The prohibited transaction rules, unfortunately, are found both in ERISA and the IRC. Although the rules are similar, they are not identical. As common in the area of pension law, Congress’ penchant for complexity borders the perverse.
ERISA §406(a)-(b) provides:
Act Sec. 406. (a) Except as provided in section 408:
(1) A fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect-
(A) sale or exchange, or leasing, of any property between the plan and a party in interest;
(B) lending of money or other extension of credit between the plan and a party in interest;
(C) furnishing of goods, services, or facilities between the plan and a party in interest;
(D) transfer to, or use by or for the benefit of, a party in interest, of any assets of the plan; or
(E) acquisition, on behalf of the plan, of any employer security or employer real property in violation of 407(a).
(2) No fiduciary who has authority or discretion to control or manage the assets of a plan shall permit the plan to hold any employer security or employer real property if he knows or should know that holding such security or real property violates section 407(a).[1]
Act Sec. 406. (b) A fiduciary with respect to a plan shall not-
(1) deal with the assets of the plan in his own interest or for his own account,
(2) in his individual or in any other capacity act in any transaction involving the plan on behalf of a party (or represent a party) whose interests are adverse to the interests of the plan or the interests of its participants or beneficiaries, or
(3) receive any consideration for his own personal account from any party dealing with such plan in connection with a transaction involving the assets of the plan.
IRC §4975(b)(1) defines a “prohibited transaction” as follows:
(1) General rule. For purposes of this section, the term "prohibited transaction" means any direct or indirect --
(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
(B) lending of money
or other extension of credit between a plan and a disqualified person;
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.[2]
ERISA §3(14) defines a “party in interest” as follows:
(14) The term “party in interest” means, as to an employee benefit plan-
(A) any fiduciary (including, but not limited to, any administrator, officer, trustee, or custodian), counsel, or employee of such employee benefit plan;
(B) a person providing services to such plan;
(C) an employer any of whose employees are covered by such plan;
(D) an employee organization any of whose members are covered by such plan;
(E) an owner, direct or indirect, of 50 percent or more of-
(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation,
(ii) the capital interest or the profits interest of a partnership, or
(iii) the beneficial interest of a trust or unincorporated enterprise, which is an employer or an employee organization described in subparagraph (C) or (D);
(F) a relative (as defined in paragraph (15)) of any individual described in subparagraph (A), (B), (C), or (E);
(G) a corporation, partnership, or trust or estate of which (or in which) 50 percent or more of-
(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,
(ii) the capital interest or profits interest of such partnership, or
(iii) the beneficial interest of such trust or estate, is owned directly or indirectly, or held by persons described in subparagraph (A), (B), (C), (D), or (E) [Not (F)!!];
(H) an employee, officer, director (or an individual having powers or responsibilities similar to those of officers or directors), or a 10 percent or more shareholder directly or indirectly,
of a person described in subparagraph (B), (C), (D), (E), or (G), or of the employee benefit plan; or
(I) a 10 percent or more (directly or indirectly in capital or profits) partner or joint venture of a person described in subparagraph (B), (C), (D), (E), or (G).
The Secretary, after consultation and coordination with the Secretary of the Treasury, may by regulation prescribe a percentage lower than 50 percent of subparagraphs (E) and (G) and lower than 10 percent for subparagraph (H) or (I). The Secretary may prescribe regulations for determining the ownership (direct or indirect) of profits and beneficial interests, and the manner in which indirect stockholdings are taken into account. Any person who is a party in interest with respect to a plan to which a trust described in section 501(c)(22) of the Internal Revenue Code of 1986 is permitted to make payments under section 4223 shall be treated as a party in interest with respect to such trust.[3]
The definition of a relative under ERISA is identical to the definition of a member of the family under the IRC. It is noteworthy in both cases that the terms do not generally include collateral relatives (brothers and sisters, nephews and nieces).
(15) The term “relative” means a spouse, ancestor, lineal descendant, or spouse of a lineal descendant.[4]
IRC §4975(e)(2) provides in pertinent part:
(2) Disqualified person. For purposes of this section, the term "disqualified person" means a person who is --
(A) a fiduciary;
(B) a person providing services to the plan;
(C) an employer any of whose employees are covered by the plan;
(D) an employee organization any of whose members are covered by the plan;
(E) an owner, direct or indirect, of 50 percent or more of --
(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation,
(ii) the capital interest or the profits interest of a partnership, or
(iii) the beneficial interest of a trust or unincorporated enterprise,
which is an employer or an employee organization described in subparagraph (C) or (D);
(F) a member of the family (as defined in paragraph (6)) of any individual described in subparagraph (A), (B), (C), or (E);
(G) a corporation, partnership, or trust or estate of which (or in which) 50 percent or more of --
(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,
(ii) the capital interest or profits interest of such partnership, or
(iii) the beneficial interest of such trust or estate,
is owned directly or indirectly, or held by persons described in subparagraph (A), (B), (C), (D), or (E) [Not (F)!!];
(H) an officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person described in subparagraph (C), (D), (E), or (G); or
(I) a 10 percent or more (in capital or profits) partner or joint venture of a person described in subparagraph (C), (D), (E), or (G).
The Secretary, after consultation and coordination with the Secretary of Labor or his delegate, may by regulation prescribe a percentage lower than 50 percent for subparagraphs (E) and (G) and lower than 10 percent for subparagraphs (H) and (I).[5]
The definition of a member of the family under the IRC is identical to the definition of a relative under ERISA. It is noteworthy in both cases that the terms do not generally include collateral relatives (brothers and sisters, nephews and nieces).
(6) Member of family. For purposes of paragraph (2)(F), the family of any individual shall include his spouse, ancestor, lineal descendant, and any spouse of a lineal descendant.[6]
It is a curious fact that, under both ERISA and the IRC, members of the family are ignored in testing whether or not a corporation, parntnership, etc. is controlled by disqualified persons!
(F) a member of the family (as defined in paragraph (6)) of any individual described in subparagraph (A), (B), (C), or (E);
(G) a corporation, partnership, or trust or estate of which (or in which) 50 percent or more of --
(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,
(ii) the capital interest or profits interest of such partnership, or
(iii) the beneficial interest of such trust or estate,
is owned directly or indirectly, or held by persons described in subparagraph (A), (B), (C), (D), or (E) [Not (F)!!][7]
This exclusion for family members from the definition of
control could be very significant.
IRC §4975 imposes an initial excise tax of 15% (up from 5%) of the “amount involved” with respect to a prohibited transaction. If the prohibited transation “is not corrected” the tax is increased to 100%. These taxes do not apply to IRAs. The death penalty is the only penalty applicable to an IRA that is involved in a prohibited transaction; in other words, the IRA is disqualified, as discussed elsewhere in this Article.
There is hereby imposed a tax on each prohibited transaction. The rate of tax shall be equal to 15 percent of the amount involved with respect to the prohibited transaction for each year (or part thereof) in the taxable period. The tax imposed by this subsection shall be paid by any disqualified person who participates in the prohibited transaction (other than a fiduciary acting only as such).[8]
Reserved.
In any case in which an initial tax is imposed by subsection (a) on a prohibited transaction and the transaction is not corrected within the taxable period, there is hereby imposed a tax equal to 100 percent of the amount involved. The tax imposed by this subsection shall be paid by any disqualified person who participated in the prohibited transaction (other than a fiduciary acting only as such).[9]
How does one go about correcting a prohibited transaction without engaging in yet another prohibited transaction in undoing the original transaction?
Reserved.
The IRC §4975 excise taxes on prohibited transactions do not apply to IRAs. Instead, and what is worse, an IRA that is involved in a prohibited transaction simply ceases to be an IRA, at which point income taxes and perhaps other excise taxes become due, as discussed elsewhere in this Article.
