Final Regulations Issued: Crediting of Tax Basis on Defaulted Particip

[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: Crediting of Tax Basis on Defaulted Participant Loan at Time of Offset

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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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No basis credited because of deemed distribution/reporting rules when defaulted loan is later offset. When a loan becomes a deemed distribution, the amount taxed is not credited as tax basis. However, see the transition rule in Q&A-22© [click], where accrued interest that was taxed as a deemed distribution is treated as tax basis. When the plan offsets the loan receivable, the offset amount is not reported again as part of the participant's gross distribution. In other words, the prior deemed distribution of the loan is treated as the distribution of that loan for reporting purposes, so the cashless portion of the distribution that represents the loan offset is not reported. Since the loan receivable is not reported when it is offset, there is no need to credit basis for that loan. Interest that accrues after the deemed distribution is also not reported as part of the gross distribution when the loan offset later occurs, even though the accrued interest was not previously subject to taxation.

Example. Bill defaulted on a participant loan in 2000. At the time of the default, the plan deemed a distribution of $12,150. That was reported on Form 1099-R for the calendar year in which the default occurred. The loan receivable remained an asset of the plan because there was no distribution event with respect to the defaulted amount. The plan posted accrued interest, but did not report it as a deemed distribution. In 2003, Bill terminates employment and requests a lump sum distribution of his account. At the time of the distribution, Bill's account consists of $61,300 cash and $15,250 loan receivable, (which includes the $12,150 initial default amount and $3,100 accrued interest). The plan offsets the loan receivable and the accrued interest and distributes the cash (20% of which is withheld for federal income taxes). The Form 1099-R should report a gross distribution of $61,300, which is the cash portion of Bill's account, and shows the same amount as the taxable distribution because Bill does not have any tax basis. He does not get tax basis for the previously-taxed loan because the loan offset is not reported as part of the gross distribution. Since the loan receivable and the accrued interest are not treated as part of the distribution, the 20% withholding liability is calculated only on the cash portion of $61,300.