Loan Re-Payments Made By Company Not Participant

[sdix401k]

Hello,

I have a plan where an owner borrowed money from the 401k Plan to help cover business expenses. They were given instructions to deduct the loan payment from the employee and make regular payments.

What actually happened was the company was making the loan repayments on the loan.

This has been going on for a year.

In need advice in correction:

Thought 1) The plan has been made whole, but source of loan repayments were incorrect. Have the company have all loan repayments run them as income to participant and participant can amend taxes and company can amend taxes.

Thought 2) Since this was not allowed reverse all loan payments plus gains-losses to company and default the loan for missed payments.

[Bird]

I'm not sure the plan cares where the money came from (be glad they were made!). They "just" have an accounting issue to resolve - all of those payments should probably be considered loans from the company to the employee/owner.

[MoJo]

I guess I'm missing something here. If I'm reading it correctly: 1) The "participant" took a plan loan. 2) The participant loaned the same amount to the employer. 3) The employer paid the loan back to the participant, but did so by directly making payments on the participant's loan back to the plan.

The participant would have "income" only to the extent of the interest paid by the employer on the loan it received from the participant in step 2 above, with no corresponding deduction for the interest the participant incurred his loan from the plan.

While not recommended, I see no problem in the employer satisfying it's obligation to the participant by making payments to the plan in satisfaction of his loan to the plan. It's a "tracing" issue, and I believe the only tax consequence (assuming the participant loan was "compliant") is the interest the employer paid on it's loan, inuring to the benefit of the participant.

[My 2 cents]

"I have a plan where an owner borrowed money from the 401k Plan to help cover business expenses." Folks, that is entirely the opposite of what 401(k) plans are for. They are not a way to accumulate special funds to cover company expenses. If they were, there would be no favorable tax treatment needed or available.

And if the business expenses became such a problem that the company failed, the remainder of the loan would become taxable income to the owner (with a 10% additional income tax if under 59 1/2) unless the owner could continue to make timely loan repayments directly with no income stream from the failed company.

I also have trouble seeing the money going directly from the employer to the plan and being treated as reducing the owner's 401(k) loan balance as something likely to pass government scrutiny.

[MoJo]

Covering business expenses or buying a bass boat - what's the difference? If the employer goes out of business, the loan FOR EITHER would probably become due and taxable. Research "ROBS" plans and see what kind of crazy stuff people have found to do with their 401(k) balances..... Good , bad or otherwise, we've given participants the power to determine what they do with plan loan proceeds.

[sdix401k]

I guess I'm missing something here. If I'm reading it correctly: 1) The "participant" took a plan loan. 2) The participant loaned the same amount to the employer. 3) The employer paid the loan back to the participant, but did so by directly making payments on the participant's loan back to the plan.

The participant would have "income" only to the extent of the interest paid by the employer on the loan it received from the participant in step 2 above, with no corresponding deduction for the interest the participant incurred his loan from the plan.

While not recommended, I see no problem in the employer satisfying it's obligation to the participant by making payments to the plan in satisfaction of his loan to the plan. It's a "tracing" issue, and I believe the only tax consequence (assuming the participant loan was "compliant") is the interest the employer paid on it's loan, inuring to the benefit of the participant.

I was thinking the same as Mojo. The loan payments need to be counted as income to the participant and the company needs to re-classify their accounting.

I agree this is not the correct way to handle a loan repayment. The funds were used to cover payroll not accumulate any benefits. It still should not have been done this way. A general purpose loan can be used for any purpose that the participant chooses assuming the trustee has signed off on the loan.

"I have a plan where an owner borrowed money from the 401k Plan to help cover business expenses." Folks, that is entirely the opposite of what 401(k) plans are for. They are not a way to accumulate special funds to cover company expenses. If they were, there would be no favorable tax treatment needed or available.

And if the business expenses became such a problem that the company failed, the remainder of the loan would become taxable income to the owner (with a 10% additional income tax if under 59 1/2) unless the owner could continue to make timely loan repayments directly with no income stream from the failed company.

I also have trouble seeing the money going directly from the employer to the plan and being treated as reducing the owner's 401(k) loan balance as something likely to pass government scrutiny.

As any loan default should become taxable to the participant that took the loan. Not sure what that point is??

[jpod]

I'd like some of what someone here is smoking.

[TPAJake]

I saw this happen on a large scale with a group of merger participants rolling from one provider to another--$50k worth of loans. The old provider said they would default them if they weren't paid back before the rollover & the Employees obviously couldn't pay. The new owners paid the old provider the $50k to "pay off" the loans & complete the rollovers. The Participants borrowed their own money & the loans are still being repaid, so in my opinion that $50k was either a donation to the old provider's bottom line or an unlawful Employer contribution to the Participant's account. Luckily, neither was my plan or client. It was a major provider holding the loans hostage too, so I imagine they're doing this 100 times a year...

In this OP's case, if that money wasn't a payroll deduction from the owner/employee's check, it smells like an Employer contribution. What kind of contribution is the question

[Belgarath]

I still don't understand the problem. If I take a bona fide participant loan, complete with appropriate paperwork, there is an obligation to repay the plan. If someone chooses to make the payments for me (my parents, employer, friends, children, The Halfway House for Wayward TPA,s, whatever) what difference does it make? The plan is whole, and the repayment obligation is satisfied.