(3) Special rule for individual retirement accounts. An individual for whose benefit an individual retirement account is established and his beneficiaries shall be exempt from the tax imposed by this section with respect to any transaction concerning such account (which would otherwise be taxable under this section) if, with respect to such transaction, the account ceases to be an individual retirement account by reason of the application of section 408(e)(2)(A) or if section 408(e)(4) applies to such account.[10]
An IRA (including a SEP-IRA) is ordinarily outside the purview of ERISA. An IRA is not a qualified plan because it is not described in IRC §401(a). An IRA is generally not subject to Title I because an IRA does not constitute an employee benefit plan.[11] Further, an IRA is specifically exempted from Parts 2 (participation and vesting) and 3 (minimum funding) of ERISA.[12]
However, an individual retirement account (IRA) is a "plan" for purposes of the IRC's[13] prohibited transaction rules.[14] While the definition of "disqualified person" does not by its terms include either the creator or the beneficiary of an IRA,[15] IRC §408(e)(2) disqualifies an IRA where the individual who establishes the IRA,[16] or his beneficiary, engages in a IRC §4975 prohibited transaction with respect to the account. If the IRA is disqualified under §408(e)(2)(A) or §408(e)(4), then §4975(c)(3) exempts the IRA owner from the 15% and 100% excise taxes otherwise applicable under, which was thoughtful of Congress.
If the creator or beneficiary of an IRA engages in a prohibited transaction during the individual's taxable year, the account ceases to be a tax-exempt IRA as of the first day of the taxable year.[17] In that case, a deemed distribution occurs on the first day of the taxable year to the extent of the fair market value of all assets in the account, and the distributee must include the entire amount in gross income under IRC §72.[18] The same disqualification results where the owner of an individual retirement annuity borrows any money under or by use of the contract (see above under the discussion of plan loans), and the owner must include in income the fair market value of the contract on the first day of the taxable year in which the prohibited act occurs.[19] If the creator of an IRA pledges a portion of the account as security for a loan, the individual treats only the pledged portion as a distribution.[20]
Is an IRA owner a “fiduciary” with respect to the IRA? Does it make any difference whether the IRA is a trusteed or custodial IRA? In an unsupported statement found in ERISA Opinion Letter 89-03A, the DOL stated rather perfunctorily:
Mr. and Mrs. Bowns are fiduciaries and, thus, disqualified persons with respect to their IRAs because of their authority under the IRAs to direct investments.[21]
Would the Browns not have been fiduciaries, and hence not have been disqualified persons, had they not had investment authority? I suspect that the Browns would not have been fiduciaries if the IRA was trusteed and the Browns had no investment authority. Nevertheless, if the owner, whether or not a fiduciary, “engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year.”
If, by analogy, an IRA owner is treated both as the an employer and as the employer’s employee, with respect to the IRA, then the IRA owner could be considered a party in interest under §4975(e)(2)(C), “an employer any of whose employees are covered by the plan.” This would seem to be quite a stretch, but the IRS sometimes conflates the owner of an IRA with an employee, and the IRA with the employer.[22]
Taxation of IRAs is governed by IRC §408. §408(e) sets forth the basic scheme:
§408 (e) Tax Treatment of Accounts and Annuities.
(1) Exemption from tax. Any individual retirement account is exempt from taxation under this subtitle unless such account has ceased to be an individual retirement account by reason of paragraph (2) or (3). Notwithstanding the preceding sentence, any such account is subject to the taxes imposed by section 511 (relating to imposition of tax on unrelated business income of charitable, etc. organizations).
(2) Loss
of exemption of account where employee engages in prohibited transaction.
(A) In general. If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year. For purposes of this paragraph -
(i) the individual for whose benefit any account was established is treated as the creator of such account, and
(ii) the separate account for any individual within an individual retirement account maintained by an employer or association of employees is treated as a separate individual retirement account.
(B) Account treated as distributing all its assets. —In any case in which any account ceases to be an individual retirement account by reason of subparagraph (A) as of the first day of any taxable year, paragraph (1) of subsection (d) applies as if there were a distribution on such first day in an amount equal to the fair market value (on such first day) of all assets in the account (on such first day).
(3) Effect of borrowing on annuity contract. If during any taxable year the owner of an individual retirement annuity borrows any money under or by use of such contract, the contract ceases to be an individual retirement annuity as of the first day of such taxable year. Such owner shall include in gross income for such year an amount equal to the fair market value of such contract as of such first day.
(4) Effect of pledging account as security. If, during any taxable year of the individual for whose benefit an individual retirement account is established, that individual uses the account or any portion thereof as security for a loan, the portion so used is treated as distributed to that individual.
(5) Purchase of endowment contract by individual retirement account. If the assets of an individual retirement account or any part of such assets are used to purchase an endowment contract for the benefit of the individual for whose benefit the account is established -
(A) to the extent that the amount of the assets involved in the purchase are not attributable to the purchase of life insurance, the purchase is treated as a rollover contribution described in subsection (d) (3), and
(B) to the extent that the amount of the assets involved in the purchase are attributable to the purchase of life, health, accident, or other insurance, such amounts are treated as distributed to that individual (but the provisions of subsection (f) do not apply).
(6) Commingling individual retirement account amounts in certain common trust funds and common investment funds. Any common trust fund or common investment fund of individual retirement account assets which is exempt from taxation under this subtitle does not cease to be exempt on account of the participation or inclusion of assets of a trust exempt from taxation under section 501(a) which is described in section 401(a).[23]
As set forth in the statute just quoted, if the application of IRC §408(e)(2)(A) or (e)(4) results in treatment of an individual retirement account as a deemed distribution, the 15% and 100% excise taxes of IRC §4975 do not apply to the individual who establishes the IRA.[24] However, if a person other than the creator (e.g., a bank trustee) engages in an IRC §4975 prohibited transaction with respect to the account, the other person is subject to the 15% and 100% excise taxes.[25] Further, the premature distribution tax of IRC §72(t) (e.g. certain distributions prior to age 59&1/2), will apply, notwithstanding the IRA’s disqualification.
Even though an IRA is not subject to ERISA, and thus is generally exempt from regulation by the Department of Labor (the DOL), the DOL has the specific authority to issue exemtions from the application of the prohibited transaction rules.[26] Enforcement of the IRA prohibited transaction rules are, however, exclusively within the jurisdiction of the Treasury.[27] Pursuant to Presidential Reorganization Plan No. 4 of 1978:
[T]he authority of the Secretary of the Treasury to issue interpretations regarding section 4975 of the Code, subject to certain exceptions . . . has been transferred to the Secretary of Labor and the Secretary of the Treasury is bound by such interpretations.[28]
If the owner of an IRA pledges or borrows against the IRA or engages in a prohibited transaction with it, the account ceases to be an IRA.[29] Ordinarily an assignment or alienation could be construed as a prohibited transaction, though the law not exactly explicit on this point.[30] However, if a division of an IRA or qualified plan takes place during lifetime, for example by transferring to the nonparticipant the nonparticipant’s community one-half interest, the interest assigned will be presumably be immediately taxable under the normal assignment of income rules, unless the assignment is pursuant to a QDRO[31] in the case of a qualified plan, or pursuant to IRC §408(d)(6) in the case of an IRA,[32] as discussed immediately above.
Contributions of property other than cash to an IRA are generally prohibited:
Except in the case of a rollover contribution described in subsection (d)(3) in section 402(a)(5), 402(a)(7), 403(a)(4), or 403(b)(8), no contribution will be accepted unless it is in cash . . .[33] [Emphasis added.]
