The Double Edged Sword of Participant Loans Sunday, April 28, 2013

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1 The Double Edged Sword of Participant Loans Sunday, April 28, 2013 Kimberly B. Martin, APA, CPC, QPA, Director of Education, National Institute of Pension Administrators

2 What We Will Cover Participants with multiple loans Refinancing participant loans Handling LOA and part-time employees Managing loan offsets and deemed distributions EPCRS correction methods for participant loans

3 Tax Rules Relating to Participant Loans Participant loans are taxable distributions unless the requirements of IRC 72(p) are met: 72(p)(2)(A) Amount limitation Lesser of $50,000 or 50% of VAB 72(p)(2)(B) 5-year repayment period Home loan exception 72(p)(2)(C) Level amortization Payments at least quarterly

4 Multiple Plan Loans Verify plan provisions. Can a participant have more than one outstanding loan? Check the plan document and any separate loan policy. It s an operational failure if the terms of the plan are not followed. Calculate the maximum amount under IRC 72(p)(2)(A). If multiple plan loans are permitted under the plan, special adjustments must be made when determining the maximum amount for additional loans. IRC 72(p)(2)(A) permits plan loans as long as all of a participant s loans combined do not exceed the maximum loan amount. If a loan exceeds the maximum amount, the excess is taxable (deemed distribution).

5 Impact of Multiple Plan Loans on Amount Limitation Maximum loan amount. The new loan plus the outstanding balance of all of the participant s other loans cannot exceed the lesser of: 50% of the participant s vested account balance, or $50,000 less adjustment. $50,000 limit adjustment The $50,000 limit takes into account loans during the last 12 months. Adjustment = participant s highest outstanding balance of all loans during the 12-month period ending on the day before the new loan, less the outstanding balance of the participant s loans on the day of the new loan. This special 12-month rule inherently limits the number of loans that can be made for larger borrowings. Adjustment doesn t apply to the 50% of VAB limit.

6 Multiple Plan Loans: Example 50% of VAB Limit Vested Acct Bal (including loans) Outstanding Bal Loan #1 Loan #2 Loan #3 Loan #1 (6/1/12) Loan #2 (12/1/12) Loan #3 (3/1/13) $60,000 $70,000 $74,000 $15,000 $13,000 $20,000 $12,000 $18,000 $ 7,000 Maximum Loan Amount: Loan #1 = $60,000 x 50% = $30,000 Total outstanding loans = $15,000 Loan #2 = $70,000 x 50% = $35,000 Total outstanding loans = $13,000 + $20,000 = $33,000 Loan #3 = $74,000 x 50% = $37,000 Total outstanding loans = $12,000 + $18,000 + $7,000 = $37,000

7 Multiple Plan Loans: Examples $50,000 Limit Participant A: < $50,000 Loan Loan #1 VAB $200,000 on 1/1/13 $50,000 max loan amount $40,000 loan taken Loan #2 VAB $210,000 on 3/1/13 Loan #1 bal = $38,000 (repaid $2,000 principal) $50,000-$2,000 = $48,000 $48,000-$38,000 = $10,000 Participant B: $50,000 Loan Loan #1 VAB $200,000 on 1/1/13 $50,000 max loan amount $50,000 loan taken Loan #2 VAB $210,000 on 3/1/13 Loan #1 bal = $47,000 (repaid $3,000 principal) $50,000-$3,000 = $47,000 $47,000-$47,000 = $0

8 Multiple Plan Loans: Example $50,000 Limit Vested Acct Bal (including loans) Outstanding Bal Loan #1 Loan #2 Loan #3 Loan #1 (6/1/12) Loan #2 (12/1/12) Loan #3 (3/1/13) $100,000+ $100,000+ $100,000+ $25,000 $23,000 $24,000 $22,000 $23,000 $ 3,000 Maximum Loan Amount: Loan #1 = $50,000 $0 = $50,000 Total outstanding loans = $25,000 Loan #2 = $50,000 ($25,000 $23,000) = $48,000 Total outstanding loans = $23,000 + $24,000 = $47,000 Loan #3 = $50,000 ($47,000 $45,000) = $48,000 Total outstanding loans = $22,000 + $23,000 + $3,000 = $48,000 Total Loans: $25,000 + $24,000 + $3,000 = $52,000!

