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Plan Loans: Case Studies on Correcting Mistakes

Practice Management

Plan loan features in DC plans can encourage workers to participate in the plan. But the rules governing plan loans can be complicated, and mistakes can be made. A recent ASPPA webcast offered a look at common plan loan mistakes and how to correct them, using case studies to illustrate.

In “St. Valentine’s Day Loan Massacre: When Good Loans Go Bad,” Alison Cohen, a partner at the Ferenczy Benefits Law Center, provided a refresher on the general rules governing plan loans. She also discussed ways in which things can go wrong and how those problems can be addressed, with a focus on helping administrators avoid problems in the first place and be better equipped to correct them if a failure does occur.

Case Study 1

A participant initiates a loan through an online request service on Jan. 15, 2018. The HR official receives notification via email that the loan has been initiated; however, before getting payroll deductions started, the HR person gets distracted and forgets to complete the process. As a result, loan repayments are not taken out. The mistake is not discovered until December 2018.

There are two options for addressing the situation, Cohen said:

1. Self-correction; and
2. correction through the IRS Voluntary Compliance Program (VCP).

Self-correction. So what does self-correction mean? Cohen noted what it is not, arguing that self-correction should not be pursued through amortization. “That really is not legitimate self-correction,” she said.

Rather, Cohen suggested considering the loan to be in default and taxing the participant for the unpaid balance, including interest, to date of default. She did aver that “That is not going to make you very popular with the participant.”

If there is a taxable distribution permitted, the portion of the account equal to loan is considered to be distributed, Cohen said. And that means that:

  • a 10% premature distribution tax would apply;
  • the account is actually permanently decreased by distributed loan; and
  • the distribution is shown on the Form 5500.

VCP. The VCP is available for all types of loan failures, not just those that are the sponsor’s fault, Cohen noted. A VCP application asks the IRS to treat the loan as if it was not in default if it is not past original maturity date, she said. And an advantage for employees is that using the VCP can avoid imposing taxes on them under certain circumstances.

When applying for the VCP, Cohen explained, the following data is required:

  • plan documents for period of failure, including loan policy;
  • the original loan documents and amortization schedule;
  • proof of correction (interest/back payments made); and
  • a revised reamortization schedule.

A VCP applicant also must provide a narrative explaining what happened. And Cohen said it was “most important” that they state “what they have done to make sure it won’t happen again.” One such step, she suggested, could be adding a cross check feature. But, she cautioned, it can’t just be a plan. “You have to have actual action,” she said.

There are some limits to the VCP, however. Cohen said that if a loan is past its original maturity date when the situation discovered, then only the VCP solution is to tax in current year. Another limitation she cited is that the VCP can only correct nonpayment during five-year permissible loan period. And she noted that the VCP used to impose lower fees for loan failures, but they are “now subject to the regular schedule,” which she called “the biggest problem” with the VCP.

If no VCP is filed and there is no deemed distribution, Cohen said, then:

  • distribution is for tax reporting purposes only;
  • the loan remains an asset of the plan;
  • no additional interest accrues for tax, plan reporting;
  • offset occurs whenever distributable event happens; and
  • any actual repayment creates “basis” that is paid to the participant on distribution tax-free

Case Study 2

An owner initiates a $50,000 loan in 2014, but never starts any repayments. In 2019, the client changes TPAs and it is discovered that the loan is outstanding, no accrued interest has been calculated, and no Form 1099-R has been issued.

The concerns that need to be addressed, said Cohen, include:

  • This involves an owner, so Form 14568-E (formerly Schedule 5) cannot be filed; instead, a general VCP application must be used.
  • The loan could be considered a prohibited transaction, and that can disqualify the plan.
  • The IRS can consider this an egregious failure which would be ineligible for the VCP.
  • Questions one can ask in such a situation, said Cohen include, “Can the owner repay the full amount owed, plus accrued interest?” and “Do we have any sort of reasonable story for how this happened?”

Cohen said that if the VCP is used in such a situation, a good explanation must be included with the general application. She said that strong consideration should be given to filing both VCP and the Department of Labor’s Voluntary Fiduciary Correction Program (VFCP). Cohen added that the ability to repay the full amount is critical, and if one declares the loan to have been a prohibited transaction, it will then be possible to ask for a waiver of excise taxes as part of the submission.

Webcast Available

The ASPPA webcast “St. Valentine’s Day Loan Massacre: When Good Loans Go Bad” is available on demand through Feb. 14, 2020. Information concerning access is available here.