Any property distributed by a qualified plan (or its proceeds), which are acceptable to the IRA sponsor, may be rolled over, with a few important exceptions. An IRA cannot invest in insurance contracts, for example.
Because there are many investments that the IRA custodian may not be in a position to accept, it is permissible to sell property received in a distribution and reinvest and rollover the proceeds.[34] If this is done, no gain or loss on the sale will be recognized; the sales proceeds are treated as part of the distribution.[35]
Although an individual may sell property distributed from a qualified plan and rollover the proceeds, one may not keep the property and rollover equivalent value.[36] Nor may one receive cash, invest in stock, and rollover the stock.[37]
A contribution of property to a qualifed plan may or may not be a prohibited transaction. This may still be an evolving area.
Section 4975(c) of the Internal Revenue Code prohibits the sale or exchange or leasing of any property between a plan and a disqualified person. An employer or plan sponsor is a disqualified person with respect to the plan.
Section 4975(f)(3) of the IRC provides that a transfer of encumbered real or personal property by a disqualified person to a plan is treated as a sale or exchange if the plan assumes or takes subject to the encumbrance and the disqualified person placed the encumbrance on the property within the 10-year period ending on the date of the transfer. Therefore, one might assume, by clear implication, that a transfer of unencumbered real or personal property by a disqualified person to a plan would not be treated as a sale or exchange and would not be considered a prohibited transaction. However, this is not necessarily the case.
In Advisory Opinion 81-69A, the Department of Labor stated that any contribution in kind to a pension plan is a prohibited sale between the plan and the employer because the employer satisfies its fixed obligation to contribute to the pension plan with its contribution of property. The DOL takes a different position regarding a profit sharing plan. The Department of Labor has advised the Chief Council of the Internal Revenue Service that the Department would not find a contribution in kind to a profit sharing plan to be a prohibited transaction if the contribution was “purely voluntary.” The DOL determines on a case by case basis whether a particular contribution in kind is purely voluntary or is a prohibited exchange of property between the plan and the employer.[38]
To sum up: the transfer of encumbered real property to any plan is a per se violation of Code §4975(f)(3) whether the contribution is “purely voluntary” or not. In all other cases, it the DOL's position that the the transfer will be prohibited unless “purely voluntary.” The DOL believes that transfers to pension plans are never purely voluntary, and are, therefore, prohibited per se under the general prohibition against the “sale, exchange or leasing” of property between a plan and a disqualified person. In view of the specific prohibition with respect to encumbered real property, described in Code §4975(f)(3), the DOL might be wrong in this opinion.
Although contributions of property are generally prohibited, distribtutions of property are not. This is because IRC §4975(d)(9) specifically exempts from the definition of a prohibited transaction the
(9) receipt by a disqualified person of any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries. . .[39]
Similarly, ERISA §408(c)(1) provides that
Nothing in section 406 [29 USCS 1106] shall be construed to prohibit any fiduciary from —
(1) receiving any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiarie.[40]
The regulations governing such distributions are replete with examples of situations involving in-kind distributions. For example, if a plan allows for distributions of property, this option is an “optional form of benefit” governed by §411(d)(6).
(1) In general. An 'optional form of benefit' is a distribution form with respect to an employee's benefit (described in paragraph (a)(1) and/or (a)(2) of this Q&A-1) that is available under the plan and is identical with respect to all features relating to the distribution form, including the payment schedule, timing, commencement, medium of distribution (e.g., in cash or in-kind) . . .[41]
* * * *
(iii) In-kind distributions after plan termination--(A) In general. If a plan includes an optional form of benefit under which benefits are distributed in specified property (other than cash), such optional form of benefit may be modified for distributions after plan termination by substituting cash for the specified property to the extent that, on plan termination, an employee has the opportunity to receive the optional form of benefit in the specified property. This exception is not available, however, if the employer that maintains the terminating plan also maintains another plan that provides an optional form of benefit in the specified property.[42]
Treasury Regulations are explicit regarding how such distributions are to be valued for income tax purposes, viz., at fair market value on date of distribution.[43]
Finally, we know that qualified plans can make distributions of property because the rules regarding the rollover of such property or its cash proceeds are detailed and comprehensive.[44] (See above).
Although it may appear that the definitions of what constitutes a prohibited transaction and who is a party in interest or disqualified person are very specific, there are two or three catch all provisions that might be applicable even though all of the other hurdles can be technically negotiated and even if a specific exception appears to apply. First of all, a fiduciary must at all times act solely in the interest of the plan participants and their beneficiaries[45] and for their exclusive benefit.[46]
This means that the fiduciary is to have no other motive for acting. Further, ERISA §406(b) has the following proscription:
(b) A fiduciary with respect to a plan shall not-
(1) deal with the assets of the plan in his own interest or for his own account,
(2) in his individual or in any other capacity act in any transaction involving the plan on behalf of a party (or represent a party) whose interests are adverse to the interests of the plan or the interests of its participants or beneficiaries, or
(3) receive any consideration for his own personal account from any party dealing with such plan in connection with a transaction involving the assets of the plan.
Similarly IRC §4975(c)(1)(E) and (F) prohibit a fiduciary from dealing “with the income or assets of a plan in his own interest or for his own account; or . . . [receiving] any consideration for his own personal account . . . in connection with a transaction involving the income or assets of the plan.” In an IRA, neither ERISA §404 nor ERISA §406(b) will (ordinarily) apply, but §4975(c)(1)(E) and (F) would, if the IRA owner is a fiduciary.
