In December '95, the IRS published proposed regulations ("prop. regs.") governing participant loans from qualified plans. Although the prop. regs. cover a lot of old ground, there are some surprises. The regs. include, for the first time, the concepts of suspending loan repayments during a leave of absence, and allowing a grace period for participants to cure a late payment/default before a taxable deemed distribution occurs. They also indicate that if a participant's account has after-tax contributions, all or a portion of the deemed distribution might not be taxable.

Background: §72(p) of the Internal Revenue Code generally provides that an amount received as a loan from a qualified employer plan by a participant (or beneficiary) is treated as a taxable "deemed distribution", except if certain conditions are satisfied. §72(p) also provides that an assignment or pledge of any portion of a participant's interest in a qualified employer plan is to be treated as a loan from the plan.

The statutory conditions that must be satisfied to avoid a deemed distribution are:

1) Loan can't exceed the lesser of $50,000 or half the participant's nonforfeitable account balance. (The $50,000 limit is reduced if there were outstanding loans during the 1-year prior to issuing the new loan.)

2) Loan must be repayable within 5 years, except that this restriction does not apply to loans to acquire a principle residence.

3) Repayment must be required in substantially level payments, not less frequently than quarterly.

The prop. regs. add a new requirement, that the loan be evidenced by a written, enforceable agreement (which can include more than one document) that includes terms that satisfy the statutory requirements.

Thus, the agreement must specify the amount of the loan, the term of the loan, and the repayment schedule. Further, if there is an express or tacit understanding that the loan will not be repaid, or, for any reason, the transaction does not create a debtor-creditor relationship, then the amount transferred is treated as an actual distribution from the plan, and is not treated as a loan or as a deemed distribution. [This strikes us an an ominous provision; we can foresee the IRS attacking loan programs that consistently have high default rates as, in effect, disqualifying in-service distributions. This could be an especially vulnerable area for plans in high turnover industries, such as construction.]

Failure to satisfy §72(p):

A deemed distribution occurs at the first time that these requirements are not satisfied in form or in operation. This may occur at the time the loan is made or at a later date. If the terms of the loan do not require repayments that satisfy the repayment term requirement, or the level amortization requirement, or the loan is not evidenced by an enforceable agreement, the entire amount of the loan is a deemed distribution under §72(p) at the time the loan is made. If the loan satisfies these requirements except that the amount loaned exceeds the limitations of §72(p), the amount of the loan in excess of the applicable limitation is a deemed distribution at the time the loan is made. If the loan initially satisfies all requirements, but payments are not made in accordance with the terms applicable to the loan, a deemed distribution occurs as a result of the failure to make such payments. (See Defaulted Loans, below).

Example 1: A participant has a nonforfeitable account balance of $200,000 and receives $70,000 as a loan repayable in level quarterly installments over five years. Under §72(p), the participant has a deemed distribution of $20,000 (the excess of $70,000 over $50,000) at the time of the loan, because the loan exceeds the $50,000 limit. The remaining $50,000 is not a deemed distribution.

Example 2: A participant with a nonforfeitable account balance of $30,000 borrows $20,000 as a loan repayable in level monthly installments over five years. Because the amount of the loan is $5,000 more than 50% of the participant's nonforfeitable account balance, the participant has a deemed distribution of $5,000 at the time of the loan. The remaining $15,000 is not a deemed distribution. (Note also, this loan may also be a prohibited transaction because the loan may not adequately collateralized).

Example 3: The nonforfeitable account balance of a participant is $100,000 and a $50,000 loan is made to the participant repayable in level quarterly installments over seven years. The loan is not eligible for the exception for loans used to acquire certain dwelling units. Because the repayment period exceeds the maximum five-year period, the participant has a deemed distribution of $50,000 at the time the loan is made.

Loan for Dwelling:

One of the repayment requirements is that the loan be repaid within five years, unless the loan is used to acquire a dwelling unit which within a reasonable time is used as the principal residence of the participant. The loan does not have to be secured by the dwelling. The regs. make it clear that a refinancing transaction will not be considered as used to "acquire" the dwelling, unless the funds meet certain "tracing" rules.

Leave of Absence:

The prop. regs. allow an exception to the level installments requirement: they permit loan repayments to be suspended up to one year, during a leave of absence (either without pay or at a rate of pay that is less than the required installment payments). However, the suspension does not delay the original required due date of the loan. (The prop. regs. do not consider how this might apply in a multiemployer plan).

Example 4: On July 1, 1997, a participant borrows $40,000 to be repaid in level monthly installments of $825 over five years. The participant makes nine monthly payments and commences an unpaid leave of absence that lasts for 12 months. Thereafter, the participant resumes active employment and resumes making repayments on the loan until the loan is repaid. The amount of each monthly installment is increased to $1,130 in order to repay the loan by June 30, 2002. Because the loan satisfies the requirements of §72(p), the participant does not have a deemed distribution. Alternatively, the participant could continue the monthly installments of $825 after resuming active employment and on June 30, 2002 he would have to pay the full remaining balance to avoid a deemed distribution.