9 Multiple Plan Loans: Example Multiple Plans All plans of the employer are treated as a single plan for loan purposes. Vested Accrued Ben (including DB loan) DB 401(k) Outstanding Bal Loan #1 Loan #2 Loan #1 (7/1/12) $100,000 $ 25,000 $ 20,000 Loan #2 (3/1/13) $120,000 $ 40,000 $ 14,000??? Maximum Loan Amount Limit for all loans (new plus outstanding) is $44,000, which is the lesser of: ($120,000 + $40,000) x 50% = $80,000, or $50,000 ($20,000 $14,000) = $44,000 Maximum amount of second loan is $30,000, which is: $44,000 limit for all loans $14,000 current loan balance Collateral: Beware of collateral issue if borrow > $20,000 from 401(k) plan.

10 Refinancing What is it? Refinancing is a transaction in which one loan replaces another loan. The loan that is replaced is treated as repaid. The refinanced loan is treated as a new loan. Interest rate and loan limit must be re-determined. Optional provision Check document and/or loan policy. Why do it? Extend amortization period (3-yr term to 5-yr term). Borrow additional funds (circumvents one loan limit). Renegotiate to a lower interest rate. Change payment frequency.

11 Impact of Loan Refinancing on Amount Limitation Any loan resulting from refinancing must still meet the requirements of IRC 72(p). Caution: The loan amount considered outstanding may be affected by the refinancing transaction. Which loans are treated as outstanding depends upon the payoff date of the replaced loan under the terms of the replacement loan. Huh? Terms to understand Replaced loan = original loan that is replaced Replacement loan = new, refinanced loan Latest permissible term (LPT) = latest payoff date permitted (5 years from date of original loan)

12 Impact of Loan Refinancing on Amount Limitation Amount limitation recap: A new loan plus the outstanding balance of all other loans cannot exceed the lesser of 50% of VAB or $50,000 as adjusted. The outstanding loan balance in a refinance transaction depends upon the replacement loan payoff date. If replacement loan term ends on or before LPT of replaced loan: Only the replacement loan is considered outstanding. If replacement loan term ends after LPT of replaced loan: Both the replacement loan and the replaced loan are considered outstanding. This could cause the maximum loan amount to be exceeded, resulting in a taxable loan (deemed distribution).

13 Loan Refinancing: Example Facts A participant loan of $30,000 is made on 1/1/2012. Payments are $449 twice a month for 3 years (due 12/31/2014) using a 5% interest rate. Loan is refinanced on 1/1/2013. VAB is $150,000. Replaced loan balance is $20,944. Replacement loan is $25,000. $20,944 original loan is considered repaid. $4,056 additional funds are disbursed to participant. 5% interest is determined to still be a commercially reasonable interest rate. The LPT of the replaced loan is 12/31/2016.

14 Loan Refinancing: Example Term Ends On Or Before LPT Option #1 Payoff by end of replaced loan term Replacement loan payments are $548 twice a month for 2 years (due 12/31/2014 before the LPT of the replaced loan). Amount limitation = $50,000 ($30,000 - $20,944) = $40,944 Since the due date for the replacement loan is the same as the replaced loan, only the $25,000 replacement loan is outstanding. Replacement loan satisfies the amount limitation of 72(p)(2)(A). Option #2 Payoff by end of LPT of replaced loan Replacement loan payments are $288 twice a month for 4 years (due 12/31/2016 the LPT of the replaced loan). Amount limitation = $50,000 ($30,000 - $20,944) = $40,944 Since the due date for the replacement loan ends on the LPT of the replaced loan, only the $25,000 replacement loan is outstanding. Replacement loan satisfies the amount limitation of 72(p)(2)(A).

15 Loan Refinancing: Example Term Ends After LPT Option #3 Payoff after LPT of replaced loan Replacement loan payments are $236 twice a month for 5 years (due 12/31/2017). Loan limit = $50,000 ($30,000 - $20,944) = $40,944 Since the due date for the replacement loan ends after the LPT of the replaced loan, both the replacement loan and the replaced loan are outstanding. Total outstanding loans = $25,000 + $20,944 = $45,944 Outstanding loans exceed the amount limitation of 72(p)(2)(A). Replacement loan does not satisfy the amount limitation. $5,000 taxable loan on 1/1/13 (deemed distribution). To satisfy 72(p) and avoid taxation, a $20,000 replacement loan with level amortization over 5 years could be made.

16 Loan Refinancing: Example Term Ends After LPT Option #4 Combination Payoff Method Replacement loan treated as two separately amortized loans the original loan with payments of $449 twice a month until 12/31/14, plus the additional funds of $4,056 with payments of $38 twice a month until 12/31/2017: Payments of $487 twice a month in 2013 and 2014, and Payments of $38 twice a month in 2015, 2016 and Loan limit = $50,000 ($30,000 - $20,944) = $40,944 Since the replacement loan is repaid by it s LPT and the replaced loan is repaid by it s LPT, only the $25,000 replacement loan is outstanding. Replacement loan satisfies the amount limitation of 72(p)(2)(A). Note: If multiple plan loans are allowed, the plan could make a separate loan of $4,056 with the same results.