For now, the discussion is Reserved. But here is the relevant statute:
(d) Exemptions.—The prohibitions provided in subsection (c) shall
not apply to—
* * * *
(2) any contract, or reasonable arrangement, made with a disqualified person for office space, or legal, accounting, or other services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefor;
(3) any loan to a leveraged employee stock ownership plan (as defined in subsection (e)(7)), if --
(A) such loan is primarily for the benefit of participants and beneficiaries of the plan, and
(B) such loan is at a reasonable rate of interest, and any collateral which is given to a disqualified person by the plan consists only of qualifying employer securities (as defined in subsection (e)(8));
(4) the investment of all or part of a plan's assets in deposits which bear a reasonable interest rate in a bank or similar financial institution supervised by the United States or a State, if such bank or other institution is a fiduciary of such plan and if --
(A) the plan covers only employees of such bank or other institution and employees of affiliates of such bank or other institution, or
(B) such investment is expressly authorized by a provision of the plan or by a fiduciary (other than such bank or institution or affiliates thereof) who is expressly empowered by the plan to so instruct the trustee with respect to such investment;
(5) any contract for life insurance, health insurance, or annuities with one or more insurers which are qualified to do business in a State if the plan pays no more than adequate consideration, and if each such insurer or insurers is --
(A) the employer maintaining the plan, or
(B) a disqualified person which is wholly owned (directly or indirectly) by the employer establishing the plan, or by any person which is a disqualified person with respect to the plan, but only if the total premiums and annuity considerations written by such insurers for life insurance, health insurance, or annuities for all plans (and their employers) with respect to which such insurers are disqualified persons (not including premiums or annuity considerations written by the employer maintaining the plan) do not exceed 5 percent of the total premiums and annuity considerations written for all lines of insurance in that year by such insurers (not including premiums or annuity considerations written by the employer maintaining the plan);
(6) the provision of any ancillary service by a bank or similar financial institution supervised by the United States or a State, if such service is provided at not more than reasonable compensation, if such bank or other institution is a fiduciary of such plan, and if --
(A) such bank or similar financial institution has adopted adequate internal safeguards which assure that the provision of such ancillary service is consistent with sound banking and financial practice, as determined by Federal or State supervisory authority, and
(B) the extent to which such ancillary service is provided is subject to specific guidelines issued by such bank or similar financial institution (as determined by the Secretary after consultation with Federal and State supervisory authority), and under such guidelines the bank or similar financial institution does not provide such ancillary service --
(i) in an excessive or unreasonable manner, and
(ii) in a manner that would be inconsistent with the best interests of participants and beneficiaries of employee benefit plans;
(7) the exercise of a privilege to convert securities, to the extent provided in regulations of the Secretary, but only if the plan receives no less than adequate consideration pursuant to such conversion;
(8) any transaction between a plan and a common or collective trust fund or pooled investment fund maintained by a disqualified person which is a bank or trust company supervised by a State or Federal agency or between a plan and a pooled investment fund of an insurance company qualified to do business in a State if --
(A) the transaction is a sale or purchase of an interest in the fund,
(B) the bank, trust company, or insurance company receives not more than reasonable compensation, and
(C) such transaction is expressly permitted by the instrument under which the plan is maintained, or by a fiduciary (other than the bank, trust company, or insurance company, or an affiliate thereof) who has authority to manage and control the assets of the plan;
(9) receipt by a disqualified person of any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries;
(10) receipt by a disqualified person of any reasonable compensation for services rendered, or for the reimbursement of expenses properly and actually incurred, in the performance of his duties with the plan, but no person so serving who already receives full-time pay from an employer or an association of employers, whose employees are participants in the plan or from an employee organization whose members are participants in such plan shall receive compensation from such fund, except for reimbursement of expenses properly and actually incurred;
(11) service by a disqualified person as a fiduciary in addition to being an officer, employee, agent, or other representative of a disqualified person;
(12) the making by a fiduciary of a distribution of the assets of the trust in accordance with the terms of the plan if such assets are distributed in the same manner as provided under section 4044 of title IV of the Employee Retirement Income Security Act of 1974 (relating to allocation of assets);
(13) any transaction which is exempt from section 406 of such Act by reason of section 408(e) of such Act (or which would be so exempt if such section 406 applied to such transaction);
(14) any transaction required or permitted under part 1 of subtitle E of title IV or section 4223 of the Employee Retirement Income Security Act of 1974, but this paragraph shall not apply with respect to the application of subsection (c)(1)(E) or (F); or
(15) a merger of multiemployer plans, or the transfer of assets or liabilities between multiemployer plans, determined by the Pension Benefit Guaranty Corporation to meet the requirements of section 4231 of such Act, but this paragraph shall not apply with respect to the application of subsection (c)(1)(E) or (F).
The exemptions provided by this subsection (other than paragraphs (9) and (12) shall not apply to any transaction with respect to a trust described in section 401(a) which is part of a plan providing contributions or benefits for employees some or all of whom are owner-employees (as defined in section 401(c)(3)) in which a plan directly or indirectly lends any part of the corpus or income of the plan to, pays any compensation for personal services rendered to the plan to, or acquires for the plan any property from or sells any property to, any such owner-employee, a member of the family (as defined in section 267(c)(4)) of any such owner-employee, or a corporation controlled by any such owner-employee through the ownership, directly or indirectly, of 50 percent or more of the total combined voting power of all classes of stock entitled to vote or 50 percent or more of the total value of shares of all classes of stock of the corpration. For purposes of the preceding sentence, a shareholder-employee (as defined in section 1379, as in effect on the day before the date of the enactment of the Subchapter S Revision Act of 1982), a participant or beneficiary of an individual retirement account, or an individual retirement annuity (as defined in section 408), and an employer or association of employees which establishes such an account or annuity under section 408(c) shall be deemed to be an owner-employee.[47]
On its face, a loan of plan assets to a plan participant or other disqualified person is a prohibited transaction, and the fact that plan loans are allowed is a result of an exception to the prohibited transaction rules. In this regard it is worth noting at the onset that the various prohibited transaction exemptions (including the loan exemption) do not apply to plans covering owner-employees,[48] nor do they apply to IRAs.[49]
If an IRA owner either borrows from the IRA or pledges it, the IRA ceases to be an IRA, and the IRA owner is immediately taxed as if a complete distribution of the IRA had taken place.[50] In fact, if any prohibited transaction occurs between an IRA and a disqualified person (including the IRA owner[51]), the IRA ceases to be an IRA and the IRA owner is immediately taxed as if a complete distribution of the IRA had taken place.[52]
However, under limited circumstances, loans can be made to certain participants under a qualified plan who are not owner-employees or shareholder-employees of an S-Corporation. There are a number of obstacles that must be overcome before a loan can be made. This is, in large measure, a result of the fact that a loan to an employee participant would otherwise be a prohibited transaction.
Absent special rules, the loan of plan assets to an employee would be a prohibited transaction. Loans between a plan and a party in interest are expressly prohibited by ERISA,[53] and loans between a plan and a disqualified person are expressly prohibited by the IRC.[54] An employee is a party in interest per se under ERISA,[55] though not always a disqualified person under the IRC.[56]
Despite the general prohibition against loans, both the IRC and ERISA contain an exception to the rule against loaning money to participants and others.
ERISA 408(b) provides:
Act Sec. 408. (b) The prohibitions provided in section 406 shall not apply to any of the following transactions:
(1) Any loans made by the plan to parties in interest who are participants or beneficiaries of the plan if such loans (A) are available to all such participants and beneficiaries on a reasonably equivalent basis, (B) are not made available to highly compensated employees (within the meaning of section 414(q) of the Internal Revenue Code of 1986) in an amount greater than the amount made available to other employees, (C) are made in accordance with specific provisions regarding such loans set forth in the plan, (D) bear a reasonable rate of interest, and (E) are adequately secured.[57]
IRC §4975 has a similar provision:
(d) Exemptions.—The prohibitions provided in subsection (c) shall not apply to—
(1) any loan made by the plan to a disqualified person who is a participant or beneficiary of the plan if such loan—
(A) is available to all such participants or beneficiaries on a reasonably equivalent basis,
(B) is not made available to highly compensated employees (within the meaning of section 414(q)) in an amount greater than the amount made available to other employees,
(C) is made in accordance with specific provisions regarding such loans set forth in the plan,
(D) bears a reasonable rate of interest, and
(E) is adequately secured.[58]
This is an area where the IRS and the DOL obviously have overlapping jurisdiction. Pursuant to a 1974 reorganization plan, the Treasury transferred its authority to the DOL.[59]
The DOL has exercised this authority in 1989 by promulgating DOL Reg. §2550-408b-1, which addresses both ERISA 408(b)(1) and IRC §4975(d)(1).
One of the requirements for an exempt loan is that loans by a plan to parties in interest who are participants or beneficiaries be made available “to all such participants or beneficiaries” on a reasonably equivalent basis.[60] Loans may be restricted to parties in interest with violating the reasonably equivalent basis rule.[61]
May loans be made available to only some parties in interest without violating the reasonably equivalent rule? Although an employee is a party in interest, not all parties in interest are employees. It might, therefore, be technically outside the scope of the safe harbor to deny loans to participants who are not employed, but it would apparently be permissible to exclude nonemployee participants who are not parties in interest (which may strike one as somewhat bizarre).
The rule that loans must not be made available to highly compensated employees in an amount greater than the amount made available to other employees will not be violated if under the facts and circumstances the loan program does not operate to exclude large numbers of plan participants from receiving loans.[62]
The DOL regulations have a number of helpful interpretations of this rule.
