Loan not defaulted

[Bird]

Proverbial takeover case - loan should have defaulted in 2006 at around $46,000.  Some payments have been made since but not many, and sporadically.  At 8.25%, John Hancock is carrying this at $75,000 now.

I'm referring this to an attorney, but just curious what BL mavens have to say as likely outcomes under VCP, or other thoughts.

[Kevin C]

My reading of Rev. Proc. 2016-51 6.07 (1) & (2) is that the tax treatment can only be changed under VCP if the loan is corrected using one of the correction methods in 6.07 AND that those correction methods are not available if the maximum allowable repayment period for the loan has expired.  Unless it was a principal residence loan, the maximum allowable period for a pre-2006 loan has long since ended and I don't think you can correct under VCP.

 

Quote

 

6.07 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.

(2) Special rules for loans. (a) In general. The correction methods set forth in section 6.07(2)(b) and (c) and section 6.07(3) are available for plan loans that do not comply with one or more requirements of §  72(p)(2) and are corrected through VCP or Audit CAP. The correction methods described in section 6.07(2)(b) and (c) and section 6.07(3) are not available if the maximum period for repayment of the loan pursuant to §  72(p)(2)(B) has expired. The IRS reserves the right to limit the use of the correction methods listed in section 6.07(2)(b) and (c) and section 6.07(3) to situations that it considers appropriate; for example, where the loan failure is caused by employer action. A deemed distribution corrected under section 6.07(2)(b) or (c) or under section 6.07(3) is not required to be reported on Form 1099-R and repayments made by correction under sections 6.07(2) and 6.07(3) do not result in the affected participant having additional basis in the plan for purposes of determining the tax treatment of subsequent distributions from the plan to the affected participant. The relief from reporting the participant's loan as a deemed distribution on Form 1099-R, as described in the preceding sentence, applies only if the Plan Sponsor specifically requests such relief and provides an explanation supporting the request.

 

 

[Bird]

Urk.  Thanks...so, in a theoretical world, does that mean the loan should retroactively default?  Or it is just broken and unfixable?

[Kevin C]

In a theoretical real world, 1.72(p)-1 Q&A 10 says the loan becomes deemed at the end of the cure period.  The only way I know of to change that is through a VCP filing.  So, it appears the loan was taxable in 2006.  The sporadic payments since then would create an after-tax basis under Q&A 21 and the additional interest that accrues does not become taxable under Q&A 19.  Of course, it sounds unlikely the participant reported the deemed loan on the 2006 tax return.

 

[Luke Bailey]

My recollection is that while the defaulted (but not distributable) "deemed" distributed loan's unpaid balance continues to bear interest for purposes of blocking new loans, that additional interest is not treated as distributed when you do the loan offset. Also, although there may be one, I don't recall there being a rule in the regs that if you miss your reporting obligation for the "deemed distributed" year the deemed distribution does not occur. I think it probably did occur, but the plan failed its reporting obligation. Had the plan discovered this within 3 years, or arguably even 6, you would probably have had a corrected 1099-R obligation, but you're way beyond even the 6-year statute of limitations for income inclusion, so no point in doing that now. So at least arguably the result is that when there is a distributable event at some point, you have to issue a 1099-R for the amount of the loan at the deemed distributed date (i.e., the amount you would have reported back in 2006), showing the portion he has paid off since then as nontaxable/basis. Under the duty of consistency rule, if nothing else, he has no basis on account of the unreported deemed distribution that occurred in 2006, assuming the participant did not somehow self-report it without the 1099-R.

Just a quick and dirty hypothetical analysis. Assumes this was an inadvertent error and the participant did not control the plan's accounting and reporting. If he did, then you may have other issues.

[Bird]

Thanks for the comments.  It's hard to say who, if anyone, controlled anything.  I don't totally trust the participant, although he seems to want to fix it more-or-less properly, and the prior TPA really didn't do anything except prepare the tax return.

Good point about the additional interest accruing being about limiting future loans, and not about the real value at time of default.

[Kevin C]

Luke,  under the duty of consistency rule, with 1.72(p)-1 Q&A 19 saying the interest accruing after the loan being deemed is not taxable, would that mean that if the participant didn't treat the loan as taxable in 2006, he couldn't treat the additional interest as not being taxable?

[CJ Allen]

Interest accrues up to date of actual deemed distribution.  Thereafter, the interest is non-taxable accrual used to determine future maximum loan amount.

In similar takeover issues, there's been a dependency on the naming convention or other sourcing of the loan as "deemed"; however, I've experienced a split in terms of loans that actually were deemed, and those that were not.  There must be good records going back 12 years on this plan, so that seems to be a "plus".

[Luke Bailey]

8 hours ago, Kevin C said:

Luke,  under the duty of consistency rule, with 1.72(p)-1 Q&A 19 saying the interest accruing after the loan being deemed is not taxable, would that mean that if the participant didn't treat the loan as taxable in 2006, he couldn't treat the additional interest as not being taxable?

Tom, I think this is a close question. The "duty of consistency" rule, which I am fairly familiar with generally, but not particularly in the 72(p) context (I doubt there is any case or guidance regarding intersection of duty of consistency with 72(p), but I could be wrong), is somewhat slippery, albeit well-established. To the extent I have been able to make any sense of it, there is generally some requirement that the taxpayer (here, the participant, of course) take some action or commit some definite omission that is inconsistent with his or her current tax position. If, for example, this was a large plan and the participant was not involved in the plan's administration and didn't understand the tax consequences and related issues, I think that the stronger argument is that his or her simply doing nothing in the face of not receiving the 1099-R that the plan should have given him or her would not be enough to invoke the duty of consistency.

Say, for example, you are a young, semi-skilled new entrant in the workforce and you have 10 jobs with different employers during the year and you get 9 W-2's. You file your return with those 9 W-2's, but you forgot about that job you had in January for a few weeks, for which the employer did not send you a W-2. The amount was way less than 25% of your income and 3+ years go by and eventually the company sends you a W-2. The statute's closed. The mere fact that you had income, but didn't pay tax on it, is not enough to invoke the duty of consistency, otherwise there would be no statute of limitations.

Now, of course, that's an extreme, oversimplified example, and when I reviewed the cases a while back I did conclude that, at least in some courts, it didn't take much to invoke the duty of consistency, but it did take something.

With regard to Q&A-10 and -19, the way I am reading them is that they don't say the deemed distribution is treated as not occurring until it's reported, but rather occurs at the end of the cure period. Here the failure (at least, assuming the participant was not involved in any way in the plan's administration or failure to report the deemed distribution, which may be contrary to the actual facts) was the plan's failure to do the required reporting, not the participant's failure to include the income, which he or she might not have even understood he or she had. As I implied previously, if the participant was complicit in the reporting failure, you might get a different result. Possibly that result would be, or the IRS would argue that it is, to require the participant to pay tax on the post deemed distribution accrued "phantom" interest, but it's hard for me to get that out of the reg, because again a straight-up interp of the reg is that the deemed distribution occurred (albeit, in the dark as it were) as of the close of the first calendar quarter following the calendar quarter of the first uncured missed payment. But it is complicated, and the cases are nuanced.

Of course, apart from the arguable nuances of the tax law, the reporting is the "meat and potatoes," so to speak, of tax compliance. The plan did not 1099-R the deemed loan, so the participant did not pay tax when he or she was supposed to. If the plan now determines, based on its interpretation of the law, that the accrued interest since the "deemed" date should be included in the amount of the loan offset "distribution," per your argument, Kevin C, then the participant will face an uphill battle fighting that with IRS.