On December 31, 1997, the Internal Revenue Service ("IRS") issued a supplemental set of proposed regulations which address the federal income tax treatment of loans made by tax qualified retirement and savings plans to plan participants. These proposed regulations provide important guidance as to how the IRS believes participant loans should be handled upon default.
Background
Since 1982, the Internal Revenue Code (the "Code") has required that participant loans be taxed as a "deemed" distribution unless the loan meets certain requirements. These include, among others, the requirements that the loans must (1) be repaid in substantially equal installments at least quarterly and (2) have a term of no more than five years (except where the loan is to be used to acquire any dwelling unit which is to be used as the borrower’s principal residence, in which case, a longer period is permissible).
While there are a number of requirements which must be met to avoid treatment as a deemed distribution, there is nothing in the Code which addresses whether and when a loan in default must be treated as a "deemed" distribution. Nor is there anything in the Code addressing how to deal with an outstanding loan which is treated as a deemed distribution. Some of these issues were initially addressed in proposed regulations issued in 1995. This proposal addresses, among other things, the following issues:
(a) Treatment of Defaulted Loan as a Taxable Distribution – The 1995 proposal provides that if a borrower fails to pay timely any loan installment (taking into account any permissible "grace period"), the loan is to be treated as a deemed distribution. The IRS also allows a fairly lengthy grace period to be used, as the regulations provide that such period could extend to the last day of the quarter following the calendar quarter in which the missed installment payment was due.
(b) Entire Loan to be Treated as a Taxable Distribution – The 1995 proposal provides that upon default, the entire loan, and not just the missed installment, is to be treated as a deemed distribution. This is to include the outstanding loan balance (both principal and unpaid interest) at the time the loan is determined to be in default.
(c) Default can Occur Prior to Offset – The 1995 proposed regulations also recognize that a deemed distribution of a defaulted loan can occur prior to the time that the defaulted loan is ultimately repaid or offset against the borrower’s plan account. This is due to the agency’s position that an actual offset cannot occur until the account can otherwise be distributed by law. However, the 1995 proposal does not address the tax treatment of defaulted loan repayment or offset made after deemed distribution has occurred.
The 1997 Proposed Regulations
The 1997 proposed regulations, which supplement the 1995 proposal, address the federal income tax treatment of both loan repayments and offsets that take place after the occurrence of a deemed distribution due to a default. Among the more important guidance provided in this proposal is the following:
- Treatment of Subsequently Accrued Interest – The 1997
proposed regulations provide that any interest accruing on a defaulted
participant loan after deemed distribution has occurred will not be
treated as an additional loan or considered taxable income at the time of
accrual.
- Tax Treatment of an Unpaid Defaulted Loan Upon Offset – The
proposal makes clear that a defaulted plan loan for which there has been a
deemed distribution will not be taxed a second time upon later offset
under the plan.
- Treatment of Loan Repayments on a Defaulted Loan – The 1997
proposal provides that repayments on a defaulted loan (for which there has
been a deemed distribution) are to be treated as "investment in the
contract" in the same way as after-tax contributions. What this means is
that upon later distribution, the repaid amounts will not be taxed a second
time. Keep in mind, however, that such repayments will not be treated as
after-tax contributions for other purposes, including the Actual
Contribution Percentage (ACP) test and the Code Section 415
contribution limits.
- Effect of Deemed Distribution on Limits for Subsequent Loans – Under the Code, to avoid deemed distribution treatment, the amount of a plan loan cannot, taking into account the outstanding balance of any previous plan loan, exceed certain monetary limits. The 1997 proposed regulations provide that for purposes of determining the outstanding loan balance at the time a new loan is made, the outstanding balance (including any accrued but unpaid interest) of a defaulted loan which has not yet been repaid must be taken into account. In taking this position, it appears that the IRS contemplates that defaulted loans should continue to accrue interest until the loan is finally offset or otherwise repaid in full. However, the proposal does not go so far as to actually impose such a requirement.
Effective Date of Proposed Loan Regulations
Both the 1995 and 1997 proposed regulations will not become effective (and then only a prospective basis) until at least 6 months after the date on which those regulations are ultimately finalized. In the meantime, a plan administrator may elect to begin applying the regulations. If the plan administrator chooses not to do so, the participant loan rules must still be applied in a reasonable, good faith manner. If, on the other hand, the administrator elects to apply the proposed default rules, the 1997 proposal contains special consistency rules for applying the new rules prior to the regulatory effective date. In addition, the proposed regulations also contain some special transitional rules applicable to pre-effective date loans in certain circumstances.