A $1000 minimum on loan amount is permissible.[63]
Loans may be limited to a set percentage of a participant’s vested accrued benefit.[64]
It appears that Loans may be limited to amounts described in IRC §72(p), above which income taxation would result.[65]
If the Plan allows the adoption of a loan policy, and such a policy is adopted, this will satisfy the requirement that loans must be made in accordance with specific provisions in the plan.[66]
This written program must include—
(i) the identity of the person or positions authorized to administer the participant loan program;
(ii) a procedure for applying for loans;
(iii) the basis on which loans will be approved or denied;
(iv) limitations (if any) on the types and amount of loans offered;
(v) the procedure under the program for determining a reasonable rate of interest;
(vi) the types of collateral which may secure a participant loan; and
(vii) the events constituting default and the steps that will be taken to preserve plan assets in the event of such default.[67]
The requirement that loans must bear a reasonable rate of interest is one of the more difficult requirements, because it is so subjective.
“A loan will be considered to bear a reasonable rate of interest if such loan provides the plan with a return commensurate with the interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances.”[68]
The regulations give three examples.[69] In example one, “the trustees, prior to making the loan contacted two local banks to determine under what terms the banks would make a similar loan taking into account A’s creditworthiness and the collateral offered.”[70]
In example three, the loan did not qualify because the state usury law prohibited charging the amount which, under the circumstances, would otherwise have been “commensurate with the interest rates charged by persons in the business of lending money under similar circumstances.”[71] It is possible that state usury laws would be preempted by ERISA in the case of a loan from a qualified plan.
The Service has indicated that charging an unreasonably low interest rate violates the anti-alienation rule,[72] but whether this also results in a distribution treatment under §72(p) is not clear.
The loan must be adequately secured.
A participant’s vested accrued benefit under the plan may be used as security[73]; however, no more than 50% of the present value of the vested benefit may be used for this purpose.[74]
No matter what the security, it should be sufficient to protect the plan against loss if the loan is not paid.[75] This requirement is more likely to be met (in the case of an individual account plan) if the plan treats a participant loan as a directed investment, earmarked for the participant’s account.
The Texas Pay Day Law makes it illegal for an employer to reduce an employee’s pay (absent a court order) without the employee’s written authorization.[76] Therefore, if loan payments are going to be made through payroll deduction, the participant’s written consent should be obtained first. Whether or not the Texas Pay Day law is preempted is uncertain.
The examples in DOL Reg. §2550-408b-1(a) make it clear that intent and real motive is important. For example, the reloaning of money to the employer or other party in interest under a prearranged plan is not an exempt loan.[77] If the participant never intends to repay the loan, the loan is not an exempt loan, no matter how structured.[78]
*****g. The Exemptions From the Prohibited Transaction Rules Do Not Apply to Loans to Owner-Employees or Shareholder Employees of S-Corporations.
It is extremely important to note that the exemptions from the prohibited transaction rules do not apply to loans to owner-employees or shareholder employees of S-corporations.[79]
This rule is frequently violated when the form of the business is changed without consulting ERISA counsel.
As if complying with the prohibited transaction rules of both ERISA and the IRC were not enough, we also must contend with the special income tax rules that were enacted as a part of TEFRA[80] in the form of IRC §72(p). (Note that loans are not permitted from an IRA to an IRA owner at all, and so the 72(p) rules are applicable only to qualified plans.)
IRC §72(p) is representative of the terse and pithy prose style of the pension laws, where the rules are set forth in a succinct manner that is easy to grasp on a first reading:
Sec. 72(p) Annuities; certain proceeds of endowment and life insurance contracts.
(1) Treatment as
distributions.
(A) Loans. If during any taxable year a participant or beneficiary receives (directly or indirectly) any amount as a loan from a qualified employer plan, such amount shall be treated as having been received by such individual as a distribution under such plan.
(B) Assignments or pledges. If during any taxable year a participant or beneficiary assigns (or agrees to assign) or pledges (or agrees to pledge) any portion of his interest in a qualified employer plan, such portion shall be treated as having been received by such individual as a loan from such plan.
(2) Exception for
certain loans.
(A) General rule. Paragraph (1) shall not apply to any loan to the extent that such loan (when added to the outstanding balance of all other loans from such plan whether made on, before, or after August 13, 1982), does not exceed the lesser of --
(i) $50,000, reduced by the excess (if any) of --
(I) the highest outstanding balance of loans from the plan during the 1-year period ending on the day before the date on which such loan was made, over
(II) the outstanding balance of loans from the plan on the date on which such loan was made, or
(ii) the greater of (I) one-half of the present value of the nonforfeitable accrued benefit of the employee under the plan, or (II) $10,000.
For purposes of clause (ii), the present value of the nonforfeitable accrued benefit shall be determined without regard to any accumulated deductible employee contributions (as defined in subsection (o)(5)(B)).
(B) Requirement that
loan be repayable within 5 years.
(i) In general. Subparagraph (A) shall not apply to any loan unless such loan, by its terms, is required to be repaid within 5 years.
(ii) Exception for home loans. Clause (i) shall not apply to any loan used to acquire any dwelling unit which within a reasonable time is to be used (determined at the time the loan is made) as the principal residence of the participant.
(C) Requirement of level amortization. Except as provided in regulations, this paragraph shall not apply to any loan unless substantially level amortization of such loan (with payments not less frequently than quarterly) is required over the term of the loan.
(D) Related employers and related plans. For purposes of this paragraph --
(i) the rules of subsections (b), (c), and (m) of section 414 shall apply, and
(ii) all plans of an employer (determined after the application of such subsections) shall be treated as 1 plan.
(3) Denial of
interest deductions in certain cases.
(A) In general. No deduction otherwise allowable under this chapter shall be allowed under this chapter for any interest paid or accrued on any loan to which paragraph (1) does not apply by reason of paragraph (2) during the period described in subparagraph (B).
(B) Period to which subparagraph (A) applies. For purposes of subparagraph (A), the period described in this subparagraph is the period --
(i) on or after the 1st day on which the individual to whom the loan is made is a key employee (as defined in section 416(i)), or
(ii) such loan is secured by amounts attributable to elective deferrals described in subparagraph (A) or (C) of section 402(g)(3).
(4) Qualified
employer plan, etc.
For purposes of this subsection --
(A) Qualified
employer plan. --
(i) In general. The term "qualified employer plan" means --
(I) a plan described in section 401(a) which includes a trust exempt from tax under section 501(a),
(II) an annuity plan described in section 403(a), and
(III) a plan under which amounts are contributed by an individual's employer for an annuity contract described in section 403(b).
(ii) Special rules. The term "qualified employer plan" --
(I) shall include any plan which was (or was determined to be) a qualified employer plan or a government plan, but
(II) shall not include a plan described in subsection (e)(7).
(B) Government plan. The term "government plan" means any plan, whether or not qualified, established and maintained for its employees by the United States, by a State or political subdivision thereof, or by an agency or instrumentality of any of the foregoing.
(5) Special rules
for loans, etc., from certain contracts.
For purposes of this subsection, any amount received as a loan under a contract purchased under a qualified employer plan (and any assignment or pledge with respect to such a contract) shall be treated as a loan under such employer plan.[81]
Prior to December of 1995, the only IRS guidance we had on the interpretation of §72(p) was found in the statute itself, Notice 82-22,[82] and the Blue Book.[83]
On 12/21/95, the IRS published Prop. Treas. Reg. 1.72(p)-1 in question and answer form, consisting of 19 numbered questions. On 12/21/97 amendments to the proposed regulations were published in the Federal Register: Q&A 19 was replaced and Q&A 20-21 were added. I have not had the time to analyze these regulations for purposes of updating this section of the outline(!) so I am simply, for now, going to reproduce the regulations in full below, as updated through 1/2/98.
Q- 1. In general, what
does section 72(p) provide with respect to loans from a qualified employer
plan?
