Proposed Regulations Issued: Participant Loan Refinancing Transactions

[Dave Baker]

The following article is from Sal Tripodi's TRI Pension Services web site ( http://cybERISA.com ) and is reprinted here with Sal's permission. Copyright 2000 TRI Pension Services, all rights reserved. Post a reply to this thread if you would like to discuss comments or questions about this article with other users!

Proposed Regulations Issued To Cover Loan Refinancing Transactions

[Effective date.] <a href="http://www.benefitslink.com/taxregs/72p-proposed-2000.shtml">Prop. Treas. Reg. §1.72(p)-1 [click]</a>, Q&A-9(B) and ©, Q&A-19, Q&A-20, Q&A-22(d), 65 F.R. 46677 (July 31, 2000), supplement final regulations issued today under IRC §72(p) ... The proposed regulations will apply to loans made on or after the first January 1 which is at least six months after the regulations are finalized. Since January 1, 2001, is already less than six months away, the earliest effective date for the rules contained in these proposed regulations will be January 1, 2002 (assuming final regulations are issued by June 30, 2001). For earlier loans, a reasonable, good faith compliance standard applies. Presumably, following these proposed regulations will satisfy this good faith standard.

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One of the issues that has perplexed plan administrators is how to apply the rules of IRC §72(p) when an existing loan is refinanced, or a new loan is made that also repays the existing loan. Some administrators have employed a very conservative approach, prohibiting any additional loans until an existing loan is fully repaid and prohibiting the refinancing or renegotiation of an existing loan. In <a href="http://www.cyberisa.com/erisa_book.htm">The ERISA Outline Book [click]</a>, we have provided suggested methods for using refinancing transactions to replace an existing loan. See Chapter 7, Section IX, Part B.1.b., of the 1999-2000 edition. Happily, these proposed regulations adopt the arguments we have used in the Outline Book to support these suggested methods.

Definition of a refinancing transaction. Proposed Q&A-20(a) defines a refinancing as any situation in which one loan replaces another. This might occur because the participant wants to add to the outstanding loan amount, but does not want to, or the plan will not permit him to, have more than one loan outstanding at a time. This also might occur because the interest rate or the repayment term is being renegotiated (e.g., to reflect a lower interest rate, or to provide more time to repay the outstanding loan balance). A refinanced loan is treated as a new loan for purposes of §72(p). That means the interest rate and the security interest on the refinanced loan must be determined as of the date of the refinancing. Thus, the interest rate under the replaced loan might not be an appropriate interest rate under the refinanced loan, because the plan must now redetermine what is a commercially reasonable interest rate. In addition, the 50% limit under IRC §72(p)(2)(A) must be redetermined to take into account the participant's vested accrued benefit as of the date of the refinancing.

How to apply §72(p) to refinancing transactions. If the loan that is replacing the original loan (the replacement loan) has a term which ends later than the term of the loan being replaced (the replaced loan), then both the replacement loan and the replaced loan are treated as outstanding on the date of the refinancing transaction. See Proposed Q&A-20(a)(2). Thus, two loans collectively must satisfy the requirements of IRC §72(p), or there will be deemed distribution consequences, in accordance with the rules set forth in the §72(p) regulations. For example, if the sum of the amount of the replacement loan and the outstanding balance of the replaced loan (plus any other existing loans not being replaced) exceeds the amount limitations under IRC §72(p)(2)(A), the excess is taxed as a deemed distribution. However, if the term of the replacement loan does not end later than the term of the replaced loan, the replaced loan is disregarded in determining whether the replacement loan satisfies §72(p), and only the amount of the replacement loan (plus the outstanding balance of any existing loans that are not being replaced) are taken into account.

Exception. The rule described in the first sentence of the prior paragraph does not apply if the replacement loan would satisfy §72(p)(2) if it were analyzed as two separate loans - one representing the replaced loan, amortized in substantially level payments over a period ending no later than the last day of the original term of that replaced loan, and the other one representing the difference between the amount of the replacement loan and the outstanding balance of the replaced loan. In other words, if the replacement loan would effectively amortize an amount equal to the replaced loan over a period that does not exceed the original term of the replaced loan, the Treasury does not feel that the refinancing transaction is being used to circumvent §72(p), so there is no need to take into account the outstanding balance of the replaced loan to determine whether the amount of the replacement loan satisfies §72(p). When this exception applies, the plan only needs to take into account the amount of the replacement loan plus any existing loans which are not being replaced to determine if the §72(p)(2) limitations are violated. The following two examples illustrate these rules. Additional examples are provided in the proposed regulations.