17 Exceptions to Repayment Rules Loan Repayment Terms Under 72(p)(2)(B)&(C) The participant must repay the loan within 5 years from the date of the loan, unless the loan is used to purchase the participant s main home. The terms of the loan must require the participant to make level amortized repayments at least quarterly. Substantially equal payments of principal and interest. Missed payments violate the amortization requirement, resulting in a deemed distribution of the entire outstanding balance. Exceptions: The suspension of payments is permitted in the event of: Leave of absence (LOA), or Military service

18 Leave of Absence Exception Leave of Absence (LOA) A plan may permit a participant to suspend repayments for up to a year while on a LOA. LOA must be without pay or with a level of pay that is insufficient to make the loan payment. Interest continues to accrue during the suspension. The loan s maximum repayment period cannot be extended. Upon return from a LOA (or after one year, if earlier), the participant must make additional payments on the loan to ensure it is repaid within the 5-year period by either: Increasing the payment amounts owed over the remaining period of the loan, or Keeping the payment amounts the same, but making a lump-sum payment for the missed installments that occurred during the leave of absence. Loan repayment includes the accrued interest.

19 Leave of Absence: Example 5-Year Loan Term Facts: Joe receives a $20,000 loan on 3/1/2012. The loan term requires 60 monthly payments of $377. The loan maturity date is 2/28/2017. Joe begins a 12-month LOA on 9/1/2012. As of 9/1/2012, six loan payments have been made. Twelve loan payments are suspended during the LOA. Joe returns from his leave on 9/1/2013. When Joe s leave ends, what are his repayment options?

20 Leave of Absence: Example 5-Year Loan Term Option #1 Resume Previous Payment Amount Resume paying $377 each month, from 9/30/2013 to 2/28/2017. On 2/28/2017, the last scheduled monthly payment of a 5-year loan, make a lump sum payment of the $4,352 remaining loan balance. Why is a balloon payment necessary? Interest continued to accrue during the LOA, and since only 48 out of 60 payments have been made, there is still principal outstanding. Option #2 Increase Payment Amount Increase the monthly payment to $472 for the remaining term, from 9/30/2013 to 2/28/2017, to cover the missed payments. By re-amortizing the outstanding balance (which includes interest that accrued during the LOA), at the end of the 5-year term, the entire balance is paid.

21 Leave of Absence: Example 5-Year and 3-Year Loan Terms Option #3 Refinance Joe may be able to start a new 5-year term with a replacement loan. Option #4 Extend Term of Loan (if < 5 years) If Joe s $20,000 loan on 3/1/2012 actually had a 3-year term with monthly payments of $599, after his LOA the plan could add 12 months (his leave period) to the end of his 3-year loan term. Joe could then continue making monthly payments of $599 until 2/28/2016 instead of 2/28/2015. Joe s payment on 2/28/2016 must also include a balloon payment of the unpaid loan balance due to his failure to pay interest on the loan during the LOA.

22 Military Service Exception A plan may suspend loan payments for more than one year for an employee performing military service. Payments are suspended for the entire period during which an employee is performing military service. The loan repayment period is extended for the period of military service. The employee must repay the loan within five years from the date of the loan, plus the period of military service. Example: A participant takes out a 5-year loan on 1/1/2012. If he suspends payments during a 1-year LOA in 2013, he must still repay the loan by the end of the original 5-year term: 12/31/2016. However, if he takes a 1-year LOA to serve in the military, he does not have to finish paying off the loan until 12/31/2017.

23 Military Service Exception Upon return from military service, repayments must resume. The loan, which includes interest that accrued during the military service suspension period, is repaid by either: Increasing the payment amounts owed over the remaining period of the loan (as extended), or Keeping the payment amounts the same, but making a lump-sum payment for the accrued interest and outstanding principal. During the military leave period, interest may be capped at 6% if requested by the participant. Example: A participant has a loan with an interest rate of 8%. The participant goes on military leave for two years. During the two-year period of military service, interest continues to accrue, but at a reduced rate of 6%. When the participant's military service ends and he resumes employment, the loan will be re-amortized at the original 8% interest rate.