A- 1 .(a) Loans. Under section 72(p), an amount received by a participant or beneficiary as a loan from a qualified employer plan is treated as having been received as a distribution from the plan (a deemed distribution), unless the loan satisfies the requirements of Q&A-3 of this section. For purposes of section 72(p), a loan made from a contract that has been purchased under a qualified employer plan (including a contract that has been distributed to the participant or beneficiary) shall be considered a loan made under a qualified employer plan.
(b) Pledges and assignments. Under section 72(p), if a participant or beneficiary assigns or pledges (or agrees to assign or pledge) any portion of his or her interest in a qualified employer plan as security for a loan, the portion of the individual's interest assigned or pledged (or subject to an agreement to assign or pledge) is treated as a loan from the plan to the individual, with the result that such portion is subject to the deemed distribution rule described in paragraph (a) of this Q&A-1. For purposes of section 72(p), any assignment or pledge of (or agreement to assign or to pledge) by a participant or beneficiary of any portion of his or her interest in a contract that has been purchased under a qualified employer plan (including a contract that has been distributed) shall be considered an assignment or pledge of (or agreement to assign or pledge) an interest in a qualified employer plan. However, if all or a portion of a participant's or beneficiary's interest in a qualified employer plan is pledged or assigned as security for a loan from the plan to the participant or the beneficiary, only the amount of the loan received by the participant or the beneficiary, not the amount pledged or assigned, is treated as a loan.
Q- 2. What is a
qualified employer plan for purposes of section 72(p)?
A- 2 .For purposes of section 72(p), a qualified employer plan means —
(a) A plan described in section 401(a) which includes a trust exempt from tax under section 501(a);
(b) An annuity plan described in section 403(a);
(c) A plan under which amounts are contributed by an individual's employer for an annuity contract described in section 403(b);
(d) Any plan, whether or not qualified, established and maintained for its employees by the United States, by a State or political subdivision thereof, or by an agency or instrumentality of the United States, a State or a political subdivision of a State; or
(e) Any plan which was (or was determined to be) described in paragraph (a), (b), (c), or (d) of this Q&A-2.
Q- 3. What requirements
must be satisfied in order for a loan to a participant or beneficiary from a
qualified employer plan not to be a deemed distribution?
A- 3 .(a) In general. A loan to a participant or beneficiary from a qualified employer plan will not be a deemed distribution to the participant or beneficiary if the loan satisfies the repayment term requirement of section 72(p)(2)(B), the level amortization requirement of section 72(p)(2)(C), and the enforceable agreement requirement of paragraph (b) of this Q&A-3, but only to the extent the loan satisfies the amount limitations of section 72(p)(2)(A).
(b) Enforceable agreement requirement. A loan does not satisfy the requirements of this paragraph unless the loan is evidenced by a legally enforceable agreement (which may include more than one document) set forth in writing or in such other form as may be approved by the Commissioner, and the terms of the agreement demonstrate compliance with the requirements of section 72(p)(2) and this section. Thus, the agreement must specify the amount of the loan, the term of the loan, and the repayment schedule.
Q- 4. If a loan from a
qualified employer plan to a participant or beneficiary fails to satisfy the
requirements of Q&A-3 of this section, when does a deemed distribution
occur?
A- 4 .(a) Deemed distribution. For purposes of section 72, a deemed distribution occurs at the first time that the requirements of Q&A-3 of this section are not satisfied, in form or in operation, with respect to that amount. This may occur at the time the loan is made or at a later date. If the terms of the loan do not require repayments that satisfy the repayment term requirement of section 72(p)(2)(B) or the level amortization requirement of section 72(p)(2)(c), or the loan is not evidenced by an enforceable agreement satisfying the requirements of Q&A-3(b) of this section, the entire amount of the loan is a deemed distribution under section 72(p) at the time the loan is made. If the loan satisfies the requirements of Q&A-3 of this section except that the amount loaned exceeds the limitations of 72(p)(2)(A), the amount of the loan in excess of the applicable limitation is a deemed distribution under section 72(p) at the time the loan is made. If the loan initially satisfies the requirements of section 72(p)(2)(A), (B) and (C) and the enforceable agreement requirement of Q&A-3(b) of this section, but payments are not made in accordance with the terms applicable to the loan, a deemed distribution occurs as a result of the failure to make such payments. See Q&A-10 of this section regarding when such a deemed distribution occurs and the amount thereof and Q&A-11 of this section regarding the tax treatment of a deemed distribution.
(b) Examples. The following examples illustrate the rules in paragraph (a) of this Q&A-4 and are based upon the assumptions described in ASSUMPTIONS FOR EXAMPLES:
Example (1). (a) A participant has a nonforfeitable account balance of $200,000 and receives $70,000 as a loan repayable in level quarterly installments over five years.
(b) Under section 72(p), the participant has a deemed distribution of $20,000 (the excess of $70,000 over $50,000) at the time of the loan, because the loan exceeds the $50,000 limit in section 72(p)(2)(A)(i). The remaining $50,000 is not a deemed distribution.
Example (2). (a) A participant with a nonforfeitable account balance of $30,000 borrows $20,000 as a loan repayable in level monthly installments over five years.
(b) Because the amount of the loan is $5,000 more than 50% of the participant's nonforfeitable account balance, the participant has a deemed distribution of $5,000 at the time of the loan. The remaining $15,000 is not a deemed distribution. (Note also that, if the loan is secured solely by the participant's account balance, the loan may be a prohibited transaction under section 4975 because the loan may not satisfy 29 CFR §2550.408b-1(f)(2)).
Example (3). (a) The nonforfeitable account balance of a participant is $100,000 and a $50,000 loan is made to the participant repayable in level quarterly installments over seven years. The loan is not eligible for the section 72(p)(2)(B)(ii) exception for loans used to acquire certain dwelling units.
(b) Because the repayment period exceeds the maximum five-year period in section 72(p)(2)(B)(i), the participant has a deemed distribution of $50,000 at the time the loan is made.
Example (4). (a) On August 1, 1998, a participant has a nonforfeitable account balance of $45,000 and borrows $20,000 from a plan to be repaid over five years in level monthly installments due at the end of each month. After making monthly payments through July 1999, the participant fails to make any of the payments due thereafter.
(b) As a result of the failure to satisfy the requirement that the loan be repaid in level monthly installments, the participant has a deemed distribution. See Q&A-10(c) Example of this section regarding when such a deemed distribution occurs and the amount thereof.
Q- 5. What is a
principal residence for purposes of the exception in section 72(p)(2)(B)(ii)
from the requirement that a loan be repaid in five years?
A- 5 .Section 72(p)(2)(B)(ii) provides that the requirement in section 72(p)(2)(B)(i) that a plan loan be repaid within five years does not apply to a loan used to acquire a dwelling unit which will within a reasonable time be used as the principal residence of the participant (a principal residence plan loan). For this purpose, a principal residence has the same meaning as a principal residence under section 1034.
Q- 6. In order to
satisfy the requirements for a principal residence plan loan, is a loan
required to be secured by the dwelling unit that will within a reasonable time
be used as the principal residence of the participant?
A- 6 .A loan is not required to be secured by the dwelling unit that will within a reasonable time be used as the participant's principal residence in order to satisfy the requirements for a principal residence plan loan.
Q- 7. What tracing
rules apply in determining whether a loan qualifies as a principal residence
plan loan?
A- 7 .The tracing rules established under section 163(h)(3)(B) apply in determining whether a loan is treated as for the acquisition of a principal residence in order to qualify as a principal residence plan loan.
Q- 8. Can a refinancing
qualify as a principal residence plan loan?
