Participant Loan Action Requested by Plan Sponsor

We administer a 70 participant 401(k) plan that does allow for participant loans. The plan loan policy restricts loans to a few categories of need. To pay past due taxes, To use to purchase a principal residence, for moving expenses etc.

They had a participant who they later found that lied on his plan loan application and the loan proceeds were not used for the purpose he stated. The loan has been in place for about 6 months and he is current on all loan repayments.

Because he lied on his application, the plan sponsor wants to demand full repayment of the loan by year end and if that does not happen, they want the balance of his loan to be offset and become a taxable distribution to him.

The plan document allows for an offset that becomes a taxable distribution to the participant in cases of non-repayment or delinquent repayments of the loan. However, the document does not seem to allow for a loan offset / taxable distribution just because he was not truthful on what the loan was going to be used for.

We think that they cannot just offset the loan so it becomes a taxable distribution even if the participant lied about what he was going to use the proceeds for.

Does anyone agree? Disagree?

Thanks.

Is the participant still employed by the employer that sponsors or participates in the retirement plan?

Most plan documents include basic loan provisions about the availability of loans, and then refer to the plan's loan policy to provide the details about how the loan will be administered.  The loan policy typically can be changed without amending the plan document.  This sort of dual controlling provisions/policy does have the potential to cause some confusion.  Notably, the loan policy can specify conditions that will cause the loan to become immediately due (as is common when a participant leaves employment), even though this is not a mandated, regulatory requirement.  The loan policy also can specify how loan repayments must be made (e.g., through payroll) and other means of making repayments are unacceptable.

In this instance, the loan is not violating any likely plan provision, but it is violating the loan policy.  The company seems to want to work with the participant by allowing the participant until the end of the year to remedy the situation.

Consider taking these steps:

• Review the requirements of the loan policy.
• Inform the participant that the loan is in violation of the policy, and beginning after the first loan repayment in July the plan will no longer accept loan repayments because of the violation of the loan policy.  
• Inform the participant of the loan policy related to the cure period for not making loan repayments (which commonly would be as of the end of the quarter following the quarter in which the last loan repayment was made).  This should give the participant until the end of the year to repay the loan.
• Inform the participant if the loan is not repaid by the end of the cure period, is will be considered a deemed distribution and taxable.

Adjust the steps to conform to the provisions of the actual loan policy.

Good luck!

1. What do the loan documents provide? For example, is fraudulent application a breach? Does the loan have an acceleration provision for the breach? Does any fiduciary have any discretion over remedies for breach?

2. What do the plan documents, broadly considered, provide? Does the employer have any say in this? I know that everyone presumes that the employer is the, or a, fiduciary with such powers. I have asserted now and then that that is not a good design, especially for a larger organization.

3. Do you have any say this? What do your engagement documents provide? Or are you just curious?

In my opinion, I don't care what the loan documents say.  This loan was not permitted under the Plan.  The Plan terms were violated and there is an operational failure.  Tell the participant he needs to pay the loan back in full because this is a distribution when no distribution was permitted and we handle like a Refund of Excess Amounts under EPCRS.   I mean, this Plan has a hardship loan provision.  This is similar to asking for a hardship withdrawal, receiving it, but there was no hardship.  So what if there's a loan promissory note.  That note is a contract and is voidable ... contracts that are entered into under fraud or misrepresentation are unenforceable.   Let him take us to court if he wants to enforce it.  He has to tell the court that even though he lied to get the loan, we have to let him pay back installments... no we want the entire amount back because he lied.

While he is talking to a lawyer (who won't take this) or going to small claims court (where it is preempted), we notify him to return the entire amount to the Plan plus earnings, no rollover.   Assuming he doesn't return the full amount (so plan stopped taking loan payments), Plan issues a 1099-R with loan proceeds as taxable, indicating no rollover eligibility.  Let him worry about early withdrawal penalty.   If he has a problem, tell him to argue with the IRS.  We have a reasonable position, misrepresentation, violation of plan terms, self-correction per EPCRS.

Just my opinion.....  oh, and I am having just a really peachy day....

Without agreeing or disagreeing with any views or suggestions expressed above:

Assuming as hypothetical facts those described above:

The plan’s administrator might consider, with its employee-benefits lawyer’s advice and employment lawyer’s advice:

Consider whether what the individual describes as a participant loan might not be a participant loan.

Consider whether one or more of the individual’s acts might be a Federal crime, such as 18 U.S.C. § 664 (theft from plan), § 1027 (false statement to an ERISA-governed plan), § 1621 (perjury).

Consider that money the individual received might be proceeds from one or more Federal crimes.

Consider what legal and equitable remedies might be available to the plan.

Consider what remedies might be unavailable to the individual because he comes with unclean hands.

Consider also the measured paths Paul I and QDROphile suggest. Those might be simpler or easier.

This is not advice to anyone.

I would also recommend either eliminating loans OR allowing loans for any reason. 
 

Other choices baffle me. 

Let me see if I understand. You have a policy which is not part of the plan documents that limits a participant's right to borrow his own money from his own 401k account to a limited number of circumstances.  Your participant borrowed money on one pretext, but used the money for another non-permitted purpose but is faithfully making the repayments. 

And your policy is to cause this participant financial grief, thereby ensuring his future love and affection for his employer?

In the original post, the plan sponsor is willing to give the participant until the end of the year to remedy the situation.  This does not sound like a plan sponsor who wants to punish the participant, but does want to enforce the terms of the loan policy.  The plan sponsor likely is willing to help the participant work out a solution that does not impact the plan.

If the plan sponsor has lost all faith in the participant's word that it can no longer be trusted, then they likely would terminate the participant's employment.

The plan sponsor does need to enforce the rules lest work get out that anyone can lie and take out a loan for any reason without consequences.  This just as easily lead some participants to think other plan or company rules where lying will not have consequences.  Or, the plan sponsor could acknowledge that restricting loans is no longer a good idea and remove the restrictions.  That is the plan sponsor's decision.

Plans should communicate in writing how the plan will operate, and then operate the plan accordingly.  Put in more common language, plans should say what they will do, and then do what they say.  Any teacher or parent can tell you that anything else is asking for trouble at some level.

@fmsinc I have several clients who do not permit loans for any reason and three who do not permit loans except for hardship circumstances.  These clients are very paternalistic and believe that the 401(k) funds are for retirement and should not be used like their bank accounts.  All of these clients provide generous matches and profit sharing contributions.  At least two of the three who permit the loans would be seriously upset at someone who would take a loan under false pretenses.  Both of these clients would have no issue causing a participant (especially if the participant was one of their union employees) "financial grief" because they would worry that the participant who took the loan under false pretenses would tell others "how easy it is" to do.