My Boss Screwed Up, Now I'm Screwed (and so is my employer I assume)

I took out a 401(k) loan in December 2015 and have been making semi-monthly loan payments through payroll deduction ever since.  My boss, whose responsibility it is to upload a report to our plan administrator that shows all employee contributions and loan payments), received the reports on a timely basis (I know this because I do payroll and I provide him with the reports myself) but failed to upload the reports in a timely manner.  Some of the reports were uploaded as much as two months after the payroll date.  As a result, my loan was called into default and declared a distribution.  I somehow missed the 1099 that was issued at the end of 2017 (I never open my statements and I assume I tossed it thinking it was just another statement) and I did not become aware of the default until I recently logged on to change some of the investment options on my plan balance.  

I have made two of the partners at my firm aware of this and I need to determine exactly what the financial ramifications will be for me (the amount shown on the 1099 is $12,810.69, although the balance is less than that since I have continued to make my scheduled payments).  The firm will have to make me whole, and I believe they will, but I need to know just exactly what this is going to cost me.  I also need to know what my firm is facing in terms of penalties because there are at least three other outstanding loans that were probably also defaulted, not to mention the 401(k) contributions that were not posted to accounts in a timely manner.  Employees will have lost out on interest since their contributions were not credited for as long as two months after they should have been.  

I am trying to arm myself with as much information as I can.  Can anyone offer insight?  Many thanks.

other who may have actually handled an event like this will probably chime in, but this will probably require more info. here is a brief summary of thoughts

usually there is a grace period on loans, so I'm a bit surprised if the loan was defaulted if a payment was only 2 months late.

regardless, the normal consequences, is if you were 1099d, then you should have included that amount as a distribution on your taxes in 2017. in addition, chances are there is a 10% penalty for early distribution. the fact that you continued to make payments after receiving a 1099r means those payments are now considered after tax, so then when you get a distribution you don't pay taxes a second time (except you pay taxes on the interest)

under EPCRS this can probably be corrected through the VCP program

(2) Special rules for loans. (a) In general. The correction methods set forth in section 6.07(2)(b) and (c) and section 6.07(3) are available for plan loans that do not comply with one or more requirements of § 72(p)(2) and are corrected through VCP or Audit CAP. The correction methods described in section 6.07(2)(b) and (c) and section 6.07(3) are not available if the maximum period for repayment of the loan pursuant to § 72(p)(2)(B) has expired. The IRS reserves the right to limit the use of the correction methods listed in section 6.07(2)(b) and (c) and section 6.07(3) to situations that it considers appropriate; for example, where the loan failure is caused by employer action. A deemed distribution corrected under section 6.07(2)(b) or (c) or under section 6.07(3) is not required to be reported on Form 1099-R and repayments made by correction under sections 6.07(2) and 6.07(3) do not result in the affected participant having additional basis in the plan for purposes of determining the tax treatment of subsequent distributions from the plan to the affected participant. The relief from reporting the participant’s loan as a deemed distribution on Form 1099-R, as described in the preceding sentence, applies only if the Plan Sponsor specifically requests such relief and provides an explanation supporting the request.

welcome to the board, and

good luck!

Is this a situation in which there was simply bad reporting or were the semi-monthly loan repayments not deposited to the Plan?  If the former,

Sorry.  [If the former,] THERE WAS NO DEFAULT.

I thought it was just a reporting issue, but I just checked with accounting and not only was he not uploading the reports timely, he was not transferring the funds timely.  So there clearly was a default -- it just wasn't my fault.  

From the employer's perspective most likely it was also a prohibited transaction.

What does that mean - prohibited transaction?  Do you mean the loan?  I process payroll but am not an administrator for the plan and don't have access to the plan account (other than my personal account).

3 hours ago, smg said:

... I do payroll …

...I never open my statements .. 

Ouch!

