Commercially Unreasonable Interest Rate and Participant Loans

If a loan is issued with a commercially unreasonable rate of interest. How is this a violation IRC 72(p) that would provide for the authority to deem the loan. If your answer is it results in a violation of substantially level amortization, please provide your reasoning bc I’m personally struggling to reach that conclusion.

Is the interest rate too low? Or, too high?

Too low.

If you're interest rate is commercial unreasonable than I don't think the initial loan satisfies the conditions set forth in §72(p) and you would have a deemed distribution on issue of the loan, and possibly a prohibited transaction. If you look at §1.72(p)-1 Loans treated as distribution - then just before the Q&A the example assumes that everything was OK with the initial loan, including a commercially available reasonable rate of interest.

Whether or not the interest rate is reasonable or not I leave for others to decide. But if a determination has been made that it is too low, I think you have a problem even if the loan itself meets all the other requirements of 72(p).

We agree that there is a problem. And we also agree that all the terms of the loan are assumed to be reasonable for the examples in the regulations. But how does an unreasonable rate of interest result in a violation IRC 72(p)? Unless you are saying that such a situation will deem the loan before 72(p) is even considered.

72(p)(1)(A) states a loan from a plan is a distribution:  "If during any taxable year a participant or beneficiary receives (directly or indirectly) any amount as a loan from a qualified employer plan, such amount shall be treated as having been received by such individual as a distribution under such plan."  Then 72(p)(2) provides an exception.  Treas. Reg. §1.72(p) initially states the exception is for bona fide loans "with adequate security and with an interest rate and repayment terms that are commercially reasonable."  I assume your unreasonable interest rate is not "commercially reasonable" and, thus, for purposes of the Regulations, would not be a bona fide loan that meets the exception.

Just my thoughts so DO NOT take these ramblings as advice...

I respectfully disagree that the regulations do that much heavy lifting. The IRC 72(p) regulations only state that the examples in the regulations are based on the assumption that a participant loan is made with adequate security and with an interest rate and repayment terms that are commercially reasonable. The IRC 72(p) regulations do not explicitly state that only loans that comply with the terms of IRC 4975 are qualified to meet the exception to avoid being a distribution.

Thus the question is rather, what is the definition of a loan in the statute? Is a loan only those devices that comply with IRC 4975(d)(1)(D) or does it include loans that don't comply with IRC 4975(d)(1)(D). If IRC 72(p) includes loans that don't comply with IRC 4975(d)(1)(D), then as long as all the exceptions of IRC 72(p) are met, the loan is not a distribution, even though it might be a qualification error and a prohibited transaction. I do not read the regulations as saying that the IRC 72(p) exception is limited to bona fide loans "with adequate security and with an interest rate and repayment terms that are commercially reasonable."

I have no issue with disagreement.... part of this life.  Quoting FSA 20047022 (though essentially "dicta"):   "In fact, the introductory language of Treas. Reg. section 1.72(p)-1 specifies that the examples in the regulations are based on the assumption that a bona fide loan is made to a participant."  The language quoted in the prior post describes what is needed for a bona fide loan (including a commercially reasonable interest rate).  Read it as you will but neither the IRS nor the Plan's internal auditor will likely agree with your reading.

As a corollary, perhaps look to ERISA, which would also govern the issuance of a plan loan and which is more explicit.  ERISA §406(a)(1) states:   "A fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such a transaction constitutes a direct or indirect-- ... lending of money or other extension of credit between the plan and a party in interest ...."   DOL Reg. §2550.408b-1 states: "Section 408(b)(1) of [ERISA] exempts from the prohibitions of section 406(a) ... loans by a plan to parties in interest who are participants or beneficiaries of the plan provided that such loans: .... bear a reasonable rate of interest."  Granted, this language applies to ERISA prohibited transactions but it seems informative as most plan documents blend the requirements of the Code and ERISA when structuring the terms of the qualified plan loan programs.

Assume that there is no IRC 72(p) statute. Just the labor statute. But then assume that even though the fiduciary is prohibited from issuing a loan that is not bonafide, one was issued anyway. (A) is there a loan? (B) if there is a loan does the fiduciary have the authority to unwind the loan unilaterally?