24 Military Service: Example Facts: Joe receives a $20,000 loan on 3/1/2012. The loan term requires 60 monthly payments of $377. The loan maturity date is 2/28/2017. Joe begins a 24-month period of military service on 9/1/2012. As of 9/1/2012, six loan payments have been made. Twenty-four loan payments are suspended during the military service period. Joe returns from military service on 9/1/2014. When Joe resumes his employment, what are his repayment options?

25 Military Service: Example Option #1 Resume Previous Payment Amount Resume paying $377 each month, from 9/30/2014 to 2/28/2019, which is 2 years from the original 5-year term date. On 2/28/2019, make a lump sum payment of the $1,079 loan balance remaining (primarily interest that accrued during the suspension of loan payments). Option #2 Increase Payment Amount Increase the monthly payment to $395 for the remaining term, from 9/30/2014 to 2/28/2019, to cover the missed payments and accrued interest. By re-amortizing the outstanding balance (which includes interest that accrued during the suspension), at the end of the extended 5-year term, the entire balance is paid.

26 Part-Time Employees Part-time employees may be eligible to participate in a qualified plan. Period of service eligibility requirement (such as 3 months) Work 20+ hours per week (20 hours x 52 weeks = 1,040 hours) Participant Loan Repayment Issue A plan may require participants to make loan payments through payroll withholding. A part-time employee s hours may fluctuate so that at times the level of pay is insufficient to make the full loan payment via payroll withholding. Seasonal employees who have become plan participants could also have difficulty making loan repayments via payroll withholding during the off season when they are not working (and not paid).

27 Loan Failures Deemed Distributions Failure to satisfy the amount limitation Deemed distribution of the excess loan amount At the time the loan is made Failure to satisfy the repayment period Deemed distribution of the entire loan amount At the time the loan is made Failure to satisfy level amortization Failure to satisfy an enforceable agreement Deemed distribution of the entire loan amount Deemed distribution of the entire loan amount At the time the loan is made or upon default At the time the loan is made

28 Deemed Distribution: Examples Amount Limitation A participant with a VAB of $200,000 receives an $80,000 loan repayable in level monthly installments over 5 years. The participant has a deemed distribution of $30,000 the excess of $80,000 over the $50,000 limit at the time the loan is made. Repayment Period A participant with a VAB of $70,000 receives a $20,000 nonhome loan repayable in level quarterly installments over 7 years. The participant has a deemed distribution of $20,000 at the time the loan is made. Level Installments A participant with a VAB of $120,000 receives a $50,000 loan repayable in annual installments over 4 years. The participant has a deemed distribution of $50,000 at the time the loan is made.

29 Deemed Distribution: Examples Legally Enforceable Agreement A participant with a VAB of $100,000 receives an $40,000 loan repayable in level monthly installments over 5 years. There is no agreement which demonstrates compliance with IRC 72(p). The participant has a deemed distribution of $40,000 at the time the loan is made. Loan Default A participant with a VAB of $40,000 receives a $20,000 loan on 2/1/2012, repayable in level bi-weekly installments over 5 years. After making payments through 1/30/2013, the participant fails to make any additional payments. The participant has a deemed distribution of the outstanding loan balance at the time the loan defaults.

30 What is a Deemed Distribution? Taxable Distribution of a Loan Failure When a loan fails to satisfy the plan loan rules with respect to amount, duration, repayment terms and enforceable agreement, the loan is treated as a taxable distribution from the plan. The amount deemed to be distributed is included in the participant s gross income and may be subject to the 10% early distribution tax. But is it an Actual Distribution? A deemed distribution is a distribution for tax purposes only. It is not treated as an actual distribution for qualification purposes. Therefore, the deemed distribution does not violate any restrictions on in-service distributions applicable to certain plans (pension plan, 401(k) plan). A deemed distribution occurs before a participant is eligible for a distribution, but because it is deemed, the plan is not disqualified.

31 Impact of a Deemed Distribution Obligation To Repay Maintain Loan On Books Because an actual distribution has not occurred, there is still an obligation to repay the loan even though it s been taxed. The participant s account balance continues to reflect the loan. Interest on the outstanding loan balance continues to accrue. The loan remains as part of the participant s account balance until a distributable event occurs. Maintaining the loan complicates recordkeeping. Top Heavy Rules As part of the participant s account balance, the loan is taken into account when calculating the top heavy ratio. Coverage and Nondiscrimination Testing The loan is included in certain coverage and nondiscrimination tests that consider accumulated accrued benefits.