Defaulted Loans:

Failure to make any installment payment when due in accordance with the terms of the loan violates §72(p) and, accordingly, results in a deemed distribution at the time of such failure. The amount of the deemed distribution equals the entire outstanding balanceof the loan (including interest) at the time of such failure.

Grace Period:

Under the statutory language, a single late payment could trigger a deemed distribution of the entire loan balance, which seems like a severe result. Under the prop. regs., the plan administrator may allow a grace period, and §72(p) will not be considered to have been violated until the last day of the grace period. The grace period can not extend beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.

Example 5: On August 1, 1998, a participant borrows $20,000 from a plan to be repaid over five years in level monthly installments. After making all monthly payments due through July 31, 1999, the participant fails to make the payment due on August 31, 1999 or any other monthly payments due thereafter. The plan administrator allows a three-month grace period. As a result of the failure to satisfy the requirement that the loan be repaid in level installments, the participant has a deemed distribution on November 30, 1999, which is the last day of the three-month grace period for the August 31, 1999 installment. The amount of the deemed distribution is $17,157, which is the outstanding balance on the loan at November 30, 1999. Alternatively, if the plan administrator had allowed a grace period through the end of the next calendar quarter, there would be a deemed distribution on December 31, 1999 equal to $17,282, which is the outstanding balance of the loan at December 31, 1999.

Tax Consequences:

A deemed distribution under §72(p) is to be treated as a taxable distribution, subject to most normal rules applicable to plan distributions. The amount includible in income as a result of a deemed distribution under §72(p) is required to be reported on Form 1099-R. If the employee's account includes after-tax contributions, all or a portion of the deemed distribution may not be taxable. A deemed distribution would also be a distribution for purposes of the 10 percent tax in §72(t) and the excise tax on excess distributions under §4980A. However, a deemed distribution under §72(p) is not treated as an actual distribution for purposes of the qualification requirements of §401, the rollover and income averaging provisions of §402 and the distribution restrictions of §403(b).

Deemed Distribution or Offset?:

Loans to a participant from a qualified employer plan can give rise to two types of taxable distributions: (i) A deemed distribution pursuant to §72(p); and (ii) A distribution of an "offset" amount. As described above, a deemed distribution occurs when the statutory requirements of §72(p) or other requirements of the prop. regs. are not satisfied, either when the loan is made or at a later time. A deemed distribution is treated as a distribution to the participant or beneficiary only for certain tax purposes and is not an actual distribution of the accrued benefit. A distribution of a plan loan offset amount occurs when, under the terms governing a plan loan, the accrued benefit of the participant or beneficiary is reduced (offset) in order to repay the loan (including the enforcement of the plan's security interest in the accrued benefit). A distribution of a plan loan offset amount could occur, for example, when the terms of the loan require that, in the event of the participant's request for a distribution, a loan be repaid immediately or treated as in default. In the event of a plan loan offset, the amount of the account balance that is offset against the loan is an actual distribution for purposes of the Internal Revenue Code, not a deemed distribution under §72(p). The distinction is important because an offset may violate plan qualification provisions that prohibit or limit distributions to an active employee.

Withholding:

To the extent that a loan is a deemed distribution when made, the amount includible in income is subject to withholding. If a deemed distribution results in income at a date after the date the loan is made, withholding is required only if a transfer of cash or property (excluding employer securities) is made to the participant or beneficiary from the plan at the same time.

Mortgage Loans as Plan Investments:

Residential mortgage loans made by a plan in the ordinary course of an investment program are not subject to §72(p) if the property acquired with the loans is the primary security for such loans and the amount loaned does not exceed the fair market value of the property. An investment program exists only if the plan has established, in advance of a specific investment under the program, that a certain percentage or amount of plan assets will be invested in residential mortgages available to persons purchasing the property who satisfy commercially customary financial criteria. Loans will not be considered as made under an investment program if the loans are only made available to, or any loan is earmarked for, any person or persons who are participants or beneficiaries in the plan, or if such loans mature upon a participant's termination from employment. In addition, no loan that benefits an officer, director, or owner of the employer maintaining the plan, or his or her beneficiaries, will be treated as made under an investment program. The prop. regs. only address tax implications; such loans will also have to satisfy rules for prohibited transactions and fiduciary responsibility.

Unanswered Questions: The prop. regs. do not address the status of the loan after a deemed distribution. We believe the IRS should address whether the loan is still payable, the extent to which the administrator must pursue collection, and the tax effects of a participant repaying a loan after a deemed distribution. Further, we believe that the descriptions of a deemed distribution and an offset distribution are still difficult distinctions that need to be further clarified. And, we would very much like to see some "safe-harbor" provisions for loan programs with high default rates, especially multi-employer programs in construction and similar industries.

Update: additional proposed regs. were issued 1/98, which specify that a deemed distribution does not reduce the loan balance, and interest continues to accrue.

(John Cheek is a CPA in Rochester, NY who has extensive experience with ERISA audits.)