Many plan administrators know that a plan loan in default is reported as a deemed distribution, but did you know that those deemed loans are not extinguished? They must be tracked, the balances increase due to unpaid interest, and they have real consequences for the plan and the participants for as long as the loan remains unpaid.
Section 72(p) of the Internal Revenue Code provides that a loan from a qualified employer plan to a participant or beneficiary is treated as received as a distribution from the plan for purposes of section 72 (a deemed distribution), and it further provides that an assignment or pledge (or an agreement to assign or pledge) of any portion of a participant's or beneficiary's interest in a qualified employer plan is treated as a loan from the plan.
However, the "deemed distribution" treatment does not apply to the extent certain conditions are satisfied. Specifically, a loan from a qualified employer plan to a participant or beneficiary is not treated as a distribution from the plan if the loan satisfies requirements relating to the term of the loan and the repayment schedule, and to the extent the loan satisfies certain limitations on the amount loaned.
Regulations were proposed in 1995 [see Participant Loans Under ERISA for a discussion of many issues surrounding participant loans; the new regs are much more limited in scope] with respect to many of the issues arising under the deemed distribution rules. In a public hearing in June 1996, one of the issues on which comments were received was the effect of a deemed distribution on the tax treatment of subsequent distributions from a plan (such as whether a participant has tax basis as a result of recognizing income).
These new proposed regulations provide that once a loan is deemed distributed under section 72(p), the interest that accrues thereafter on that loan is not included in income.
[This treatment applies for purposes of determining the amount taxable under section 72 (including application of return of tax basis). However, as discussed below, the loan is still considered outstanding for purposes of determining the maximum amount of any subsequent loan to the participant. Even though interest continues to accrue on the outstanding loan and is taken into account for purposes of determining the maximum amount of any subsequent loan, this additional interest is not treated as an additional loan that results in a further deemed distribution for purposes of section 72(p).]
Further, because the loan amount is treated as distributed for purposes of section 72, neither the income that resulted from the deemed distribution nor the interest that accrues thereafter increases the participant's investment in the contract (tax basis) for purposes of section 72.
For example, assume that, after a loan has been made from a defined contribution plan to a participant, a deemed distribution occurs (let's say in 1994) as a result of failure to make timely loan repayments as required by section 72(p). The participant's total account then consists of non-loan assets and a receivable for the loan balance. At separation from employment in 1998, the participant's vested account balance is reduced (offset) by the loan amount and the remaining account balance is distributed in a lump sum to the participant. In this case, the participant would have a taxable distribution in 1998 for the remaining account balance reflecting the non-loan assets that are distributed in a lump sum. The fact that a deemed distribution occurred in 1994, and income taxes were paid at that time, does not give the participant any tax basis in his account.
However, the proposed regulations provide that if a participant makes any cash repayments on a loan after the loan is deemed distributed, the repayments increase the participant's tax basis in the plan in the same manner as if the repayments were after-tax contributions.
A loan that is deemed distributed under section 72 is nevertheless outstanding for other purposes until the loan obligation is satisfied (e.g., by cash repayment or by offset against the participant's accrued benefit). In addition, for purposes of calculating the maximum permitted amount of any subsequent loan, a loan that has been deemed distributed is considered outstanding until the loan obligation has been satisfied.
Generally, a plan is permitted to apply the new proposed regulations to loans made before the regulatory effective date. However, the regulations include a special consistency rule applicable if there has been any deemed distribution of the loan before the date the plan switches to the new proposed regulations for the loan. In this event, a plan is not permitted to apply the new proposed regulations to the loan unless the plan reported, in Box 1 of Form 1099-R, a gross distribution with respect to the loan that is at least equal to the amount required by the 1995 proposed regulations (referred to as the initial default amount in the new proposed regulations) for a taxable year that is not later than the latest year that would be permitted under the 1995 proposed regulations. In such a case, the plan may apply the new proposed regulations to the loan even though, in the past, the plan reported deemed distributions with respect to the loan in a manner that is not consistent with the new proposed regulations.
