Take-Away: Many qualified plans, like 401(k) plans, permit a participant to borrow against his/her account balance. The rules are pretty straight-forward on how to document the loan and how it is paid back. But when those rules are not followed, a deemed distribution from the qualified plan account to the participant occurs, which results in income taxes, penalties, and interest.

Background: Some qualified plans permit a plan participant to borrow from their own account. Many qualified plans do not permit loans from account balances for a couple of reasons. First, borrowing from retirement funds is counter-intuitive to saving for the participant’s retirement. Second, many administrative nightmares arise for the plan sponsor to monitor the loan and assure the payments to amortize the loan are timely made. Third, a failure to follow the terms of the loan creates an immediate income tax liability for the participant, arguably at a time when the participant is already financially struggling (which explains why they had to borrow from their own retirement account in the first place.) To restate the point,  the qualified plan must actually permit loans, and many plans do not; thus, the right to borrow from an account balance is not automatic. Moreover, there is no comparable right to borrow from an IRA.

  • Terms of the Loan: The loan will not be treated as a taxable distribution from the qualified plan if the loan: (i) is manifested in a legally enforceable agreement; (ii) does not exceed specified amounts in IRC 72(p)(2)(A)(i) or (ii);  (iii) by its terms the loan is to be repaid within 5 years; and (iv) has substantially level amortization over the term of the loan with installment payments made at least quarterly. [Reg.1.72(p)-1] Usually the loan taken by the participant is repaid through payroll withholding in order to simplify the repayment process.
  • Deemed Distribution: Although a loan originally may satisfy the requirements to avoid taxation, a deemed distribution from the qualified plan will occur the first time that the requirements are not satisfied, in form or in operation. If payments are not made in accordance with the terms applicable to the loan, a deemed distribution occurs; e.g. the failure of the participant to timely make a payment, and income taxes will have to be paid.
  • Opportunity to Cure: The qualified plan administrator can provide the participant an opportunity to cure a failure to make a timely payment on the loan, and a deemed distribution will not occur, unless the participant fails to pay the delinquent payment within the specified cure period. Normally the cure period is the end of the month that follows the month that the installment payment on the loan is in default.
  • Example: I borrow from my 401(k) account $50,000 because my 401(k) plan permits participant loans. My first payment on my note  held by the qualified plan administrator is due July 2. I miss that July 2 payment. I have until August 31 in which to cure that default and pay the late installment plus interest that is due on the note- close to two months to cure my default. If I do not cure that default in the payment of the installment  payment that was due July 2, by August 31, I will be deemed to have received a $50,000 taxable distribution from the qualified plan. If my payment was due on July 30, I would have only 32 days in which to cure my default. If I am under 59.5 (don’t I wish!) I will also pay the 10%  penalty for receiving an early distribution from the qualified plan. At a time when I needed money badly enough that I had to borrow $50,000 from my 401(k) account, I might find myself paying $14,625 in unexpected federal and state income taxes and another $5,000 in federal excise taxes.

Employer Drops the Ball:  What are the implications if the employer fails to follow through with the loan repayment agreement, causing the participant to not timely make installment payments on their loan from their account balance? That was the situation in Frias v Commissioner, T.C. Memo, 2017-139 (July 11, 2017).

