Plan sponsor wants to pay a participant's loan

[ldr]

Good morning to all,

Here's a new one for us.  A client called this morning to say that she (owner of the company sponsoring the plan) wants the company to pay off an existing participant loan.  The participant happens to be her son who of course is Key and HCE by virtue of his relationship to his parents, the owners.  He is currently making payroll deducted payments but "the company" wants to pay his loan off for him in 4 quarterly installments beginning now.  She had already called John Hancock to find out if this was feasible and they told her to call us as the TPA.

Our first inclination is to say "Sure, why not?" but then we started wondering if this could somehow be construed by an auditor to be a contribution that went only to this one employee and was therefore discriminatory, or whether there is some other problem associated with it.

We have no idea how the company would eventually treat this for tax purposes.  It's not supposed to be a contribution to the plan of course.  It might be additional pay for the son, from which it appears that he's making the payments? This is an issue they have to work out with their CPA.

At a minimum, we should run a new amortization schedule for them to correspond to the payments they actually intend to make.

Any thoughts on how this could somehow get the client in trouble?

Thanks as always for your advice, thoughts, help.

 

[CuseFan]

This is perfectly fine provided the amounts are treated as compensation (for all purposes) to the son - which would be the case regardless of status of HCE or NHCE.

[jpod]

If they handle it correctly it is additional W-2/941 compensation to the employee, subject to all applicable withholdings, whether or not it actually passes through his hands.  So, for example, if $10,000 is to be paid off, maybe the Company needs to report $15,000 as compensation, pay $10,000 to the Plan, and  $5,000 is for required tax withholdings.  I don't see how this could be fairly characterized as a plan contribution or create any other tax-qualification issue. 

[shERPA]

Right, this is effectively giving him a quarterly bonus, presumably grossed up for taxes, with the net amount going to the loan payoff.

They can't do it as a tax-deductible contribution.  Even if they can give son a plan contribution that would meet coverage and non-discrimination, a contribution is not a loan payment. 

[ldr]

@CuseFan, jpod and shERPA, thank you, your ideas correspond with what we were thinking.  I just had to run it up the flagpole to be sure there wasn't some obscure rule I might be violating in telling her to proceed as she wishes. (creating extra payroll for the son, from which he makes his loan payments).

 

[jpod]

Naturally, it all assumes the Company is willing to provide the tax gross-up.  Absent that this would be much trickier and require more thought than I have given it. 

[CuseFan]

If it ran through regular payroll period then additional payroll and income tax withholding associated with the extra payment for the loan could be taken from his remaining regular wages.

[Bird]

Agree with everything said so far, but there could be other ways to do it; e.g. extra pay to the owner and then use that for the loan payments; then it is a gift.  Probably a case of someone who doesn't understand double-entry accounting and sees "the company" as a pocketbook.  She might change her mind after understanding the ramifications.

[ldr]

Thank you, all of you.  I had a conversation with the client and explained that it needs to be handled through payroll as all of you described above.  They are going to think about it and get back to me, but at least they understand that it's not a tax deductible contribution to the plan.

[jpod]

2 hours ago, Bird said:

Agree with everything said so far, but there could be other ways to do it; e.g. extra pay to the owner and then use that for the loan payments; then it is a gift.  Probably a case of someone who doesn't understand double-entry accounting and sees "the company" as a pocketbook.  She might change her mind after understanding the ramifications.

It may be a gift for tax purposes, but not necessarily (e.g., a constructive contribution to capital of the company followed by a constructive payment of taxable compensation to the son.  In any event, you still have the issue of having to gross-up the owner to cover the withholding taxes so that there is enough net cash to make the loan repayment.   

[rhb401]

Perhaps, this is simplistic, but why don't the parents just write checks each quarter from their personal account and make a gift to him. Son then just writes loan repayment checks.No implications for Company, Plan or other taxes.

[Luke Bailey]

If the money comes from mom's personal funds and is not deducted, it would likely be a gift, unless there is a compensatory motive, i.e. he has to work extra hours at the company or stay employed by the company for a certain period of time in order for mom to pay it, in which latter case most likely jpod's characterization of constructive contribution to corporation's capital and payment by corporation to son would apply.

[card]

Does the plan document allow employees to increase their installment payments?

[Luke Bailey]

I've never seen a plan or participant loan promissory note that did not permit prepayments.

[Bob the Swimmer]

In 2018 and 2019, you can give up to $15,000 to someone in a year and generally not have to deal with the IRS about it. If you give more than $15,000 in cash or assets (for example, stocks, land, a new car) in a year to any one person, you need to file a gift tax return. One parent could gift-split with another parent and give $30k in one year without having to file a gift tax return.

[Bird]

16 hours ago, rhb401 said:

Perhaps, this is simplistic, but why don't the parents just write checks each quarter from their personal account and make a gift to him. Son then just writes loan repayment checks.No implications for Company, Plan or other taxes.

Often, simpler is better.  This is probably the best solution.  I think we're all wasting a lot of time on an issue that arises, as I noted earlier, because the owner sees the company as a a pocketbook and doesn't understand the ramifications of doing what was suggested.

[jpod]

I had the impression from the original post that there may have been a concern that the loan may not actually be paid off unless repayment was taken out of the son's hands, but I could be way off base on that.

[ldr]

Thanks again to all of you.....I don't know what their motivation is in paying off the loan for the kid.  The Mom (our client) didn't give us any explanation as to whether there was any danger that he wouldn't repay it.

The outstanding balance is only a little bit over $12,000.  So am I understanding correctly that she can just gift up to $15,000 to him and there are no tax consequences?  I understand that no gift tax return has to be filed but does the kid somehow have to recognize this money as income?  If not, that could be their best solution.

[ldr]

We will take a good look at the methodology of repayments allowable and amend the plan to allow for whatever they want to do.  Right now it most likely says that payments can only be made via payroll deductions and we have to fix that much, we know.

 

[Mike Preston]

30 minutes ago, ldr said:

We will take a good look at the methodology of repayments allowable and amend the plan to allow for whatever they want to do.  Right now it most likely says that payments can only be made via payroll deductions and we have to fix that much, we know.

 

Money is fungible.  Let mom give a gift of $x to be accessed immediately at pay date to the extent of the load repayment.  Do not amend the plan for this circumstance.

[jpod]

Extremely unlikely that the Plan or the loan instrument expressly prohibits accelerated repayment in any manner.  If they are silent, it is permissible.