Deemed Loans

A participant in a qualified plan, stopped making loan repayments in which after 90 days the loan was deemed and reported on a 1099R the following year.  The active participant would like to borrow again from the plan, the plan allows for one (1) per participant at any time, is the participant permitted to take a brand new loan?  Or will he be required to pay-off the prior deemed loan first before he is able to initiate a new loan?

My understanding is that the loan still exists, it was just taxable as a deemed distribution, which is different than a distribution/offset where the loan is actually "distributed" and no longer in the plan - but I defer to others who deal with this more regularly, as I do not.

This all ignores the prudency and possible other concerns lending to someone who recently defaulted. Again, not my area so I'll others argue any issues there.

It is still counted as a loan and still accrues "phantom interest" until such such time as the loan can be offset under a distributable event of some sort.

And if the participant pays the loan, the plan will have to track basis. Wheeeee!

8 hours ago, Lou S. said:

It is still counted as a loan and still accrues "phantom interest" until such such time as the loan can be offset under a distributable event of some sort.

Yes, but my recollection is that the additional phantom interest (i.e., the phantom interest that accrues after the loan has been deemed) is treated as taxable at the time of offset. I think it is only used for purposes of determining whether a new loan can be taken under the $50,000/50% test.

10 hours ago, Luke Bailey said:

Yes, but my recollection is that the additional phantom interest (i.e., the phantom interest that accrues after the loan has been deemed) is treated as taxable at the time of offset. I think it is only used for purposes of determining whether a new loan can be taken under the $50,000/50% test.

It's not taxable at time of offset. Which means your second sentence is accurate; it is only used for applying limits (and in fact the loan exists so if the limit is one per participant it counts as a loan and another one can't be taken).

That is my recollection as well. No additional taxable income at time of offset.

Which brings up an interesting question that I've never had to deal with in real life since I have not had a participant default and then later pay back.

The previously defaulted loan amount is clearly after tax basis . If the additional accrue interest is also paid, as required to retire the loan, is that also after tax basis or is that portion considered pretax earnings subject to income tax when distributed?

Check your loan policy and procedure carefully. We have a few plans with a loan policy that states: If the participant is currently in default on a loan from this Plan or any other plan of the employer, the participant may not have an additional loan from this Plan. 

Whether the deemed distribution is still considered as being in default, I'm not sure. 

Lou S:

 I am going to take an uninformed and unresearched shot at guessing that interest payments on the defaulted and taxed loan are “pre-tax” amounts, just as are regular plan loan interest payments, and also earnings on other after – tax amounts, such as voluntary contributions (excluding Roth).

18 hours ago, QDROphile said:

Lou S:

 I am going to take an uninformed and unresearched shot at guessing that interest payments on the defaulted and taxed loan are “pre-tax” amounts, just as are regular plan loan interest payments, and also earnings on other after – tax amounts, such as voluntary contributions (excluding Roth).

Mmmm. Equally unresearched, I reach the opposite conclusion. One reason is that I don't want to have to keep track of it, another is that this interest is coming from outside the plan, paid by the participant, whereas earnings on voluntary contributions are earned within the plan. Treating the interest as pre-tax makes it effectively deferrals. I see regular loan interest payments differently but don't ask me to explain it.

I am glad that you owned up to being unable to explain why interest payments on both defaulted and undefaulted loans, all originating outside the plan, would have different treatment for tax purposes once paid to the plan by the participant. I am sympathetic to the additional complexities for recordkeeping, but I think that treating the interest as “pre-tax” in the plan as is all undefaulted plan loan interest would be simpler compared to the alternative. However, I have never had to do recordkeeping, so I do not know how accounts are best set up to track sources and earnings. The basis of the repaid defaulted loan alone is a monkey wrench in most plans. Interest on a regular plan loan does not smell like a deferral, though much has been argued about how plan loans are more or less tax favored in the repayment. I haven’t seen that argument in a long time and hope to never see it again.

Let's be mindful that a loan to a participant is an asset of the plan.  The loan may be a general asset or may be earmarked as an asset to the participant.  Since most loans are from individual account plans and are earmarked as an asset of the participant, most discussions of loans assume that loan rules are solely between the individual and the plan.