32 Impact of a Deemed Distribution RMD Rules The deemed distribution does not count toward satisfying RMDs. Future Loans The loan plus accrued interest count as an outstanding loan for determining the maximum amount under the 50%/$50,000 limit. If the loan is not repaid after a deemed distribution, the plan must require that certain conditions be satisfied for all future loans. Either: Repayments must be made by payroll deduction, or The participant must provide additional collateral. One of these conditions must be met for the entire term or the subsequent loan will be treated as a new deemed distribution. If a plan has a one loan limit, the participant may be forced to repay the loan to get a new one.

33 Loan Default A loan default occurs when the loan is not repaid according to its terms. The default results in a deemed distribution at the time of the default if the participant is not entitled to a distribution The participant is taxed on the unpaid loan balance, but still owes the plan the borrowed funds. The unpaid loan balance includes interest that has accrued through the date of default. Payroll Withholding To reduce the chances of default, the plan may require active participants loan payments to be made by payroll withholding. Check the plan document and loan policy for instructions. The plan will specify loan when a loan is in default.

34 Cure Period A plan may provide a period of time to allow the participant to make up any missed payments and bring them current. Statutory cure period: A plan may provide that a loan is not in default until the end of the calendar quarter following the quarter in which the repayment was missed. For example, if a participant failed to make the January 31 st monthly payment and any subsequent payments, the loan would be in default and would be treated as a deemed distribution as of June 30 th. A plan can provide a shorter cure period, such as 30 or 90 days. The loan defaults when the cure period ends. Without a cure period, a deemed distribution would occur if a loan payment is one day late! Interest accrues during the cure period. $$$ Past Due

35 Accrued Interest After a Deemed Distribution Interest continues to accrue after a deemed distribution. Previously-taxed loans continue to be due and payable. Consequently, the plan must continue to charge interest on an outstanding loan until the loan is repaid or offset. Failure of the loan to bear a reasonable interest rate would result in a prohibited transaction. To repay the entire loan, the participant must pay the unpaid loan balance plus the accrued interest. Interest accrued after a deemed distribution is not taxable to the participant. Accrued interest must be tracked. The outstanding loan (including accrued interest) is considered outstanding when calculating the maximum loan amount for future loans.

36 Accrued Interest: Example Mary borrowed $10,000 on 1/1/2013 to be repaid bi-weekly via payroll deduction. The plan uses the statutory cure period. Mary s employer forgets to set up the loan repayments on payroll, and 20 missed loan payments are discovered on 10/7/2013. Based on the plan s cure period, the loan defaults on 6/30/2013. Accrued interest through 6/30/2013 is $233, and from 7/1/2013 to 12/31/2013 is $278. Mary requests a $1,500 loan on 1/1/2014 when her VAB is $23,000. Effect of Accrued Interest: The loan defaults on 6/30/2013, causing a $10,233 deemed distribution ($10,000 loan + $233 interest accrued through the cure period). The additional 2013 accrued interest of $278 is not taxable. Mary is unable to obtain a $1,500 loan on 1/1/2014 since her maximum loan amount is $11,500 ($23,000 x 50%), but her outstanding loan balance on 12/31/2013 is $10,511 ($10,000 + $233 + $278).

37 Taxation of Deemed Distributions Amount Taxed Default = principal and interest accrued through cure period Other failures = see Loan Failures Deemed Distribution slide Tax Withholding A deemed distribution is not an eligible rollover distribution. As such, the distribution is not eligible for rollover. The distribution is not subject to the 20% mandatory tax withholding. A deemed distribution is subject to the voluntary 10% withholding rules that apply to nonperiodic distributions. However, withholding only occurs only if there is cash or other property distributed at the same time as the deemed distribution. Designated Roth Account A deemed distribution of Roth money is treated as a nonqualified distribution under the Roth rules.

38 Reporting Deemed Distributions Form 1099-R Loans that are deemed distributions must be reported on Form 1099-R for the year the deemed distribution occurred. Code L designates the distribution as a deemed distribution in Box 7. Code 1 or Code B may also be used in conjunction with Code L. Interest that accrues after the deemed distribution is not an additional loan and is therefore is not reportable on Form 1099-R. Form 5500 Series A loan that is deemed distributed remains on the books, except for the Form 5500 financials if the loan is not being repaid. The deemed distribution is reported on Form 5500-SF or either Schedule H or I, but the loan is not included on Schedule G or in end-of-year assets for the distribution year or subsequent years.

39 Deemed Distribution vs. Loan Offset Deemed Distribution Loan Offset Taxable Yes Maybe Actual Distribution (for qualific purp, TH, etc.) No Yes Offset Against Account (Obligation to Repay/Track) No (Yes) Yes (No) Interest Accrues After Event Yes No Report on Form 1099-R Yes Maybe Report on 5500 Series Yes Maybe Deemed distribution occurs when not entitled to a distribution. Loan offset occurs when entitled to a distribution.

