IRS Updates Issue Snapshot on Participant Loans

The IRS on Sept. 28 updated the Issue Snapshot in which it discusses the laws and regulations governing plan loans. 

Many retirement plans make it possible for participants to take out loans against their retirement accounts, although plans are not required to do so, the IRS reminds. Qualified plans that satisfy the requirements of Code Section 401(a), annuity plans that satisfy the requirements of Sections 403(a) or 403(b), and governmental plans as defined in Section 72(p)(4)(B) can make loans available; IRAs and IRA-based plans such as SEPs, SARSEPs and SIMPLE IRA plans cannot offer loans. 

Enforceable Agreement Requirement

A participant loan must be a legally enforceable agreement (which may include more than one document) and the terms of the agreement must demonstrate compliance with the requirements of Section 72(p)(2) and Treas. Reg. §1.72(p)-1. Thus, the agreement must specify the amount and date of the loan and the repayment schedule. The agreement does not have to be signed if the agreement is enforceable under applicable law without being signed. However, the agreement must be set forth in a written paper document or in a document that is delivered through an electronic medium under an electronic system as specified under Treas. Reg. §1.401(a)-21. 

Loan Amount Limits

Section 72(p)(2)(A) provides that the amount of a participant loan, when added to the outstanding balance of all other loans to the participant from all plans of the employer, may not exceed the lesser of:

• $50,000, reduced by the excess (if any) of the highest outstanding balance of loans from the plan during the one-year period ending on the day before the date on which such loan was made, over the outstanding balance of loans from the plan on the date on which such loan was made, or
• The greater of: 
  • 50% of the participant's vested accrued benefit; or
  • $10,000.

Section 2202(b)(1) of the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) changes the dollar limit on loans made to a qualified individual on or after March 27, 2020 and before Sept. 23, 2020. For those loans, the limits increase under Section 72(p)(2)(A) as follows:

• the $50,000 aggregate limit increases to $100,000 and
• the aggregate amount of loans limit increases from 50% of the participant's vested accrued benefit to 100%.

Repayments

Under Section 72(p)(2)(B), the repayment period of the plan loan must be limited to five years unless the loan is to be used to purchase a dwelling unit which will, within a reasonable amount of time, be used as the participant’s principal residence. 

Section 72(p)(2)(C) requires substantially level amortization over the term of the loan, with payments not less frequently than quarterly. However, this requirement does not apply if a participant is on a bona fide leave of absence for a year or less, but the loan (including interest that accrues during the leave of absence) must be repaid by the latest permissible term of the loan and the amount of the installments due after the leave ends must not be less than the amount required under the terms of the original loan. The payment amount must be adjusted to ensure the loan is still paid off in five years. 

Code Section 414(u) provides a repayment exception for those in active military service. The plan may suspend the obligation to repay a loan during the period of active military service without causing the loan to be in default if the payments resume upon completion of the active military service. When the obligation to repay a loan is based on a period of active military service, the five-year repayment period can be extended. 

The due date of any loan repayment for a qualified individual that occurs between March 27, 2020 and Dec. 31, 2020 is delayed for one year by Section 2202(b)(2) of the CARES Act. Any subsequent repayments of the loan must be adjusted to reflect the delay and any interest accruing during the delay. The period of delay must be disregarded in determining the 5-year period and the term of the loan under Sections 72(p)(2)((B) and C).

If the plan elects to apply the provisions of the CARES Act, the plan document must be updated. The amendment must be adopted on or before:

• the last day of the first plan beginning on or after Jan. 1, 2022, or
• a later date the Secretary of the Treasury may specify.

Deemed Distributions

A participant loan or a portion of it will become a deemed distribution for tax purposes if it: 

• exceeds the maximum dollar amount;
• has payment schedules that do not meet the time or payment requirements; or 
• goes into default when payments are not made.

A deemed distribution occurs the first time that any of the requirements above are not satisfied in form or operation. This may occur at the time the loan is made or at a later date. 

In three situations, the entire loan is considered a deemed distribution on the date the loan is made:

1. The loan terms violate the repayment term requirement of Section 72(p)(2)(B),
2. The loan terms violate the level amortization requirement of Section 72(p)(2)(C), or
3. There is no legally enforceable agreement as defined in Treas. Reg. §1.72(p)-1 Q&A-3(b).

A deemed distribution of an amount different than the original amount of the loan can occur if:

1. the amount loaned exceeds the limitations of Section 72(p)(2)(A), then the deemed distribution is the amount by which the loan exceeds the limitations.
2. the participant failed to make any installment payment when due in accordance with the terms of the loan, then the deemed distribution is the amount of the outstanding balance of the loan, plus accrued interest.

Addressing Failures 

When a participant fails to make an installment payment when due, the plan may provide for a “cure period” that cannot extend beyond the last day of the calendar quarter following that in which the required installment payment was due. 

The CARES Act provides that plans may implement certain special rules for qualified individuals relating to plan loan aggregate limits and repayment terms. Under the CARES Act and IRS Notice 2020-50, which implements portions of it, a qualified individual is anyone who is diagnosed—or whose spouse or dependent is diagnosed—with COVID-19 or is experiencing adverse financial consequences as a result of the COVID-19 pandemic. 

Action Steps

The IRS provides the following tips concerning indications that an issue may exist, and how to be ready for an audit. 

• Review the plan document and/or loan policy to ensure that the plan is operating consistent with Section 72(p).
• Examine the outstanding participant loan documents. Records containing the necessary information may include, but are not limited to, loan agreements, promissory notes, spousal consents, and residential purchase documents.
• Determine whether a loan should be considered a deemed distribution. Factors to consider are failure to comply with the maximum amount, level amortization, or the enforceable agreement requirements of Treas. Reg. Section 1.72(p)-1.
• Examine any Forms 1099-R for deemed distributions to ensure that they were issued for the tax year the participant failed to cure the defect by the expiration of the cure period that resulted in the deemed distribution.
• Look for indicators of fraud.