Let's recast the conversion from the perspective of a loan as a plan asset:

A participant takes out a loan from the plan.  The participant gets cash and the plan gets a promissory note.  The participant makes repayments that include principal and interest.  The principal repayment reduces the outstanding principal on the promissory note and the interest is income to the plan.  All is in balance.

The participant stops making repayments on the loan.  The principal on the promissory note no longer is being repaid, and the plan no longer is receiving interest as income to the plan. 

The loan goes into default and the outstanding amount of the promissory note is declared a deemed distribution and reported as taxable to the participant (after all, the participant effectively still has the "cash" from the remaining original principal of the loan):

• The plan still hold the promissory note for the remaining outstanding principal. 
• According to the terms of the promissory note, this outstanding principal continues to accrue interest effectively increasing the amount due to the plan from the participant.
• If the plan loan is earmarked to the participant, the plan remains an asset in the participant's account.  If the plan loan is not earmarked to the participant, the participant's accrued benefit is not affected.

If the loan is offset (say the participant terminates employment):

• The promissory note is worthless as a plan asset that the associated accrued interest and the remaining loan principal are written off by the plan as an investment loss.
• After the deemed distribution, the participant never repaid any additional principal or interest, and the participant does not receive any additional distribution on the amount of the loan offset.
• The participant's account balance is reduced by the amount of the remaining outstanding principal.  The participant does not receive any of the interest that was accrued on the deemed loan.  In effect, for the participant with an earmarked loan, the participant bears the investment loss applied against this accrued interest.  If the loan was not earmarked as an asset for the participant, the plan bears the investment loss.

Let's now consider what happens if the participant remains active and begins making loan repayments for the deemed loan:

• The plan begins to credit repayments of principal and interest against outstanding balance of the promissory note that includes the interest that accrued after the loan was declared a deemed distribution.
• The amount of the deemed distribution is considered as after-tax basis for the participant.
• The interest on these repayments is treated no differently that the way interest was treated before the deemed distribution.  It is interest received as income to the plan.  The interest repaid by the participant does not create additional basis in the account (just like how income on after-tax contributions does not create additional basis for the participant).

Some loan policies may address the plan accounting which can impact the accounting of the above scenarios, but these policies should not create additional basis for the participant.

Practitioners who have many, many years in the business may remember when interest on personal loans, credit card interest, and interest on plan loans were all deductible.  Those were the days where loan interest was the equivalent of a pre-tax deferral.

Paul I, thanks for that excellent and detailed analysis. I believe that in a "pooled" situation, or as you say a loan being a general asset of the plan, it is best (required?) that the loan effectively becomes an earmarked asset (i.e. self-directed) when it is deemed. Then, at the later time of offset, the interest just washes away along with the loan. If it is maintained as a general asset of the plan, the written-off interest would be a loss to all of the participants (it was phantom interest at the time it was accrued so it all nets out on a global basis, but different participants who come and go will be affected differently). If the participant does make payments...ugh.

I think there is something wrong with all of us who seem to enjoy this discussion!

On 12/2/2023 at 9:15 PM, QDROphile said:

I am glad that you owned up to being unable to explain why interest payments on both defaulted and undefaulted loans, all originating outside the plan, would have different treatment for tax purposes once paid to the plan by the participant. I am sympathetic to the additional complexities for recordkeeping, but I think that treating the interest as “pre-tax” in the plan as is all undefaulted plan loan interest would be simpler compared to the alternative. However, I have never had to do recordkeeping, so I do not know how accounts are best set up to track sources and earnings. The basis of the repaid defaulted loan alone is a monkey wrench in most plans. Interest on a regular plan loan does not smell like a deferral, though much has been argued about how plan loans are more or less tax favored in the repayment. I haven’t seen that argument in a long time and hope to never see it again.

Re-thinking it, I believe you are right. I know this happened once "in real life" and I am confident we handled it correctly. I'd have to go back and look, or else experience it again, to be sure. I hope not to re-experience it.