Final Regulations Issued: Accruing Interest on Defaulted Participant L

[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 of BenefitsBoards.net!

Final Regulations Issued: Accruing Interest on Defaulted Participant Loan

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Effective date. The regulations are effective for loans made on or after January 1, 2002. See Q&A-22(B) [click]. (The 1998 proposed regulations clarified that the effective date would be no earlier than the January 1 which is at least 6 months following the publication of final regulations.) The plan year of the plan is irrelevant. In other words, all plans become subject to the regulations as of January 1, 2002, even if that date occurs in the middle of a plan year. This effective date does not mean that plans may ignore IRC §72(p) before January 1, 2002. The statutory effective date of §72(p) was for loans made after August 13, 1982 (although the quarterly amortization rule and some changes to the principal residence loans did not apply until after 1986). Between the applicable statutory date of any provision of §72(p) and the regulatory effective date, plan administrators must apply a reasonable, good faith standard of compliance. Compliance with the proposed regulations, or any provisions of these final regulations, before the regulatory effective date would be treated as satisfying the good faith compliance standard. The final regulations follow the proposed regulations very closely, so a detailed analysis is not provided in this summary. Here are some highlights.

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Accruing interest on defaulted loans. addresses the treatment of accrued interest following the taxation of a loan as a deemed distribution, adopting the rules as they were stated in the proposed regulations. After a loan is deemed distributed under section 72(p) (e.g., the plan goes into default, as described in Q&A-10), interest that accrues thereafter is disregarded for section 72 purposes. That means the accrued interest is not taxable, neither at the time it accrues nor at the time the loan receivable is later offset. However, until an offset occurs, the accrued interest is taken into account to determine the maximum amount of any subsequent loan to the participant. (Note that the offset is an actual distribution event and cannot be permitted before an actual distribution is permitted under the plan. Until there is an actual distribution, the loan is not treated as a distribution for qualification purposes, only for tax purposes.)

Example. Lynn borrows $10,000 from her employer's profit sharing plan. The loan is not repaid through payroll withholding deductions. Instead, Lynn must make monthly installment payments by writing a check to the plan for each payment. As of December 31, 2002, the outstanding balance becomes a deemed distribution because of a monthly payment missed on September 30, 2002. (Lynn makes no payments between September 30, 2002, through December 31, 2002, that can be treated as covering the missed payment.) The outstanding balance as of December 31, 2002, is $8,250 (which includes accrued interest through that date). That amount is taxed as a deemed distribution under section 72(p). Under the terms of the plan, distribution is not available to Lynn, so the loan amount cannot be offset at the time of default. After December 31, 2002, interest continues to accrue at $200 per month. The post-2002 accrued interest is not included in Lynn's income. However, the accrued interest is added to the deemed distribution amount ($8,250) to determine whether any subsequent loan made to Lynn satisfies the limitations under section 72(p). As a non-401(k) profit sharing plan, the plan could be written to treat default as a distribution event, which would trigger a loan offset, i.e., an actual distribution, coincident with the default. The example assumes the plan does not contain this provision. If such a provision were in the plan, Lynn's account would be offset by the unpaid loan balance, and would be reported as an actual distribution, rather than as a deemed distribution. No interest would accrue and there would be no outstanding loan to Lynn if a new loan were to be made to her. Note that proposed regulations also issued today (see separate summary above) would impose additional conditions if another loan is made to the participant before the defaulted loan is offset. These conditions are designed to ensure that any subsequent loan is more likely to be repaid.