EPCRS Correction / Loan Default

[austin3515]

Long story short, no payments were made on a loan, which should have defaulted in 2015.  This was figured out in 2016.  In the midst of implementing the correction, the participant terminated and opted NOT to repay any portion of the loan.  1099 was issued in 2016.

The IRS is basically forcing us to use the "taxed in year of correction instead of year of default box" which sounds reasonable enough, EXCEPT that that correction requires the plan sponsor to pay for any related withholding.  Does anyone know what that actually means?  Does the plan sponsor make a contribution equal to the withholding to the participant's account?  If the participant rolled over their account, there is no withholding. Is plan sponsor off the hook?

[Tom Poje]

this might be a starting point

The ERISA Outline Book has the following note:

Chapter 7 section IX part D

 

1.b.Withholding requirements on deemed distributions. The withholding requirements with respect to deemed distributions are discussed in Treas. Reg. §1.72(p)-1, Q&A-15. As noted in 1.a. above, the deemed distribution is not an eligible rollover distribution, so the 20% mandatory withholding under IRC §3405(c), as described in Section VI of this chapter, does not apply. Are the voluntary withholding rules under IRC §3405 applicable, since the deemed distribution triggers current taxation to the participant? That depends on whether the deemed distribution occurs when the loan is made or on some later date.

 

1.b.1)Deemed distributions occurring after the loan is made. When a deemed distribution occurs on a date which is after the loan is made, which is usually the case, no withholding is required if the deemed distribution is the only distribution being made at that time, even if the participant has not formally elected to waive withholding. If other cash or property is being distributed at the same time as the deemed distribution, then, unless the participant has waived withholding on the deemed distribution, the required withholding would be taken from the cash or other property, to the extent such other cash or property is sufficient to cover the withholding obligation, as illustrated in the examples involving offsets in Part E.3.b. of this section. Generally, the withholding rate on the deemed distribution would be 10% since it is a nonperiodic distribution that is not eligible for rollover. See IRC §3405(b) and the discussion in Section VI, Part A.3., of this chapter. For example, if the employee is also receiving a distribution with respect to the non-loan portion of his/her account at the same time as the deemed distribution is triggered, any withholding with respect to the deemed distribution would be taken from the additional distribution.

[austin3515]

OK, so if he rolled his money over it is moot, no correction, right?  But alas, he did not, so mechanically what do I do? A deposit equal to 20% of his loan balance into his account?

[Tom Poje]

I am guessing in most cases 2 1099s are created because you are talking 2 separate events.

1. if the person took a distribution then 20% was already withhold and that event is done.

2. now a 1099 is issued for the late loan. there is no withholding because there is no assets left.

if the distribution hasn't taken place, then the 1099R for the loan is issued, no withholding because no other distribution has been made at this time.

 

[austin3515]

In this situation, the loan should have been defaulted in 2015.  We went to correct in 2016 and he then closed his account in 2016, so it was all done together at the same time.

[Tom Poje]

but you said he already took his distributions. Arguably, if you had done it at the same time you should have included more withholding. and if you hadn't have paid the person out you wouldn't tack on withholding, unless that is what the govt expects in all cases if you file this way. I haven't heard that being done, but then, I don't handle that end of things. so maybe someone who has done these things can say what they do.

 

personally I'm not even sure why that provision is in there, because it becomes a windfall for the participant, which makes no sense. I understand it if there are additional tax penalties, but EPCRS is clear if it is the sponsor's fault they are responsible for those.

[RatherBeGolfing]

Let me see if I'm getting the facts right...

1. Participant had a loan that should have been defaulted and taxed to the participant in 2015.

2. Instead, the loan was defaulted when participant terminated in 2016.  For 2016, the participant was issued a 1099 for the defaulted loan and for the remaining assets in his account.

3. Because there were additional assets distributed when the loan was deemed distributed, 20% withholding should have been done on the entire amount, rather than non-loan assets only.  Withholding was done on non-loan assets and IRS is making the sponsor pay for the tax 20% tax deposit on the loan assets.  

 

[austin3515]

1. Participant had a loan that should have been defaulted and taxed to the participant in 2015.

Right

2. Instead, the loan was offset when participant terminated in 2016 and closed his account.  For 2016, the participant was issued a 1099 showing a taxable distribution equal to the sum of his investments plus his unpaid loan..