I simply meant that I don't open the snail-mail statements on my personal 401(k) account -- everything is online so they're a waste of paper as far as I'm concerned.

If all your loan payments were withheld timely from your paychecks, then your loan should not have gone into default.  It may be difficult to convince the recordkeeper of that since they are going by the dates the payments were deposited with them, not the dates you actually made the payments. I would start by asking your employer to contact the recordkeeper about getting the incorrect 1099-R voided.

If your employer held the amounts withheld from paychecks too long before depositing them, that is a separate issue that needs to be corrected.  Deposits are required to be made as soon as the withheld amounts can reasonably be segregated from the assets of the employer.  Small plan  (<100 participants) deposits are considered to be timely if the deposit is made within 7 business days.  The deadline for large plans depends on the circumstances, but generally, the DOL considers it to be faster than their standard for small plans.  If the employer holds the assets too long, they are holding plan assets, which is a prohibited transaction under the plan rules.  The employer's correction will include lost income and depending on how they correct, possibly an excise tax.  They will probably need the recordkeeper/TPA's assistance with the correction. 

"Probably"? ?

14 hours ago, Kevin C said:

If all your loan payments were withheld timely from your paychecks, then your loan should not have gone into default.  It may be difficult to convince the recordkeeper of that since they are going by the dates the payments were deposited with them, not the dates you actually made the payments. I would start by asking your employer to contact the recordkeeper about getting the incorrect 1099-R voided.

Kevin C, as usual, is 100% accurate (and jpod too!).  To emphasize/rephrase - once amounts are withheld from your paycheck, they are considered "plan assets."  Therefore, as you have indicated, you have done nothing wrong and in fact the loan payments were made - they just weren't deposited properly to the plan investment accounts.  The problem is that the recordkeeper has an automated system that spits out 1099s if deposits aren't made in what they consider to be a timely manner.  Fixing it won't be easy, but that's the proper way to approach it IMO - someone has to firmly and persistently nag the recordkeeper into amending the 1099-R.  Also then there is the related but different issue of late deposits, which need to be corrected (made up, with interest).  Good luck and keep us posted.

Thank you all VERY much for your expertise and willingness to offer advice.  I feel a bit more "armed" if you will in approaching our executive committee about this.  

I will report back when we (hopefully) get this resolved.

We just handled several of these loan defaults. It is a VCR filing under EPCRS and there is a need to file to correct the errors if you want it to not be an ongoing risk under audit (and my understanding is that it must be disclosed on the 5500 for this year)----I'm not sure if your employer is willing to foot the expense of having this done, but this is the only way now that I know to validly cure this for posterity.

10 hours ago, Bob the Swimmer said:

We just handled several of these loan defaults. It is a VCR filing under EPCRS and there is a need to file to correct the errors if you want it to not be an ongoing risk under audit (and my understanding is that it must be disclosed on the 5500 for this year)----I'm not sure if your employer is willing to foot the expense of having this done, but this is the only way now that I know to validly cure this for posterity.

Really?  I see this as a 1099 issued in error that simply needs to be fixed.  I thought the EPCRS cite was for other employer errors, such as not withholding at all.  I don't deal with that much so I'm just askin' - doesn't really seem right.

45 minutes ago, Bird said:

Really?  I see this as a 1099 issued in error that simply needs to be fixed.  I thought the EPCRS cite was for other employer errors, such as not withholding at all.  I don't deal with that much so I'm just askin' - doesn't really seem right.

I agree with Bird.  Can you run it through VCP? Yes, but I don't think that you have to. 

The participant made the loan payments when they were withheld from pay.  The fact that the employer did not deposit the loan payments on time is a different issue.  If a participant defers $18,500 today, and the employer makes the deposit to the plan in January of 2019, were the deferrals made today or January 2019?  Why is this any different?

The problem will be to get the RK/admin to understand the issue and take appropriate action, that is sometimes easier said than done.