If a plan does apply the new proposed regulations to a pre-regulatory effective date loan that has been deemed distributed, then the plan, in its subsequent reporting and withholding, must not attribute investment in the contract (tax basis) to the participant based upon the initial default amount. For example, a plan that reported income for the initial default amount plus all interest accruing thereafter as a result of the default and made corresponding increases in the participant's tax basis would comply with this consistency rule by reducing the participant's tax basis by an amount equal to the initial default amount. In addition, a special rule applies if a plan had increased a participant's tax basis by the initial default amount and, just before the first actual distribution made after the plan switches to applying the new proposed regulations to the loan, the sum of the participant's tax basis immediately before the switch plus any increase in basis thereafter (e.g., from after-tax contributions) is less than the initial default amount (as a result of intervening distributions). In this case, a loan transition amount equal to the amount by which the initial default amount exceeds the participant's tax basis is treated as remaining outstanding and that amount is includible in the participant's income at the time of the next actual distribution from the plan to the participant. The proposed regulations include examples illustrating the application of the consistency rule.
What Should a Trustee Do About This?
If your loan program has a history of multiple defaults, consider a one-default only rule: no loans, ever, after the first default. If your fund does not record a deemed distribution by segregating the account into an active balance and a defaulted loan balance, go back now and correct your records. You will probably need extensive programming changes to implement this, and to credit interest on old defaulted loans. Have your professionals review your program, and recommend changes to comply with the the prop regs.beneficiary's income at the time of the actual distribution.
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Examples. (Example 1, Example 2, and Example 4 illustrate the application of these rules to a plan that, before the transition date, did not treat interest accruing after the initial deemed distribution as resulting in additional deemed distributions under section 72(p). Example 3 illustrates the application of these rules to a plan that, before the transition date, treated interest accruing after the initial deemed distribution as resulting in additional deemed distributions under section 72(p). )
EXAMPLE 1.
(a) In 1995, when a participant's account balance under a plan is $50,000, the participant receives a loan from the plan. The participant makes the required repayments until 1996 when there is a deemed distribution of $20,000 as a result of a failure to repay the loan. For 1996, as a result of the deemed distribution, the plan reports, in Box 1 of Form 1099-R, a gross distribution of $20,000 (which is the initial default amount in accordance with paragraph (c)(2)(ii) of Q&A-21 of this section) and, in Box 2 of Form 1099-R, a taxable amount of $20,000. The plan then records an increase in the participant's tax basis for the same amount ($20,000). Thereafter, the plan disregards, for purposes of section 72, the interest that accrues on the loan after the 1996 deemed distribution. Thus, as of December 31, 1998, the total taxable amount reported by the plan as a result of the deemed distribution is $20,000 and the plan's records show that the participant's tax basis is the same amount ($20,000). As of January 1, 1999, the plan decides to apply Q&A-19 of this section to the loan. Accordingly, it reduces the participant's tax basis by the initial default amount of $20,000, so that the participant's remaining tax basis in the plan is zero. Thereafter, the amount of the outstanding loan is not treated as part of the account balance for purposes of section 72. The participant attains age 59-1/2 in the year 2000 and receives a distribution of the full account balance under the plan consisting of $60,000 in cash and the loan receivable. At that time, the plan's records reflect an offset of the loan amount against the loan receivable in the participant's account and a distribution of $60,000 in cash.
(b) For the year 2000, the plan must report a gross distribution of $60,000 on Box 1 of Form 1099-R and a taxable amount of $60,000 in Box 2 of Form 1099-R.
EXAMPLE 2. The facts are the same as in Example 1, except that in 1996, immediately prior to the deemed distribution, the participant's account balance under the plan totals $50,000 and the participant's tax basis is $10,000. For 1996, the plan reports, in Box 1 of Form 1099-R, a gross distribution of $20,000 (which is the initial default amount in accordance with paragraph (c)(2)(ii) of Q&A-21 of this section) and reports, in Box 2 of Form 1099-R, a taxable amount of $16,000 (the $20,000 deemed distribution minus $4,000 of tax basis ($10,000 times ($20,000/$50,000)) allocated to the deemed distribution). The plan then records an increase in tax basis equal to the $20,000 deemed distribution, so that the participant's remaining tax basis as of December 31, 1996 totals $26,000 ($10,000 minus $4,000 plus $20,000). Thereafter, the plan disregards, for purposes of section 72, the interest that accrues on the loan after the 1996 deemed distribution. Thus, as of December 31, 1998, the total taxable amount reported by the plan as a result of the deemed distribution is $16,000 and the plan's records show that the participant's tax basis is $26,000. As of January 1, 1999, the plan decides to apply Q&A-19 of this section to the loan. Accordingly, it reduces the participant's tax basis by the initial default amount of $20,000, so that the participant's remaining tax basis in the plan is $6,000. Thereafter, the amount of the outstanding loan is not treated as part of the account balance for purposes of section 72. The participant attains age 59-1/2 in the year 2000 and receives a distribution of the full account balance under the plan consisting of $60,000 in cash and the loan receivable. At that time, the plan's records reflect an offset of the loan amount against the loan receivable in the participant's account and a distribution of $60,000 in cash.
