Avoiding and Correcting Problems with Plan Loans

Participant loans from qualified retirement plans made on or after Jan. 1, 2002 must comply with final plan loan regulations under Sec. 72(p). These new regulations—which address issues such as repayment periods, suspension of repayments, and default and cure procedures—add to the complexity surrounding plan loans. This can lead to missteps, resulting in the loan amount being taxable to the participant, a prohibited transaction or a qualified plan operational failure.

Operational Failures

Under the qualification standards, a Sec. 401(k) plan may not distribute plan assets to a participant prior to a distributable event (e.g., death, termination, attainment of age 59¹/2 or hardship). Plan loans that adhere to the Sec. 72(p) limits and otherwise satisfy the standards for valid plan loans are not deemed distributions. Sec. 72(p) sets forth requirements as to the amount, term, repayment schedule and documentation of plan loans.

If it does not meet the Sec. 72(p) requirements, a plan may have made a prohibited distribution of its assets to a participant. Although such a distribution theoretically can result in plan disqualification, more likely the plan sponsor may be subject to penalties. Also, a prohibited distribution imposes a reporting obligation on the plan and subjects the participant to income inclusion to the extent of the prohibited distribution.

Another potential qualification failure—the alienation or assignment of benefits in violation of Sec. 401(a)(13)—might occur if the plan does not adhere to the requirements applicable to plan loans under Sec. 4975(d)(1), which provides an exception from the prohibited transaction rules. Again, such a violation could subject the plan to disqualification or the sponsor to penalties. Additionally, failure to follow Sec. 4975(d) may result in a prohibited transaction under Sec. 4975(c), which prohibits the direct or indirect lending of money between a plan and a disqualified person (such as an owner, officer or director). If a prohibited transaction occurs, an excise tax may be imposed on the plan sponsor.

Avoiding Plan Failures

Given the potential consequences of administrating plan loans improperly, plan sponsors need to understand how to avoid and correct failures.

Avoiding plan loan operational failures may be as simple as proactive plan drafting. Establishing comprehensive plan loan procedures and properly training administrative personnel on these procedures also reduces the potential for failures. Ideally, these procedures cover all aspects of loan administration, including:

• The requirements necessary to initiate a loan;
• The determination of the allowable amount of the loan;
• The loan terms and documentation; and
• The timely repayment of the loan (including reporting defaults).

Because comprehensive procedures reduce administrative interpretation, they reduce errors. Periodic review of personnel compliance with plan loan procedures also helps detect potential problems and provides an opportunity for correction.

Correction Programs

When plan loan failures are discovered, the plan sponsor can either seek to self-correct without the IRS's approval or can implement a correction with the Service's approval. Over the years, the IRS has developed a number of formal programs to permit plan administrators to correct plan defects as an alternative to plan disqualification. The Employee Plans Compliance Resolution System (EPCRS) consolidates the corrective mechanisms that permit plan sponsors to correct qualification defects and continue to provide their employees with retirement benefits on a tax-favored basis.

The Self-Correction Procedure (SCP), a program under the EPCRS, permits plan sponsors to correct eligible operational failures without the Service's approval and without the payment of any compliance fee or dollar sanction. Alternatively, the plan may use another program under the EPCRS, the Voluntary Correction Program (VCP), which permits a qualified plan sponsor to disclose voluntarily to the IRS, operational failures the sponsor has discovered in its plans. Once disclosure has been made, the sponsor may obtain the Service's approval of the plan's correction methodology in exchange for a fixed fee.

The EPCRS program does not permit the IRS to waive the rule that a defective loan must be included in the income of the participant who received the loan (or related excise taxes or penalties for failure to report). As a result, the EPCRS often does not provide a complete solution for problem loans; frequent review of plan documents, administrative procedures and operational compliance with the plan document and loan procedures must be the primary line of defense for qualified retirement plan loan programs.

From Corina Trainer, J.D., Washington, DC