A- 8 .(a) Refinancings. In general, no. However, a loan from a qualified employer plan used to repay a loan from a third party will qualify as a principal residence plan loan if the plan loan qualifies as a principal residence plan loan without regard to the loan from the third party.
(b) Example. The following example illustrates the rules in paragraph (a) of this Q&A-8 and is based upon the assumptions described in ASSUMPTIONS FOR EXAMPLES:
Example (a) On July 1, 1999, a participant requests a $50,000 plan loan to be repaid in level monthly installments over 15 years. On August 1, 1999, the participant acquires a principal residence and pays a portion of the purchase price with a $50,000 bank loan. On September 1, 1999, the plan loans $50,000 to the participant, which the participant uses to pay the bank loan.
(b) Because the plan loan satisfies the requirements to qualify as a principal residence plan loan (taking into account the tracing rules of section 163(h)(3)(B)), such plan loan qualifies for the exception in section 72(p)(2)(B)(ii).
Q- 9. Does the level
amortization requirement of section 72(p)(2)(C) apply when a participant is on
a leave of absence without pay?
A- 9 .(a) Leave of absence. The level amortization requirement of section 72(p)(2)(C) does not apply for a period, not longer than one year, that a participant is on a leave of absence, either without pay from the employer or at a rate of pay (after income and employment tax withholding) that is less than the amount of the installment payments required under the terms of the loan. However, the loan must be repaid by the latest date permitted under section 72(p)(2)(B) and the installments due after the leave ends (or, if earlier, after the first year of the leave) must not be less than those required under the terms of the original loan.
(b) Example. The following example illustrates the rules of paragraph (a) of this Q&A-9 and is based upon the assumptions described in ASSUMPTIONS FOR EXAMPLES:
Example (a) On July 1, 1997, a participant with a nonforfeitable account balance of $80,000, borrows $40,000 to be repaid in level monthly installments of $825 each over five years. The loan is not a principal residence plan loan. The participant makes nine monthly payments and commences an unpaid leave of absence that lasts for 12 months. Thereafter, the participant resumes active employment and resumes making repayments on the loan until the loan is repaid. The amount of each monthly installment is increased to $1,130 in order to repay the loan by June 30, 2002.
(b) Because the loan satisfies the requirements of section 72(p)(2), the participant does not have a deemed distribution. Alternatively, section 72(p)(2) would be satisfied if the participant continued the monthly installments of $825 after resuming active employment and on June 30, 2002 repaid the full balance remaining due.
Q- 10. If a participant
fails to make the installment payments required under the terms of a loan that
satisfied the requirements of Q&A-3 of this section when made, when does a
deemed distribution occur and what is the amount of the deemed distribution?
A- 10 .(a) Timing of deemed distribution. Failure to make any installment payment when due in accordance with the terms of the loan violates section 72(p)(2)(C) and, accordingly, results in a deemed distribution at the time of such failure. However, the plan administrator may allow a grace period, and section 72(p)(2)(C) will not be considered to have been violated until the last day of the grace period. Any such grace period shall be given effect for purposes of section 72(p)(2)(C) only to the extent it does not continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.
(b) Amount of deemed distribution. If a loan satisfies Q&A-3 of this section when made, but there is a failure to pay the installment payments required under the terms of the loan (taking into account any grace period allowed under the preceding paragraph (a) of this Q&A-10), then the amount of the deemed distribution equals the entire outstanding balance of the loan at the time of such failure.
(c) Example. The following example illustrates the rules in Q&A-10(a) and (b) of this section and is based upon the assumptions described in ASSUMPTIONS FOR EXAMPLES:
Example (1) On August 1, 1998, a participant has a nonforfeitable account balance of $45,000 and borrows $20,000 from a plan to be repaid over five years in level monthly installments due at the end of each month. After making all monthly payments due through July 31, 1999, the participant fails to make the payment due on August 31, 1999 or any other monthly payments due thereafter. The plan administrator allows a three-month grace period.
(2) As a result of the failure to satisfy the requirement that the loan be repaid in level installments pursuant to section 72(p)(2)(C), the participant has a deemed distribution on November 30, 1999, which is the last day of the three-month grace period for the August 31, 1999 installment. The amount of the deemed distribution is $17,157, which is the outstanding balance on the loan at November 30, 1999. Alternatively, if the plan administrator had allowed a grace period through the end of the next calendar quarter, there would be a deemed distribution on December 31, 1999 equal to $17,282, which is the outstanding balance of the loan at December 31, 1999.
Q- 11. Do sections 72
and 4980A apply to a deemed distribution as if it were an actual distribution?
A- 11 .(a) Tax basis. If the employee's account includes after- tax contributions or other investment in the contract under section 72(e), section 72 applies to a deemed distribution as if it were an actual distribution, with the result that all or a portion of the deemed distribution may not be taxable.
(b) Sections 72(t) and (m). Section 72(t) (which imposes a 10 percent tax on certain early distributions) and section 72(m)(5) (which imposes a separate l0 percent tax on certain amounts received by a 5-percent owner) apply to a deemed distribution under section 72(p) in the same manner as if the deemed distribution were an actual distribution.
(c) Section 4980A. For purposes of section 4980A, a deemed distribution under section 72(p) is taken into account in determining an individual's excess distributions, as provided in §54.4981A-1T, Q&A a-8.
Q- 12. Is a deemed
distribution under section 72(p) treated as an actual distribution for purposes
of the qualification requirements of section 401, the distribution provisions
of section 402, or the distribution restrictions of section 401(k)(2)(B) or
403(b)(11)?
A- 12 .No. Thus, for example, if a participant in a money purchase plan who is an active employee has a deemed distribution under section 72(p), the plan will not be considered to have made an in-service distribution to the participant in violation of the qualification requirements applicable to money purchase plans. Similarly, the deemed distribution is not eligible to be rolled over to an eligible retirement plan and the participant is not eligible to elect income averaging with respect to the deemed distribution. See also §§1.402(c)-2, Q&A-4(d) and §1.401(k)-1(d)(6)(ii).
Q- 13. How does a
reduction (offset) of an account balance in order to repay a plan loan differ
from a deemed distribution?
A- 13 .(a) Difference between deemed distribution and plan loan offset amount. (1) Loans to a participant from a qualified employer plan can give rise to two types of taxable distributions —
(i) A deemed distribution pursuant to section 72(p); and
(ii) A distribution of an offset amount.
(2) As described in Q&A-4 of this section, a deemed distribution occurs when the requirements of Q&A-3 of this section are not satisfied, either when the loan is made or at a later time. A deemed distribution is treated as a distribution to the participant or beneficiary only for certain tax purposes and is not a distribution of the accrued benefit. A distribution of a plan loan offset amount (as defined in §1.402(c)-2, Q&A-9(b)) occurs when, under the terms governing a plan loan, the accrued benefit of the participant or beneficiary is reduced (offset) in order to repay the loan (including the enforcement of the plan's security interest in the accrued benefit). A distribution of a plan loan offset amount could occur in a variety of circumstances, such as where the terms governing the plan loan require that, in the event of the participant's request for a distribution, a loan be repaid immediately or treated as in default.
(b) Plan loan offset. In the event of a plan loan offset, the amount of the account balance that is offset against the loan is an actual distribution for purposes of the Internal Revenue Code, not a deemed distribution under section 72(p). Accordingly, a plan may be prohibited from making such an offset under the provisions of section 401(a), 401(k)(2)(B) or 403(b)(11) prohibiting or limiting distributions to an active employee. See §1.402(c)-2, Q&A-9(c) Example 6.
Q- 14. How is the
amount includible in income as a result of a deemed distribution under section
72(p) required to be reported?