The loan payments were made on time, so the loan was not taxable under 72(p) and there is no need to request different tax treatment from the IRS under VCP.  The employer may want to consider a VFCP filing with the DOL for the late deposits. 

Now, if the employer had failed to withhold the loan payments from paychecks, a VCP filing would be needed.  But, that isn't the situation in this case. 

I haven't read the entire thread but is there some authority confirming that there is no 72(p) default here?  That doesn't sound right to me because the lender is the plan, not the employer.

21 minutes ago, jpod said:

I haven't read the entire thread but is there some authority confirming that there is no 72(p) default here?  That doesn't sound right to me because the lender is the plan, not the employer.

The loan payment is a plan asset as soon as withheld right?  It is never an employer asset.

23 minutes ago, jpod said:

I haven't read the entire thread but is there some authority confirming that there is no 72(p) default here?  That doesn't sound right to me because the lender is the plan, not the employer.

@jpod, good point but I think the better argument is that the amounts withheld from borrower's paychecks become plan assets after only a few days.  If they are plan assets, even though not deposited to the trust, then the plan has arguably been paid.  

Granted they are considered plan assets for purposes of Title I of ERISA and Section 4975 of the IRC, and that makes for a very credible argument, but I am not certain that necessarily works for purposes of Section 72(p). 

1.72(p)-1 Q&A 10 addresses deemed distribution of a loan for failure to pay an installment when due. In this case, the payments were made when due and they became plan assets on the date they could have reasonably been segregated from the assets of the employer under 2510.3-102.    

If you think another part of 72(p) or its regs makes the loan taxable under the situation described in this thread, please provide a cite.

Obviously I don't have a citation.  What makes you so comfortable with your position?  Do you have authority for the position that the "plan asset" concept applies for purposes of Section 72(p)?  Maybe it exists but I don't recall ever seeing it.  If you have it I am happy to look foolish.  While I already said that I thought your argument is credible, it's not what you think or I think, it's what the IRS thinks.  If I was advising the payor responsible for IRS reporting and at risk of penalties for incorrect reporting I don't believe I would be prepared to let this go in the manner you suggest without some reliable authority, or at least an indemnification from whoever it is that is trying to get me to not report a deemed distribution.

I'm comfortable with my position because the 72(p) regulations spell out when a loan is taxable and the situation described by smg doesn't fit any of the circumstances where a loan is taxable. 

If you are going to advise the payer that the amount is taxable, wouldn't you want some reliable authority indicating that the amount really is taxable?  Reporting something as taxable when it is not taxable is also incorrect reporting.   

But, here's the thing:  Applying the 72(p) regs literally there is a default because the lender was not repaid in a timely manner, unless your "plan asset" theory is correct, but I haven't seen any authority that it is correct.  Keep in mind that the plan asset theory is a fiction created to enable enforcement of the PT rules and the ERISA rules of fiduciary responsibility, and for good reason, but it nonetheless is a fiction. 

Interesting arguments both ways---all I can say conclusively is that if there is a default, then VCR is the only solution we know of and have utilized. 

I'm with Kevin on this.

@jpod Section 3(42) of ERISA vests authority for defining "plan assets" with the Secretary of Labor.  From that I think we can safely assume that the Secretary of Treasury and the IRS would be bound by the guidance on that definition.  

Yes it does, but only for Title I of ERISA and Section 4975 of the IRC.

On 9/9/2018 at 8:41 AM, jpod said:

Yes it does, but only for Title I of ERISA and Section 4975 of the IRC.

Thanks for following through on the application of the ERISA statute and regulations. 

In that case, I will have to revert to common sense which informs me (FWIW) that the employee/participant should not be held responsible for an processing error not of his or her own making. I frankly have trouble seeing the IRS make the argument that the loan was not repaid - no matter how heartless that it may seem at times.

I hear you, but if all it took was common sense many of us would have to find a new line of work.  

You know the old saying, "Common sense is the least common of all senses."