40 Loan Offset Loan Offset is an Actual Distribution. May not be a distribution for tax purposes. Is treated as a distribution for all other purposes, including qualification requirements. Can offset loan against participant s account without violating the inservice distribution restrictions. Since the loan is actually distributed, There is no longer an obligation to repay the loan, so the loan is not maintained in the books Is triggered by a distributable event: Termination of employment Distribution of VAB Loan default Check plan document and loan policy for timing of loan offset. Interest accrues until the loan is offset.

41 Taxation of Loan Offset Amount Taxed If the loan amount has not been previously taxed, the loan offset is taxable. Loan offset may be subject to the 10% early distribution tax. Loan offset = principal and interest accrued through offset Designated Roth Account A loan offset from a designated Roth account may be treated as a qualified Roth distribution under the Roth rules, if: The loan has not previously been taxed as a deemed distribution, and The 5 taxable years and qualified events requirements are satisfied.

42 Taxation of Loan Offset: Examples Loan offset upon termination of employment. Debra has an outstanding loan of $10,000 in her employer s plan and loan payments are current. Debra terminates employment with a VAB of $30,000 but elects to postpone a distribution. The plan provides for a loan offset upon termination. Even though Debra doesn t receive a distribution, a $10,000 loan offset occurs. Her taxable distribution is $10,000, and her remaining non-loan VAB is $20,000. Loan offset upon distribution of VAB. The plan provides for a loan offset upon distribution of benefits. If instead Debra has an outstanding loan of $10,000 in her employer s plan and loan payments are current. Debra terminates employment and elects a distribution of her VAB. The actual amount distributed to Debra is reduced by $10,000 the loan offset. However, her taxable distribution is $30,000.

43 Taxation of Loan Offset Loan Default A default triggers a loan offset if an actual distribution to the participant is permitted by the plan. The immediate loan offset is a taxable distribution. If an actual distribution is not permitted at the time of default, the default instead triggers a deemed distribution, and a loan offset occurs at a later time when the plan is able to foreclose against the participant s VAB. The later loan offset is not a taxable distribution. Accrued Interest After a deemed distribution, interest continues to accrue until a loan offset occurs. Post-default accrued interest is not taxed.

44 Taxation of Loan Offset: Loan Default Example Example: Going back to Mary who defaulted on a $10,000 loan Mary s loan default triggered a $10,233 deemed distribution on 6/30/2013. Additional 2013 accrued interest totaled $278, and interest of $537 accrued in Mary terminates on 12/31/2014 with an outstanding loan balance of $11,048. The plan provides for an immediate loan offset upon termination of employment. Consequences of loan offset: Mary s account balance is offset (reduced) by the $11,048 loan balance on 12/31/2014. The loan offset is not taxable in The additional 2013 accrued interest of $278 is not taxable in 2013 or The 2014 accrued interest of $537 is not taxable in Interest no longer accrues after the offset since the loan is no longer a plan asset.

45 Taxation of Loan Offset Loan Repayments of Deemed Distributions If a loan is taxed as a deemed distribution and the participant repays the loan, the repayment generates basis. When a distribution is subsequently made, a portion of the distribution (the basis) will be tax-free. Basis includes interest paid on the outstanding loan. Example: Tim receives a $20,000 loan. Before the loan is repaid, he stops making payments, resulting in a $10,000 deemed distribution. Over a period of time, Tim repays the loan, with total payments of $12,500. Tim has basis of $12,500. He later terminates and is receives a distribution of $50,000. The taxable portion is $37,500 ($50,000 distribution $12,500 basis).

46 Taxation of Loan Offset Rollover of Loan Offset A loan offset is an eligible rollover distribution. A participant can elect to roll over a loan offset. The portion of the loan offset not rolled over is subject to the mandatory 20% tax withholding. The automatic rollover rules do not apply to a loan offset. Rollover options of a taxable loan offset: Cash equivalent of the offset amount may be contributed to a qualified plan or IRA. Must be within 60 days of the offset date. Direct rollover of loan note to a qualified plan if not offset. Rollover to an IRA, SIMPLE or SEP is not permitted. Rollover options of a previously-taxed deemed distribution: Cash equivalent contribution within 60 days to an IRA. Repay loan and directly roll over to qualified plan.

