Owner Defaulted on Loan, PT?

[erinak03]

I have an owner who took a distribution from his 401k plan. The terms of the loan followed all the requirements of 72(p) thereby making it a permissible loan and was not a prohibited transaction upon the loan issuance.

Now the owner has defaulted on the loan. I've done extensive research regarding the ramifications of a disqualified person defaulting on a loan. I cannot find any direct information from code sections 72 or 4975 but I did find the following on two separate IRS communications (one was a phone forum, the link below is from a TEGE/EP Nationwide Tax Forum in 2013): a disqualified person defaulting on a loan results in a prohibited transaction.

https://www.irs.gov/pub/irs-tege/forum13_loans_hardship_distns.pdf

(the example is on page 22)

Has anyone declared a defaulted loan to an owner as a PT and is there some regulations or code sections that I'm missing? The example from the IRS in the above link is very cut and dry but I'm irritated that I can't find an official regulation somewhere.

[Belgarath]

I suspect that in this example, they may be assuming that this was not a "bona fide" loan. If it isn't a bona fide loan, then yes, it would be an actual distribution (See 1.72(p)-1, Q&A-17)and therefore it would be a PT. But if it is determined to be a bona fide loan, then it is a deemed distribution. Facts and circumstances, and the mood of the auditor...

[K2retire]

and the mood of the auditor...

And that's the scary part!

[erinak03]

For what it's worth, here's the other piece of information that I found suggesting the defaulted loan causes a PT:

https://www.irs.gov/pub/irs-tege/loans_phoneforum_transcript.pdf

(see page 5)

It's a transcript from an IRS phone forum on participant loans. It's a little cumbersome to read sometimes since it was originally spoken so the sentences are not always complete, etc. but this is the part that worries me: "if they default, a disqualified person defaults, they've come into a really expensive issue for themselves tax wise because it's not only a deemed distribution and they have to take it into income but they have to file 5330s and it's considered a prohibited transaction [...] so they're going to continue to have to file 5330s and they're going to owe excise tax until they have actually paid that amount of money back to the plan".

As far as facts and circumstances go, he took the loan and made correct, timely payments on it for a year before he came into financial difficulties and stopped making the payment (unbeknownst to me, naturally) so I would argue that it was a bona fide loan and would like to merely deem it as a distribution and be done, just as Belgarath suggested. Can anyone poke holes in the transcript above??

[BG5150]

This is the next paragraph, at the top of p. 6:

In order for a loan to a disqualified person to be exempt and not subject to excise tax under IRC 4975© participant loan must be available to participants and beneficiaries on a reasonably equivalent basis; not be made available to highly compensated employees in an amount greater than the amount made available to other employees; made in accordance with plan terms; bear a reasonable rate of interest; and be adequately secured. In most cases for the adequately secured you will see that the security is the amount of the participant’s account balance.

Does that help?

[erinak03]

This is the next paragraph, at the top of p. 6:

In order for a loan to a disqualified person to be exempt and not subject to excise tax under IRC 4975© participant loan must be available to participants and beneficiaries on a reasonably equivalent basis; not be made available to highly compensated employees in an amount greater than the amount made available to other employees; made in accordance with plan terms; bear a reasonable rate of interest; and be adequately secured. In most cases for the adequately secured you will see that the security is the amount of the participant’s account balance.

Does that help?

From what I understand, the quote you gave is in reference to when a loan is originally issued. If a loan is issued and those items are not followed, the loan is automatically a prohibited transaction; the loan isn't even given the opportunity to be defaulted upon. Here is my one last piece of research on this subject (IRS 401(k) Fix-It Guide regarding participant loans):

https://www.irs.gov/Retirement-Plans/401(k)-Plan-Fix-It-Guide-Participant-loans-do-not-conform-to-the-requirements-of-the-plan-document-and-IRC-section-72(p).

(see question 9b)

It does go into detail regarding what requirements must be met to avoid being a PT (same as you indicated above) but under the "How to find the mistake" section, item #5 says

5. Review the disqualified person’s actual loan payments to determine whether he or she is following the loan document terms. The law treats amounts not timely paid per the loan terms as unsecured loans and prohibited transactions.

I'm not entirely sure as to why an unpaid loan payment is considered an unsecured loan since the entire balance of the loan was secured at the time of issuance but that appears to be the IRS's stance given #5.

Thoughts??