United States: 401(k)/403(b) Loan Borrowers – Check Your Paystubs!

A recent tax court case, Louelia Salomon Frias, v. Commissioner, TC Memo 2017-139, illustrates why it is good practice to verify that employee loan repayments have been timely deducted.

Plan Loan Requirements. An employer can amend its defined contribution plan to allow participants to take loans from their accounts. Under Internal Revenue Code Section 72(p)(2) a loan will not be treated as a distribution if the loan:

  • Is documented by a legally enforceable agreement;
  • Does not exceed the maximum limit as set by the Code;
  • Has a repayment term of no longer than five years, unless the loan is for the purchase of the borrower's principal residence; and
  • Is repaid in substantially level amounts over the repayment term. A loan goes into default when it fails to satisfy any one of these requirements. The outstanding loan balance and interest at the time of default are reported to the Internal Revenue Service (IRS) and to the borrower as a taxable distribution. If the borrower is younger than age 59 and a half at the time of default, a 10 percent excise tax would also apply (unless marked as an exception under Code Section 72(t)).

Facts. In the recent case, Ms. Frias participated in her employer's 401(k) plan. On July 27, 2012 she signed a loan agreement to borrow $40,000 from her plan account. This loan was to be repaid over the next two years by deducting $342 from every bi-weekly paycheck. On July 30, 2012, Ms. Frias began an approved maternity leave of absence. During the first five weeks of her leave she opted to be paid via her accrued – but unused – sick, personal and vacation days. Based on this election she was paid:

August 10, 2012 $2,181
August 24, 2012 $2,181
September 7, 2012 $2,181
October 19, 2012 $2,328

The remainder of her leave was unpaid. Her first loan repayment was due August 24, 2012. The plan included a "cure period," meaning that a loan repayment would not be late if it was paid by the last day of the month following the month which included the missed payment date. Therefore, September 30, 2012 was the end of the cure period for the August 24 payment.

However, the employer deducted none of the loan repayments from Ms. Frias' paychecks while she was on leave. Ms. Frias did not know of this failure until she returned to work on October 12, 2012. She immediately made a $1,000 payment on November 20, 2012, and authorized an increase in her repayments to $500 through July 15, 2013, and thereafter the original $342 loan repayment was reinstated. The loan was repaid in full on July 9, 2014.

Mutual of America, the plan's record keeper, accepted all loan repayments and in July 2014 wrote Mrs. Frias that her loan had been repaid in full. But in 2012 Mutual of America issued a Form 1099-R, reporting a deemed distribution because of the late August 24, 2012 loan repayment. The deemed distribution was $40,065, which was additional taxable income to Ms. Frias. Because Ms. Frias was younger than 59 and a half, the Section 72(t) 10 percent early distribution excise tax applied as well.

When Mutual of America posted the Forms 1099-R online, Ms. Frias had access to the website, however she did not access the site. (The case records do not indicate whether she was given notice that a Form 1099-R had been issued.) This led to a cascade of events, with significant tax consequences for the employee. Because Ms. Frias did not know a deemed distribution had been reported, she did not recognize the $40,065 as additional taxable wages on her 2012 income tax return. In 2014 the IRS determined that she owed an additional $19,129 in taxes, $15,941 in taxes which included the 10 percent excise tax, as well as an additional $3,188 penalty for a substantial underpayment of tax.

The tax court disagreed with Ms. Frias that a deemed distribution should not have been reported because she was on an unpaid leave of absence. Treas. Reg 1.72(p)-1, Q&A-9(a) provides that a borrower is exempt from the requirement to make timely level loan repayments if the borrower is on a bona fide leave of absence for no longer than one year, either without pay or if the rate of pay is less than the loan repayment amount. However, because Ms. Frias used her paid time-off days (PTO) for the first five weeks of her leave, she could not rely on this exception for her first repayment – her paychecks during her leave were greater than the loan repayment. The court was also not persuaded by Ms. Frias' arguments that PTO payments did not constitute wages or that she timely corrected the mistake when she returned to work.

However, the court did decide in Ms. Frias's favor regarding the 20 percent penalty for the substantial underpayment of tax, which applies if the understatement of tax exceeds the greater of (i) 10 percent of the tax required to be shown, or (ii) $5,000. Application of this penalty depends upon the facts and circumstances, but a major factor is the tax payer's good faith to assess her proper tax liability. The court held that the penalty was not excused just because she did not receive the Form 1099-R. But the court decided that she had reasonably relied on her employer to timely deduct the repayments from her paychecks because the loan agreement required that repayments would be made by payroll deductions. Under these circumstances, it was not fatal that she failed to check her pay stubs. Finally, as soon as she learned of the mistake, she tried to correct it by making a $1,000 repayment and increasing her repayment amount to pay off the loan within its two-year term.

As this case demonstrates, the rules regarding repayment of retirement plan loans can be quite complicated, turning on a number of specific factors. Whether because of unclear understanding of the rules, miscommunications between human resources and payroll, or other reasons, loan repayments are not always timely deducted.

To avoid these types of problems, employers should make sure that the loan agreement accurately reflects a plan's terms regarding loans, leaves of absences, repayment methods, and cure periods. A borrower should be provided with and understand all of the terms of the loan before signing the loan agreement. Moreover, while it was not a fatal flaw that Ms. Frias did not check her paystubs while on leave, it is always good practice for borrowers to check them to assure that loan repayments are deducted properly and for employers to encourage borrowers to do so. By taking these precautions, a borrower can avoid an unexpected tax bill and a nasty fight with the IRS while employers can avoid claims that a borrowing employee was harmed because of the employer's actions or failure to inform the employee of relevant information.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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