3. Because there were additional assets distributed when the loan was offset, 20% withholding was done on the entire taxable amount.  As part of the VCP requirements, when a loan is being taxed in year of correction as opposed to year of default "any applicable income tax withholding amount that was required to be paid in connection with the failure (see §  1.72(p)-1, Q&A-15) must be paid by the employer" (2016-51 6.01(1))

[Tom Poje]

I didn't realize that was what had happened.

I'm not sure what happens then if you follow those instructions - the participant is 'correct', the withholding has been completed, it is already done.

if you toss in an additional amount from the employer at this point that would really botch things up....well, I guess since it is VCP you can always ask the friendly IRS folks and tell us what they say.

[austin3515]

"well, I guess since it is VCP you can always ask the friendly IRS folks and tell us what they say."

I did - she had no idea!!  I'm just going to have them put in the 20% to put an end to this.  It's a relatively small amount of money.

[RatherBeGolfing]

43 minutes ago, austin3515 said:

1. Participant had a loan that should have been defaulted and taxed to the participant in 2015.

Right

2. Instead, the loan was offset when participant terminated in 2016 and closed his account.  For 2016, the participant was issued a 1099 showing a taxable distribution equal to the sum of his investments plus his unpaid loan..

3. Because there were additional assets distributed when the loan was offset, 20% withholding was done on the entire taxable amount.  As part of the VCP requirements, when a loan is being taxed in year of correction as opposed to year of default "any applicable income tax withholding amount that was required to be paid in connection with the failure (see §  1.72(p)-1, Q&A-15) must be paid by the employer" (2016-51 6.01(1))

Thanks, makes a lot more sense now.  

It seems to me that the requirement for the Employer to pay the applicable income tax would be there regardless of whether the 20% withholding was required at the time of the distribution since that  is connected to the failure that made the loan taxable in the year of correction rather than the year of default.  

Basically, the employer is on the hook for the applicable income taxes regardless of whether additional distributions were made which made the entire amount (loan and non loan assets) subject to 20% withholding.  The controlling factor is that the loan assets are taxable in the year of correction rather than the year of default.

Interesting fact pattern...

[austin3515]

So tell me like I'm stupid - what do you think I should do?  Deposit the 20% as an additional employer contribution?

[RatherBeGolfing]

2 minutes ago, austin3515 said:

So tell me like I'm stupid - what do you think I should do?  Deposit the 20% as an additional employer contribution?

That sounds reasonable.  It should have been paid by the employer, but was paid by the employee, so making a QNEC in that amount to would make the participant whole (more than whole..)

At least that is what I get from reading 6.07(1).  It would make less sense for the employer to only be on the hook for the withholding if other assets were also distributed, since the failure has to do with when the loan was taxable...

Quote

07 Rules relating to reporting plan loan failures. (1) General rules for loans. Unless correction is made in accordance with section 6.07(2) or (3), a deemed distribution under § 72(p)(1) in connection with a failure relating to a loan to a participant made from a plan must be reported on Form 1099-R with respect to the affected participant and any applicable income tax withholding amount that was required to be paid in connection with the failure (see § 1.72(p)-1, Q&A-15) must be paid by the employer. As part of VCP and Audit CAP, 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 the failure). The relief of reporting the participant’s loan as a deemed distribution on Form 1099-R in the year of correction, as described in the preceding sentence, applies only if the Plan Sponsor specifically requests such relief.

 

[Belgarath]

There's a certain level of insanity to all of this - I'm not disagreeing with the comments, but the end result is simply bizarre. There isn't, IMHO, any need to make an employee "whole" - this is only withholding, NOT the applicable income tax. So the employee receives all of the income to which the employee is entitled, has to declare it as taxable, and pays the appropriate income tax. The employee is in the same position, ultimately, that the employee would have been had the error not occurred. Am I missing something?

Now the employee gets an extra 20% bonus on the defaulted loan amount. I just don't think this specific situation was probably considered when they were creating the correction.

I do agree that particularly for small amounts, just not worth messing around with it any further - pay it and be done! On larger amounts, I'd think I'd try to pursue some other alternative.

[austin3515]

They just did not explain what they meant at all.  Shocking because the IRS never makes consequential statements that leave us nuts and bolts people wondering how the heck we actually implement things.

[Tom Poje]

reminds me of the Far Side cartoon in which the rat looks into the kitchen cupboard and sees a box of rat poison and says

"I don't even know why this is up there"

not that I am implying the folks at the IRS are rats, but rather here is a provision that says the employer pays the withholding but they can't tell you why.