  • Facts: The facts in Frias are troublesome, for both the participant and her employer. Louelia worked in administration at a 182 bed nursing and rehabilitation center. Louelia requested and was granted a leave of absence due to her pregnancy with her third child. Louelia used her accrued sick, personal, and vacation leave which covered 5 weeks of her leave. The remainder of her leave was unpaid. At the same time as her leave request, Louelia took a $40,000 loan from her 401(k) account. Louelia entered into a payroll deduction agreement with her employer, which was incorporated into a participant loan agreement, that required Louelia’s employer to deduct from her after-tax salary for each payroll an amount necessary to amortize the loan over the next 24 months- about $341 applied to the loan balance biweekly. The biweekly payroll deductions were to start on August 10. The first payment was due on August 24. The cure period specified under the qualified plan would have expired on September 30. However, at no time between Louelia taking her loan and signing the payroll withholding agreement and then going on leave of absence, and September 30, did Louelia’s employer withhold the $341 from her paychecks. Her employer did, however, include with each paycheck an earnings statement which included information about Louelia’s pay, including what the deductions were for from that paycheck. Louelia, dealing with her pregnancy, did not pay any attention to the earnings statements that she received in August and September. [Unclear from the facts is if Louelia had a direct deposit of her paychecks.] Louelia only learned that her employer had failed to withhold loan payments from her paychecks until sometime in mid-October when she returned from her pregnancy leave and her employer informed her of that fact. Louelia made a $1,000 payment on the loan on November 20. To her credit, Louelia also instructed her employer to increase the payroll deduction amount from $341 to $500 each payroll, which was done through the following July. Thereafter, Louelia went back to the original payroll withholding amount of $341 each pay period until the loan was fully paid off within the agreed upon two year repayment period.
  • 1099-R: The insurance company that administered Louelia’s employer’s 401(k) plan issued Louelia a 1099-R for the year of the plan loan, showing a deemed distribution to her of $40,065  However, the Form 1099-R was not mailed to Louelia. Rather the Form was made available to her online. While Louelia had access to the insurance company’s website, she did not access or review the Form 1099-R. There was no evidence in the court proceeding if Louelia had notice that the Form 1099-R had been issued to her. The key fact for the Tax Court was that Louelia did not report the $40,065 for the calendar year in question when the deemed distribution to her occurred, precipitating an IRS Notice of Deficiency leading to this Tax Court litigation.
  • Court Holding: The Tax Court had no sympathy for Louelia or that she was on a pregnancy leave at the time the withholding mistake occurred, or that the mistake was caused by Louelia’s employer, or that Louelia took steps to ‘fix’ the oversight once she learned of it. Louelia was found liable for the underpayment of her income taxes for the calendar year in question.
  • Deemed Distribution: The Tax Court found that Louelia had violated the terms of her plan loan, and that the loan had failed to satisfy the substantially level amortization requirement. While the form of the plan loan was correct on its face, the substance or practice was not. The Tax Court found that any time a missed installment payment occurs, that missed payment violates the ‘substantially level amortization’ requirement, if the missed payment is not corrected in the specified cure period. The default in the loan repayment period (and following cure period) resulted in a deemed distribution of the entire outstanding loan, plus all accrued interest to Louelia.
  • 10% Penalty: The Tax Court also found that because Louelia was under the age 59.5 years when the deemed distribution occurred, she also had to pay the 10% early distribution excise tax imposed by IRC 72(p)(2)(C) on the amount that is deemed distributed to her.
  • Form over Substance: This inflexible approach taken by the Tax Court was indicated by the following remark in its decision: If, as petitioners contend, all parties agreed to suspend payments on [Louelia’s] loan, such an agreement should have been evidenced by a writing or a qualifying electronic medium. Moreover, petitioner’s argument that the substance of what happened rather than the form of what happened should control ignores the express requirements of the loan agreement and applicable regulations.” In short, the Tax Court focused solely on what happened, not on how those facts came to exist.
  • Ignored by the Court: What is surprising about the Court’s decision is that at no time did it take the employer to task for its failure to implement the payroll deduction agreement that it had with Louelia. [Nor did it mention in passing that Louelia may have a breach of contract action against her employer for its failure to abide by the payroll withholding agreement.] Nor did the Court take note that  Louelia had no control over her employer’s payroll department or its practices- being on a leave of absence due to her pregnancy. Equally surprising is that the Tax Court made virtually no mention of the fact that Louelia ‘could have’ discovered the mistake and brought it to her employer’s attention, or that she did so as soon as she returned from her pregnancy leave of absence. The fact that Louelia missed making a curative payment in the cure period was sufficient to bring down on Louelia the immediate payment of the income tax and interest on that deemed distribution.
  • George the Cynic: Not addressed by the Tax Court were the steps that Louelia did take after being informed that her employer had dropped the ball, and the Form 1099-R was issued, in order to make catch-up payments to repay the loan. If the loan became a deemed distribution, then the amount that Louelia did pay over the next 21 months repaying that ‘non-loan’ may have resulted,  in effect, in excess contributions to Louelia’s retirement 401(k) account. The cynic in me wonders how long it will take the IRS to impose a 6% excise tax on Louelia for her excess contributions to her 401(k) account.
  • Throw Her a Bone: One bone was thrown by theTax Court to Louelia was to refrain from imposing on her a second penalty.  Our friends at the IRS also wanted a 20% penalty imposed on the underpayment of income tax attributable to a substantial understatement of income tax. IRC 6662(d). The Tax Court did find that Louelia had reasonable cause and that she acted in good faith. The Court found that while Louelia did not have the actual Form 1099-R in hand, that fact did not excuse her from the duty to report the income on her Form 1040 income tax return;  the fact that Louelia did not receive a copy of the Form 1099-R did not constitute reasonable cause. But the Tax Court did conclude that Louelia did not have a reason to know that her loan had been treated as a deemed distribution for the year in question:
  • Glen Island [employer] had an obligation to withhold the loan repayment amounts from [Louelia’s] paychecks and to transmit the amounts to Mutual of America. Glen Island failed to meet this obligation. [Louelia] was on maternity leave, and part of her leave period was without pay. She reasonably relied on Glen Island and Mutual of America to withhold required loan payments and properly administer her loan account. Under the circumstances it is understandable that [Louelia] assumed her loan repayments were being made to the extent the loan agreement required, and her failure to check her earning statements is not fatal to this analysis.”
  • Advice of her Employer: What the Tax Court did not mention in its recitation of the underlying facts, but what it alluded to in relieving Louelia of the 20% substantial underpayment penalty, was that while she was aware the loan from her 401K account could have tax consequences {this was not Louelia’s first loan from her 401k account} she had no reason to know that this loan had tax consequences ‘considering the advice she had received from her employer and the obligation of her employer to withhold loan payments under the loan agreement.” Nowhere in the decision is there any mention of the employer advising Louelia how to respond to its failure to withhold the loan repayment amount from Louelia’s paychecks. One wonders if the employer told Louelia to pay the $1,000 in November and then make increased payments for the next 7 months to ‘fix’ its mistake. If that was the advice the plan sponsor gave to Louelia it was wrong, or more accurately, it was too late once the cure period had passed.

Conclusion: The Frais decision is unfortunate. An employee on a maternity leave of absence relying on her employer to implement its promised payroll withholding, and perhaps following her employer’s ‘advice’ when it confessed that it failed to implement their payroll withholding agreement, finds herself with an immediate income tax liability, payment of interest, and a non-deductible excise tax of 10%. Only the plan participant was hurt by her employer’s mistake. Only the plan participant incurred the 10% penalty. Upon the her employer’s ‘advice’ (?) she might also incur an additional 6% excess contribution penalty. The Frias decision is a strong example why loans from qualified plans are dangerous and usually discouraged by plan sponsors. It is pretty easy to stumble on the IRS’s deemed distribution rules, and the associated penalties can be very steep, adding to the participant’s financial woes.