47 Taxation of Loan Offset: Example Rollover John is a terminated participant with a $100,000 VAB, including an outstanding loan of $20,000 that has never been taxed. The plan provides 30 days from date of termination before a loan offset occurs. Options include: To defer taxation, John can elect a direct rollover of his $100,000 VAB, including the loan (assuming the receiving plan accepts it). If the receiving plan will not accept the note, John can repay the loan and defer taxation through a direct rollover of his entire VAB. If the rollover is to an IRA or if the loan offset has occurred, John can elect a direct rollover of his non-loan VAB and come up with $20,000 out-of-pocket which he can roll over within 60 days. If John is not able to come up with $20,000, he can roll over the non-loan VAB and be taxed on the $20,000 loan offset. John can elect a distribution of all or part of his VAB and be taxed on the amount distributed, including the $20,000 loan offset.

48 Tax Withholding Taxation of Loan Offsets The taxable portion of a loan offset is subject to the mandatory 20% tax withholding. The required withholding applies since a loan offset is an eligible rollover distribution. If the loan offset is part of a taxable distribution of cash, the 20% withholding will apply to the entire taxable distribution assuming the cash is sufficient to cover the withholding. However, the tax withholding cannot exceed the cash distributed. Example: Mary s loan default triggered a $10,233 deemed distribution on 6/30/2013. Mary terminates on 12/31/2014 with a VAB of $30,000, including an $11,048 outstanding loan balance. Mary elects a lump sum distribution, which triggers a loan offset. Mary s taxable distribution is only $18,952 ($30,000-$11,048). The $10,233 previously-taxed default and subsequent accrued interest is not taxed upon offset. Withholding applies to the non-loan $18,952.

49 Taxation of Loans: Example Tax Withholding John is a terminated participant with a $100,000 VAB, including an outstanding loan of $20,000 that has never been taxed. Options: Direct rollover of entire VAB, including loan: Tax is deferred on the full $100,000, so no withholding is required. Repay loan and roll over entire VAB: Tax is deferred on the full $100,000, so no withholding is required. Incur a loan offset, direct rollover of remaining VAB and indirect rollover of $20,000 out-of-pocket offset amount: Tax is deferred on $80,000 direct rollover. No cash is distributed so withholding is not required on the $20,000 loan offset. Incur a loan offset and direct rollover of remaining VAB: Tax is deferred on $80,000 direct rollover. No cash is distributed so no withholding is required on the $20,000 taxable loan offset. Incur a loan offset and receive a cash distribution of remaining VAB: Entire $100,000 distribution is taxable for required $20,000 tax withholding ($100,000 x 20%). Actual cash payment is $60,000 ($100,000 VAB $20,000 offset $20,000 tax).

50 Reporting Deemed Distributions Form 1099-R Taxable loan offsets must be reported on Form 1099-R for the year the offset occurred. Includes when loan defaults and offset occur simultaneously. Code L in Box 7 is not used for a loan offset. Nontaxable loan offsets, such as loan defaults that occur prior to offset, are not reported on Form 1099-R. Interest that accrues after the deemed distribution is not reportable on Form 1099-R. Form 5500 Series A taxable loan offset is reported on Form 5500-SF or either Schedule H or I as an actual distribution. A deemed distribution that is later offset is not reportable as a distribution on the Form 5500 series for the offset year.

51 EPCRS: Correcting 72(p) Loan Failure Plan Loans under IRC 72(p) Loans that satisfy the requirements of IRC 72(p) are exempt from treatment as taxable distributions. Once a loan violates a requirement, there are a few situations in which the plan administrator can make correction and preserve the exemption. Employee Plans Compliance Resolution System (EPCRS) Rev. Proc Loans that do not comply with the 72(p) requirements may not be corrected under the Self-Correction Program (SCP). Correction may be made under the Voluntary Correction Program (VCP) or the Audit Closing Agreement Program (Audit CAP).

52 EPCRS: Tax Relief Available for Loan Failures Relief = Timing of Deemed Distribution If a plan loan that fails to satisfy the IRC 72(p) requirements is properly corrected under EPCRS, the employer may request the ability to report the loan as a deemed distribution in the year of correction rather than the year of failure. Relief = No Deemed Distribution Alternatively, the employer may request relief from reporting such loan as a deemed distribution. Generally, for a plan loan to be eligible for relief from income tax reporting: The loan failure must be properly corrected within the maximum repayment period (generally 5 years), and Employer action must have caused the loan failure.

