Deemed Distribution Made in Error

[Lauren0507]

A Plan participant was mistakenly terminated in the TPA’s system on 9-30-2025, which stopped his loan payments.  In November 2025, a 1099-R was issued using Code M (plan loan offset).  The error was not discovered until May 2026 after the maximum cure period expired.  Since his employment did not terminate, I believe he should have been issued a 2026 Form 1099-R using Code L (deemed distribution).

Normally, we would advise the loan be reinstated.  However, since the error was not discovered until after the maximum cure period had expired, the TPA is unable to reinstate the loan.  The employee was harmed by the error since his loan became taxable.  Does anyone have any suggestions as to how this can be remedied under the Plan? 

[CuseFan]

I assume the employee was not deferring at the time or those would have stopped as well. The employee could make pre-tax contributions in the amount of the loan repayments to restore his balance to what it would have been upon repayment and on a pre-tax basis. 

Maybe an EPCRS filing, but he's already been taxed, then that also involves amending 1099 (to zero?) and tax return.

Whose error in "terminating" the employee? The employer or the TPA? Maybe TPA covers (a portion of) the EPCRS?

As I've opined over the years on these types of situations, the employee needs to accept some responsibility here as well - he didn't notice that his net paycheck increased or think to explore why?

Agree that 1099 coding was incorrect.

 

[Lauren0507]

1 hour ago, CuseFan said:

I assume the employee was not deferring at the time or those would have stopped as well. The employee could make pre-tax contributions in the amount of the loan repayments to restore his balance to what it would have been upon repayment and on a pre-tax basis. 

Maybe an EPCRS filing, but he's already been taxed, then that also involves amending 1099 (to zero?) and tax return.

Whose error in "terminating" the employee? The employer or the TPA? Maybe TPA covers (a portion of) the EPCRS?

As I've opined over the years on these types of situations, the employee needs to accept some responsibility here as well - he didn't notice that his net paycheck increased or think to explore why?

Agree that 1099 coding was incorrect.

 

Thanks so much for your input.  I like the idea of suggesting pre-tax contributions to the employee to restore his balance.  The plan is currently under IRS audit, so audit cap may be an option, although I don't want to open up years not currently under review.  I am considering suggesting the employer assist with the employee's tax liability outside of the Plan.  I agree the employee bears some responsibility.  I'm not sure he speaks English (which could be a hindrance on his end).  I see no way to correct this in a way to put him in the position he would have been in had the error not occurred.

[Artie M]

Seems that this should be corrected as an operational failure and an amended 1099R issued showing a $0 distribution.  I mean the participant remained continuously employed and was in compliance with the loan repayment schedule until the TPA or payroll screwed up the coding.  Then, payroll deductions stopped and the loan was incorrectly processed as a default with a QPLO solely because of the TPA's or payroll's error.  Sure, the participant has some responsibility in this but they simply missed the opportunit(ies) to correct the error at an earlier date; but, not picking up the error doesn't mean the error didn't occur.  Seems that the error was an operational failure in plan administration, not a participant default.   Look at Rev. Proc. 2021-30 §6.07(3) which let's you restore the loan to the status it would be in absent the administrative error through reamortization, etc. Since the participant didn't terminate or have any other distributable event (at least not under your facts), issuing Form 1099-R and reporting a QPLO (Code M) was wrong and should be corrected.  A Code L wouldn't be appropriate either because there should never have been a distribution at all.   

The cure period issue concerns me but arguably there really was never a "failure to repay" under 72p legally speaking.  The cure period exists because a participant fails to make a scheduled payment.  Your facts seem different as the participant didn't stop the payments, the error caused it.  The Plan (through the TPA or payroll) unilaterally made the participant's performance impossible.  If just looking at the regs, this argument might not float (doesn't matter what reason the payments stopped) but this should be looked at under EPCRS.  There go back to 6.07(3).  IIRC there is an example in there about not starting payroll payments when a participant enters into a loan, the cure period runs out, and EPCRS still stated to correct by reamortization, make-ups, etc.  I think that what happens..... sorry no time to check.  If so, you should be able to fix after cure period.  Experientially we have no support for this as we've never submitted a VCP or Audit Cap on that, nor have we ever taken part in an audit where SCP was used after the cure period.

So,, again just thoughts....  

[Lauren0507]

4 minutes ago, Artie M said:

Seems that this should be corrected as an operational failure and an amended 1099R issued showing a $0 distribution.  I mean the participant remained continuously employed and was in compliance with the loan repayment schedule until the TPA or payroll screwed up the coding.  Then, payroll deductions stopped and the loan was incorrectly processed as a default with a QPLO solely because of the TPA's or payroll's error.  Sure, the participant has some responsibility in this but they simply missed the opportunit(ies) to correct the error at an earlier date; but, not picking up the error doesn't mean the error didn't occur.  Seems that the error was an operational failure in plan administration, not a participant default.   Look at Rev. Proc. 2021-30 §6.07(3) which let's you restore the loan to the status it would be in absent the administrative error through reamortization, etc. Since the participant didn't terminate or have any other distributable event (at least not under your facts), issuing Form 1099-R and reporting a QPLO (Code M) was wrong and should be corrected.  A Code L wouldn't be appropriate either because there should never have been a distribution at all.   

The cure period issue concerns me but arguably there really was never a "failure to repay" under 72p legally speaking.  The cure period exists because a participant fails to make a scheduled payment.  Your facts seem different as the participant didn't stop the payments, the error caused it.  The Plan (through the TPA or payroll) unilaterally made the participant's performance impossible.  If just looking at the regs, this argument might not float (doesn't matter what reason the payments stopped) but this should be looked at under EPCRS.  There go back to 6.07(3).  IIRC there is an example in there about not starting payroll payments when a participant enters into a loan, the cure period runs out, and EPCRS still stated to correct by reamortization, make-ups, etc.  I think that what happens..... sorry no time to check.  If so, you should be able to fix after cure period.  Experientially we have no support for this as we've never submitted a VCP or Audit Cap on that, nor have we ever taken part in an audit where SCP was used after the cure period.

So,, again just thoughts....  

I appreciate your comments and agree the was an operational failure and as such, not the participant's fault or responsibility to correct.  When I said he bears some responsibility, I did not mean that legally he has any obligation to find or fix the failure.  The TPA is refusing to reinstate the loan, so I'm going to review the citations you provided and push back on reinstating/reamortizing the loan.  Thank you, Artie!