(b) For the year 2000, the plan must report a gross distribution of $60,000 on Box 1 of Form 1099-R and a taxable amount of $54,000 in Box 2 of Form 1099-R.
EXAMPLE 3. (a) In 1990, when a participant's account balance in a plan is $100,000, the participant receives a loan of $50,000 from the plan. The participant makes the required loan repayments until 1992 when there is a deemed distribution of $28,919 as a result of a failure to repay the loan. For 1992, as a result of the deemed distribution, the plan reports, in Box 1 of Form 1099-R, a gross distribution of $28,919 (which is the initial default amount in accordance with paragraph (c)(2)(ii) of Q&A-21 of this section) and, in Box 2 of Form 1099-R, a taxable amount of $28,919. For 1992, the plan also records an increase in the participant's tax basis for the same amount ($28,919). Each year thereafter through 1998, the plan reports a gross distribution equal to the interest accruing that year on the loan balance, reports a taxable amount equal to the interest accruing that year on the loan balance reduced by the participant's tax basis allocated to the gross distribution, and records a net increase in the participant's tax basis equal to that taxable amount. As of December 31, 1998, the taxable amount reported by the plan as a result of the loan totals $44,329 and the plan's records for purposes of section 72 show that the participant's tax basis totals the same amount ($44,329). As of January 1, 1999, the plan decides to apply Q&A-19 of this section. Accordingly, it reduces the participant's tax basis by the initial default amount of $28,919, so that the participant's remaining tax basis in the plan is $15,410 ($44,329 minus $28,919) as of December 31, 1999. Thereafter, the amount of the outstanding loan is not treated as part of the account balance for purposes of section 72. The participant attains age 59-1/2 in the year 2000 and receives a distribution of the full account balance under the plan consisting of $180,000 in cash and the loan receivable equal to the $28,919 outstanding loan amount in 1992 plus interest accrued thereafter to the payment date in 2000. At that time, the plan's records reflect an offset of the loan amount against the loan receivable in the participant's account and a distribution of $180,000 in cash.
(b) For the year 2000, the plan must report a gross distribution of $180,000 in Box 1 of Form 1099-R and a taxable amount of $164,590 in Box 2 of Form 1099-R ($180,000 minus the remaining tax basis of $15,410).
EXAMPLE 4. (a) The facts are the same as in Example 1, except that in 1997, after the deemed distribution, the participant receives a $10,000 hardship distribution. At the time of the hardship distribution, the participant's account balance under the plan totals $50,000. For 1997, the plan reports, in Box 1 of Form 1099-R, a gross distribution of $10,000 and, in Box 2 of Form 1099-R, a taxable amount of $6,000 (the $10,000 actual distribution minus $4,000 of tax basis ($10,000 times ($20,000/$50,000)) allocated to this actual distribution). The plan then records a decrease in tax basis equal to $4,000, so that the participant's remaining tax basis as of December 31, 1997 totals $16,000 ($20,000 minus $4,000). After 1996, the plan disregards, for purposes of section 72, the interest that accrues on the loan after the 1996 deemed distribution. Thus, as of December 31, 1998, the total taxable amount reported by the plan as a result of the deemed distribution plus the 1997 actual distribution is $26,000 and the plan's records show that the participant's tax basis is $16,000. As of January 1, 1999, the plan decides to apply Q&A-19 of this section to the loan. Accordingly, it reduces the participant's tax basis by the initial default amount of $20,000, so that the participant's remaining tax basis in the plan is reduced from $16,000 to zero. However, because the $20,000 initial default amount exceeds $16,000, the plan records a loan transition amount of $4,000 ($20,000 minus $16,000). Thereafter, the amount of the outstanding loan, other than the $4,000 loan transition amount, is not treated as part of the account balance for purposes of section 72. The participant attains age 59-1/2 in the year 2000 and receives a distribution of the full account balance under the plan consisting of $60,000 in cash and the loan receivable. At that time, the plan's records reflect an offset of the loan amount against the loan receivable in the participant's account and a distribution of $60,000 in cash.
(b) In accordance with paragraph (c)(2)(iv) of Q&A-21 of this section, the plan must report in Box 1 of Form 1099-R a gross distribution of $64,000 and in Box 2 of Form 1099-R a taxable amount for the participant for the year 2000 equal to $64,000 (the sum of the $60,000 paid in the year 2000 plus $4,000 as the loan transition amount).