53 EPCRS: Amount Limitation Exceeded Correction The participant must repay the excess loan amount plus interest. The amount that must be repaid is based on how previous payments have been applied to the loan, using one of three alternatives: Reduce portion of loan that did not exceed maximum amount limit: Corrective repayment = excess loan amount plus allocable interest; Reduce allocable interest on excess loan amount, with remainder used to reduce portion of loan which did not exceed maximum amount limit: Corrective repayment = original excess loan amount; or Reduce excess loan and maximum loan amount on pro-rata basis: Corrective repayment = outstanding balance of excess loan. The remaining principal balance of the loan is then re-amortized over the remaining period of the original loan, but not beyond 5 years from the date of the original loan.

54 EPCRS: Amount Limitation Exceeded Example On March 1, 2012, Peter took a $55,000 plan loan with a VAB of $110,000. Peter received an excess loan of $5,000. Correction of the loan amount failure under EPCRS: Repay the excess loan amount (including interest) Apply prior payments: Option #1 To portion of loan that did not exceed the maximum amount, in which case the corrective payment is $5,000 plus interest; Option #2 First to the interest on excess amount, and then to portion of loan that did not exceed the maximum amount, in which case the corrective payment is $5,000; or Option #3 Pro-rata to reduce the excess loan amount (9.09%) and the proper loan amount (90.91%), in which case the correction payment is remaining excess loan balance plus interest. Re-amortize remaining balance (after applying prior payments) over the remaining period of the loan.

55 EPCRS: Improper Loan Repayment Terms Correction The remaining principal balance of the loan is re-amortized over the remaining portion of the maximum 5-year repayment period, measured from the date of the original loan. Example Paul took a plan loan of $25,000 on June 1, The loan provided a 6-year term. The mistake is discovered in 2013, when the outstanding principal balance on the loan is $16,000. To correct the loan failure, the $16,000 outstanding balance is reamortized over a period ending not later than May 31, 2016, reflecting the maximum 5-year repayment period.

56 EPCRS: Loan Default Correction Either: The participant may repay the missed payments plus accrued interest in a lump sum payment, The loan balance may be re-amortized over the remaining original term or over a period up to 5 years from the date of the original loan (if the original term was less than 5 years), or A combination of the above methods. If the default is due to employer error, the employer should pay the interest on the unpaid amount. The interest is generally determined at a rate equal to the greater of the plan loan interest rate or the rate of return under the plan.

57 EPCRS: Loan Default Example Mary borrowed $10,000 on 5% interest with 130 biweekly payroll withholding payments of $87 for 5 years until 12/25/2017. The employer forgot to set up the loan repayments on payroll, and 20 loan payments were missed (through 10/7/2013). Based on the plan using the latest statutory cure period, technically the loan defaulted on 6/30/2013 resulting in a $10,233 deemed distribution. Correction under EPCRS to obtain tax relief: Option #1 Lump sum payment of 20 missed payments plus accrued interest = $1,773 ($1,740 by the participant, $33 by the employer), with payments of $87 for the remaining loan term; Option #2 Re-amortize outstanding loan balance of $10,391 on 10/7/2013 (which includes accrued interest) over remaining loan term, resulting in a bi-weekly payment of $105; or Option #3 Partial lump sum payment (less than $1,773) and reamortize remaining loan balance over remaining loan term.

58 EPCRS: VCP Submissions The VCP compliance fee is reduced by 50% if: The submission involves an IRC 72(p)(2) failure; No more than 25% of participants are affected by loan errors, and The loan failure is the only failure of the submission. Coordination with VFCP The DOL s Voluntary Fiduciary Correction Program allows fiduciaries to correct breaches relating to prohibited transactions arising from failure to follow the plan s terms regarding loans. Correction under VFCP requires a VCP submission with the IRS. VCP VFCP

59 EPCRS: Audit CAP Correction on Audit Audit CAP is available to correct IRC 72(p)(2) loan failures found by the IRS in an examination. The same correction principles apply to both VCP and Audit CAP. When negotiating the sanction under Audit CAP relating to loan failures, The Maximum Payment Amount will include the tax the IRS could collect as a result of the loan not being excluded from gross income under 72(p)(2), and The IRS will take into account the extent to which the failure is a result solely of action or inaction of the employer or its agents, or the extent to which failure is a result of the employee s actions or inactions.

60 EPCRS: Correcting Plan Document Loan Failures Allowing Plan Loans The plan document must provide for participant loans in order for loans to be issued. Plan sponsors should check their plan documents before allowing participants to borrow money from the plan. Correction If loans have been issued to participants under a plan that does not provide for loans, the plan is amended retroactively under SCP to provide for loans. The amendment must satisfy IRC 401(a). The plan, as amended, would have satisfied 401(a) and 72(p) had the amendment been adopted when loans were first made available.

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