Example - increasing loan and starting new 5-year term. Will has a vested account balance of $23,000 as of December 1, 2002. He receives a loan for $8,000. The loan bears the maximum 5-year payment term, so the loan will not be fully amortized until November 30, 2007. On June 1, 2004, Will has an outstanding balance of $6,000 on the original loan. As of that date, his vested account balance is $32,000. Will's loan limit is now $16,000 (i.e., 50% x $32,000), $6,000 of which is outstanding. Will needs $4,000 additional cash. The plan lends Will another $4,000 on June 1, 2004, and starts a new 5-year repayment term ending May 31, 2009. The new loan requires monthly amortization (deducted through payroll withholding). The principal of the new loan (i.e., the replacement loan) is $10,000, which represents the $4,000 of additional cash given Will and the $6,000 outstanding balance on the original loan (i.e., the replaced loan). In other words, the replacement loan pays off the outstanding balance of the replaced loan, and also gives Will another $4,000. The refinancing transactions satisfies the requirements of Proposed Q&A-22. The replaced loan had an outstanding balance of $6,000. The replacement loan is for $10,000. Since the repayment term of the replacement loan ends after the term of the replaced loan, the plan must treat both loans as outstanding on June 1, 2004, to determine if the §72(p)(2) limits have been exceeded. If we add the loans together, we get a total of $16,000. Will's 50% limit under §72(p)(2)(A) is $16,000 because, as of the date of the replacement loan, Will's vested account balance is $32,000. In addition, the repayment rules of §72(p)(2)(B) and © have not been violated by either loan. Compliance with the repayment rules is determined separately with respect to each loan because the replacement loan is treated as a separate, new loan. The replaced loan had a term that would have ended on November 30, 2007. The loan, during its existence, satisfied the level amortization requirements, and the refinancing transaction has resulted in that loan being paid in full. The replacement loan also does not violate §72(p)(2)(B) and ©. It has a repayment term that does not exceed 5 years from the date of that loan, and the loan provides for level amortization on at least a quarterly basis. The plan could have made a separate loan to Will in the amount of $10,000, assuming the plan permits more than one loan to be outstanding at a time. A new loan of $10,000 plus an outstanding loan balance of $6,000 would have equaled Will's maximum loan limit on June 1, 2004, which is $16,000. Will could then have used $10,000 of the proceeds from the second loan. The net effect of this alternative approach is the same as the refinancing example, illustrating why the proposed regulations approve of the refinancing transaction. By disbursing an additional $4,000 to Will and treating a new loan of $10,000 to have started on June 1, 2004, the plan is simply consolidating steps.

Example - 50% loan limit would be exceeded if replacement loan were added to outstanding balance of replaced loan. Let's modify the prior example slightly. Suppose Will's vested account balance as of June 1, 2004, is only $26,000, because of market fluctuations on his non-loan investments in his account. Now, Will could not have two loans outstanding that total $16,000, because his maximum loan limit is only $13,000. Therefore, the plan can't treat Will as receiving a second loan for $10,000, and using $6,000 of the proceeds from the second loan to retire the first loan, as suggested in the prior example. What options are available here?

<UL>

Option #1 - separate loans (i.e., don't do any refinancing). Make a separate loan for $4,000 (rather than for $10,000), which is the additional cash that Will needs. The origination date of the separate loan is June 1, 2004. Will continues to amortize his original loan over its remaining term (which ends November 30, 2000), which has a balance of $6,000 at this time, and he starts a new amortization period on the second loan of $4,000, which would have a separate repayment term that could end as late as May 31, 2009 (i.e., 5 years after the origination date). This option is available only if the plan permits Will to have more than one loan outstanding at a time. Since the original loan is not being replaced by the second loan, the plan simply adds the outstanding balance of the first loan to the amount of the second loan to determine if the limits of §72(p)(2)(A) are satisfied, using Will's vested account balance at the time of the second loan to make such determination.

Option #2 - refinancing of the original loan with original repayment term. Another option is to consolidate Will's loans into a single loan of $10,000 as of June 1, 2004, through a refinancing transaction. The replacement loan is for $10,000, but only $4,000 is disbursed to Will because the other $6,000 is used to payoff the original loan. However, the repayment term of the replacement term ends November 30, 2007, which is the same date as the original loan. Since the term of the replacement loan is not later than the term of the replaced loan, the plan does not treat the replaced loan as outstanding at the time of the replacement loan for purposes of §72(p)(2). Proposed Q&A-20(a)(2) applies only if the term of the replacement loan ends later than the term of the replaced loan. Thus, the plan looks only at the replacement loan to determine if the limitations under §72(p)(2)(A) have been exceeded. A loan of $10,000 does not exceed Will's loan limit of $13,000, so §72(p)(2)(A) is not violated. In addition, the replacement loan has a repayment term that does not exceed the 5-year rule under §72(p)(2)(B) and the amortization schedule satisfies the requirements of §72(p)(2)©. After the refinancing transaction, Will's loan payments will be greater because he is amortizing a greater amount over the remainder of the term of the replaced loan.

