just posted under the Benefits Link Newsletter.

2. § 72(p) – Plan Loans
A participant who took out a loan from a Section 401(k) plan fails to make timely payment of the loan (after the cure period). As a result, a deemed distribution occurs in April due to a loan default and later in the same calendar year in November a loan offset occurs because the defaulted participant later reached age 59½ in November which is a distribution event under the plan. At the time the participant defaulted on the loan, no exception to the Code Section 72(t) early distribution penalty was available to him. Does the plan administrator who issues Form 1099-R still indicate that the distribution was a deemed distribution (Code L in box 7 of Form 1099-R) and an early distribution (Code 1) even if there is a loan offset and the participant is over 59½ by the time the plan administrator issues the Form 1099-R?
Proposed Response: Yes. Once the participant defaults on the loan, the loan is considered a deemed distribution regardless of whether a loan offset occurs later in the same calendar year.
IRS Response: The Service representative agrees with the proposed response. The Service representative stated that it does not matter that the Form 1099-R has not yet been issued at the time the individual turns 59½ as the general rules would apply.

[Tom Poje]

here is the revised VCP schedule for loan failure under the EPCRS program

see page 15 of the PDF file.

epcrs revised.pdf