Now, the fact that someone is essentially giving me a gift may possibly have other implications for the gift giver, or perhaps under some circumstances there may somehow be taxable income to me - that's another issue, and I have no opinion on that, but I don't see how there is any PLAN problem.

[ESOP Guy]

I agree with the others on this isn't a plan problem. The loan rules only talk about the loan being paid back. It doesn't require any kind of source of the payment. My guess is the rule writers didn't even think of the idea someone might pay the loan for the participant.

One issue that hasn't been addressed and it might be minor but most loan notes do specify that the loan will be taken from the person's pay check. That is a valid contract that hasn't been followed. I can't decide if that would change anyone's answer regarding implications outside the plan but my guess the terms of the note were not followed here so a contract was violated. .

[RatherBeGolfing]

The Halfway House for Wayward TPA,s

Can I have their contact info, I might need them after this October 15 since the IRS decided to audit two clients with less than month before the October 15 deadline....

As far as the loan is concerned, I don't see a problem either. The loan was repaid, where the money came from doesn't matter for plan purposes. May have tax implications for the payee/payor but the plan is fine.

[K2retire]

The Halfway House for Wayward TPA,s

Can I have their contact info, I might need them after this October 15 since the IRS decided to audit two clients with less than month before the October 15 deadline....

It would be a great public service to provide us with this information ASAP!

[sdix401k]

I saw this happen on a large scale with a group of merger participants rolling from one provider to another--$50k worth of loans. The old provider said they would default them if they weren't paid back before the rollover & the Employees obviously couldn't pay. The new owners paid the old provider the $50k to "pay off" the loans & complete the rollovers. The Participants borrowed their own money & the loans are still being repaid, so in my opinion that $50k was either a donation to the old provider's bottom line or an unlawful Employer contribution to the Participant's account. Luckily, neither was my plan or client. It was a major provider holding the loans hostage too, so I imagine they're doing this 100 times a year...

In this OP's case, if that money wasn't a payroll deduction from the owner/employee's check, it smells like an Employer contribution. What kind of contribution is the question

This was a concern I had as well. It really depends on how you look at it but in the end the employer was making a loan payment to the participants account. They were not putting in a contribution to the plan prior to a paydate or some un-categorized amount of funds.

[sdix401k]

Additional Thoughts - The loan policy does state that the loan shall be repaid through salary deduction.

I am not sure if that failure would cause the entire loan to be in default??

[My 2 cents]

I am not an attorney. I do not practice in the area of defined contribution plans. Anyway, here are my thoughts as a layman:

If someone not having direct responsibility for repayment of the loan pays it back, and that someone is not the participant's employer, wouldn't that fall under the category of taxable gifts?

If that someone is the participant's employer, wouldn't that fall under the category of taxable compensation?

Prior to distribution, notwithstanding the participant's status as an owner, the 401(k) plan assets do not belong to the participant, to do with as he or she pleases. They are held under a trust prohibiting reversion to the sponsor. The sponsor cannot take loans out from the 401(k) plan - that is clearly a prohibited transaction. Treating the loan as having been made to the sponsor and not to the owner as an individual participant (who is, owner or not, an individual in this context) would not be permissible. I would wonder whether the arrangement of owner takes 401(k) plan loan, loans the proceeds to the sponsor, and the sponsor pays off the 401(k) loan strikes me as a pretext to get money from the plan to the sponsor and may well, upon governmental scrutiny, cause all kinds of problems.

Then there is the issue of the plan actually requiring that the loan be repaid through salary deductions.

I would distinguish this from a 401(k) rollover to IRA that invests in recipient's business venture (assuming that such arrangements are still acceptable). Such arrangements would (I presume) be set up to keep money from flowing to and/or from the recipient, maintaining a strict distinction between the recipient's money and the IRA funds (except for payments to the recipient treated as taxable IRA withdrawals).

[MoJo]

My 2 Cents: I think this thread has gone afar (and that's not bad). The bottom line is, it depends on what was the nature of the transaction between the participant in using the proceeds of his plan loan to pay business expenses. IF that was structured as a "loan" then the employer paying back the loan (by making payments to the plan to pay the participant loan), then there is no taxable gift or taxable compensation (although, as I suggested previously, there may be an interest component of the loan to the company that the participant would have to claim as interest income on his tax return). IF the paying of business expenses was NOT a loan, then your points are valid (and I would side on the taxable compensation part of it - businesses typically don't make taxable gifts to employees - it gets booked as "compensation").

Keep in mind that a "loan" does NOT have to be in writing (although some would say it is stupid not to have a written document evidencing the loan - myself included - but clients are often "stupid"). In my mind, the fact that the employer made payments on the participant's behalf is EVIDENCE of the fact that the payment of business expenses was intended to be a loan.

The fact that the plan loan "contract" specified payroll deduction as the repayment means to me is insignificant. Plan fiduciaries have a DUTY to collect loan payments, and if they come in by pony express delivery, they probably ought to take it (unless clearly the delivery places an unreasonable burden on the plan - like payments all in pennies, and the like).