Option #3 - refinancing of the original loan with a new repayment term which amortizes the original loan within its original term. Under this option, the plan disburses $4,000 to Will and consolidates the first loan and the second loan into a refinanced loan for $10,000, as under Option #2, effective June 1, 2004. The difference from Option #2 is that instead of having the $10,000 loan fully amortized by November 30, 2007 (as under Option #2), the new loan has a full 5-year amortization term that ends May 31, 2009, (or an earlier date that is later than November 30, 2007). However, the amortization schedule is structured so that at least $6,000 of the principal (which was the loan balance on the replaced loan at the time of the refinancing) is amortized by the original term of the replaced loan (i.e., November 30, 2007), and the difference is amortized on a level basis during the new 5-year term. This would be accomplished by having Will's payments through November 30, 2007, equal the payments under the replaced loan (as adjusted, if necessary, to reflect a change in the applicable interest rate under the refinanced loan) plus an additional amount needed to amortize the additional $4,000 over a 5-year period starting June 1, 2004, and his payments from December 1, 2007, through May 31, 2009, equal only to the amount needed to finish amortizing the additional $4,000. To illustrate, suppose the replaced loan had monthly payments of $100, and monthly amortization of an additional $4,000 over 5 years requires additional monthly payments of $65. Also suppose that there has been no change in the interest rate. Under this option, Will would pay $165 per month under the replacement loan until November 30, 2007, and then only $65 for December 2007 through May 2009. Since the outstanding balance of the replaced loan is still being repaid by November 30, 2007, the plan does not treat the replaced loan as outstanding at the time of the replacement loan for purposes of §72(p)(2). See Proposed Q&A-20(a)(2). Thus, the plan looks only at the replacement loan to determine if the limitations under §72(p)(2)(A) have been exceeded. A loan of $10,000 does not exceed Will's loan limit of $13,000, so §72(p)(2)(A) is not violated. In addition, the replacement loan has a repayment term that does not exceed the 5-year rule under §72(p)(2)(B) and the amortization schedule satisfies the requirements of §72(p)(2)© (the drop in the amortization payment after November 30, 2007, is not treated as violating the level amortization requirement).

Option #4 - bridge loan to repay first loan. Under this option, Will obtains a third-party loan for $6,000 to repay the outstanding balance on the first loan. He then requests $10,000 as a new loan from the plan. The $10,000 will not violate Will's 50% limit under §72(p) because the $6,000 outstanding balance on the first loan has been repaid before the $10,000 loan is taken. The $10,000 loan can have a 5-year amortization term. Will then uses $6,000 of the proceeds from that loan to repay the third-party lender. The guidance in Proposed Q&A-20 makes this option the least desirable, because the other options, which satisfied the proposed regulation, eliminate the need to involve an outside lender. However, if the plan does not permit refinancing transactions, and also does not allow for more than one loan to be outstanding at a time, Will would have to use this option to accomplish his desired result.</UL>[Edited by Dave Baker on 08-01-2000 at 11:44 AM]

[Fredman]

Ok, I think understand all of this. I have one question:

If on the day of the refinancing, there is a replacement loan and the replaced loan for purposes of §72(p)(2), how does this apply to a loan policy that only allows one loan at a time?

Here's the part from Sal's text that has me befuddled:

"Since the repayment term of the replacement loan ends after the term of the replaced loan, the plan must treat both loans as outstanding on June 1, 2004, to determine if the §72(p)(2) limits have been exceeded. If we add the loans together, we get a total of $16,000."

Two loans, eh?

What do you think?

[Fredman]

...I'm bumping this back to the top.

[david shipp]

I think it is a matter for the plan loan program to address. Since the loan program is what restricts the number of loans, a policy can be established to either permit refinancing under a one-loan restriction or to bar refinancing. Whether regs. treat the transaction as one or two loans for section 72 purposes would be immaterial.

[pjkoehler]

While the final and proposed 72(p) regs contain some welcome clarification regarding refinancing of participant loans in avoiding adverse income tax consequences, it's important to keep the PT exemption requirements in mind as well, lest the plan begin to take on the trappings of an employee credit union. For instance, a loan program should be prudently established and administered for the exclusive purpose of providing benefits to participants and beneficiaries of the plan. 29 CFR Sec. 2550.408b-1(a)(4). Example 6 in these regs stresses that a fiduciary should take into account only those factors which would be considered in a normal commercial setting by an entity in the business of making comparable loans. Since both the 72(p) regs and the PT regs consider a renewal or modification of an existing loan to be a new loan, it may be hard to square a loan refinancing, for example, solely to reduce the interest rate on the replaced loan, with normal commercial lending practice, since commercial lenders rarely agree to allow a borrower on demand to refinance a loan secured by the same collateral for this purpose. Even if it is normal commerical lending practice, how does reducing the rate of return to the plan square with the fiduciary's obligations under ERISA's exclusive purpose standard? Furthermore, loan refinancings may impose a substantial administrative cost on the employer and/or the plan. A plan sponsor has no obligation to adopt a loan program that permits loan refinancings, and should consider the appropriate cost recovery mechanism (e.g. reasonable refinancing fees charged to the participant's account) before modifying its program to make them widely available.[Edited by PJK on 08-09-2000 at 04:34 PM]