A- 14 .The amount includible in income as a result of a deemed distribution under section 72(p) is required to be reported on Form 1099-R (or any other form prescribed by the Commissioner).
Q- 15. What withholding
rules apply to plan loans?
A- 15 .To the extent that a loan, when made, is a deemed distribution or an account balance is reduced (offset) to repay a loan, the amount includible in income is subject to withholding. If a deemed distribution of a loan or a loan repayment by benefit offset results in income at a date after the date the loan is made, withholding is required only if a transfer of cash or property (excluding employer securities) is made to the participant or beneficiary from the plan at the same time. See §§35.3405- 1(f)(4) and 31.3405(c)-1, Q&A-9 and Q&A-11 of this chapter for further guidance on withholding rules.
Q- 16. If a loan fails
to satisfy the requirements of Q&A-3 of this section and is a prohibited
transaction under section 4975, is the deemed distribution of the loan under
section 72(p) a correction of the prohibited transaction?
A- 16 .A deemed distribution is not a correction of a prohibited transaction under section 4975. See §§141.4975-13 and 53.4941(e)-1(c)(1) of this chapter for guidance concerning correction of a prohibited transaction.
Q- 17. What are the income
tax consequences if an amount is transferred from a qualified employer plan to
a participant or beneficiary as a loan, but there is an express or tacit
understanding that the loan will not be repaid?
A- 17 .If there is an express or tacit understanding that the loan will not be repaid, or, for any reason, the transaction does not create a debtor-creditor relationship, then the amount transferred is treated as an actual distribution from the plan for purposes of the Internal Revenue Code, and is not treated as a loan or as a deemed distribution under section 72(p).
Q- 18. If a qualified
employer plan maintains a program to invest in residential mortgages, are loans
made pursuant to the investment program subject to section 72(p)?
A- 18 .Residential mortgage loans made by a plan in the ordinary course of an investment program are not subject to section 72(p) if the property acquired with the loans is the primary security for such loans and the amount loaned does not exceed the fair market value of the property. An investment program exists only if the plan has established, in advance of a specific investment under the program, that a certain percentage or amount of plan assets will be invested in residential mortgages available to persons purchasing the property who satisfy commercially customary financial criteria. Loans will not be considered as made under an investment program if the loans are only made available to, or any loan is earmarked for, any person or persons who are participants or beneficiaries in the plan, or if such loans mature upon a participant's termination from employment. In addition, no loan that benefits an officer, director, or owner of the employer maintaining the plan, or his or her beneficiaries, will be treated as made under an investment program. No inference should be drawn that a transaction under such an investment program is not a prohibited transaction under section 503 or 4975 or is not a violation of the applicable fiduciary standards for an employee benefit plan, so that such a loan could be a prohibited transaction if it does not satisfy the requirements of 29 CFR 2550.408b-1.
Q- 19. When is the
effective date of these regulations?
A- 19 .This section applies to assignments, pledges, and loans made on or after the date that is three months after the date of publication of the final regulations in the Federal Register.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-30874 Filed 12-20-95; 8:45 am][84]
Q- 19. If there is a
deemed distribution under section 72(p), is the interest that accrues
thereafter on the amount of the deemed distribution an indirect loan for income
tax purposes?
A- 19 .(a) General rule. Except as provided in paragraph (b) of this Q&A-19, a deemed distribution of a loan is treated as a distribution for purposes of section 72. Therefore, a loan that is deemed to be distributed under section 72(p) ceases to be an outstanding loan for purposes of section 72, and the interest that accrues thereafter under the plan on the amount deemed distributed is disregarded in applying section 72 to the participant or beneficiary. Even though interest continues to accrue on the outstanding loan (and is taken into account for purposes of determining the tax treatment of any subsequent loan in accordance with paragraph (b) of this Q&A-19), this additional interest is not treated as an additional loan (and, thus, does not result in an additional deemed distribution) for purposes of section 72(p). However, a loan that is deemed distributed under section 72(p) is not considered distributed for all purposes of the Internal Revenue Code. See Q&A-11 through Q&A-16 of this section.
(b) Exception for purposes of applying section 72(p)(2)(A) to a subsequent loan. A loan that is deemed distributed under section 72(p) (including interest accruing thereafter) and that has not been repaid (such as by a plan loan offset) is considered outstanding for purposes of applying section 72(p)(2)(A) to determine the maximum amount of any subsequent loan to the participant or beneficiary.
Q- 20. Is a
participant's tax basis in the plan increased if the participant repays the
loan after a deemed distribution?
A- 20 .(a) Repayments after deemed distribution. Yes, if the participant or beneficiary repays the loan after a deemed distribution of the loan under section 72(p), then, for purposes of section 72(e), the participant's or beneficiary's investment in the contract (tax basis) under the plan increases by the amount of the cash repayments that the participant or beneficiary makes on the loan after the deemed distribution. However, loan repayments are not treated as after-tax contributions for other purposes, including sections 401(m) and 415(c)(2)(B).
(b) Example. The following example illustrates the rules in paragraph (a) of this Q&A-20 and is based on the assumptions described in ASSUMPTIONS FOR EXAMPLES:
Example (a) A participant receives a $20,000 loan on January 1, 1999, to be repaid in 20 quarterly installments of $1,245 each. On December 31, 1999, the outstanding loan balance ($19,179) is deemed distributed as a result of a failure to make quarterly installment payments that were due on September 30, 1999 and December 31, 1999. On June 30, 2000, the participant repays $5,147 (which is the sum of the three installment payments that were due on September 30, 1999, December 31, 1999, and March 31, 2000, with interest thereon to June 30, 2000, plus the installment payment that was due on June 30, 2000). Thereafter, the participant resumes making the installment payments of $1,245 from September 30, 2000 through December 31, 2003. The loan repayments made after December 31, 1999 through December 31, 2003 total $22,577.
(b) Because the participant repaid $22,577 after the deemed distribution that occurred on December 31, 1999, the participant has investment in the contract (tax basis) equal to $22,577 as of December 31, 2003.
Q- 21. When is the
effective date of section 72(p) and these regulations?
A- 21 .(a) Statutory effective date. Section 72(p) generally applies to assignments, pledges, and loans made after August 13, 1982.
(b) Regulatory effective date. This section applies to assignments, pledges, and loans made on or after the first January 1 that is at least 6 months after the date of publication of the final regulations in the Federal Register (the regulatory effective date).
(c) Loans made before the regulatory effective date. (1) General rule. A plan is permitted to apply Q&A-19 and Q&A-20 of this section to a loan made before the regulatory effective date (and after the statutory effective date in paragraph (a) of this Q&A-21) if there has not been any deemed distribution of the loan before the transition date or if the conditions of paragraph (c)(2) of this Q&A-21 are satisfied with respect to the loan.
(2) Consistency transition rule for certain loans deemed distributed before the regulatory effective date. (i) The rules in this paragraph (c)(2) apply to a loan made before the regulatory effective date (and after the statutory effective date in paragraph (a) of this Q&A-21) if there has been any deemed distribution of the loan before the transition date.
(ii) The plan is permitted to apply Q&A-19 and Q&A-20 of this section to the loan beginning on any January 1, but only if the plan reported, in Box 1 of Form 1099-R, for a taxable year no later than the latest taxable year that would be permitted under this section, a gross distribution of an amount at least equal to the initial default amount. For purposes of this section, the initial default amount is the amount that would be reported as a gross distribution under Q&A-4 and Q&A-10 of this section and the transition date is the January 1 on which a plan begins applying Q&A-19 and Q&A-20 of this section to a loan.
(iii) If a plan applies Q&A-19 and Q&A-20 of this section to such a loan, then the plan, in its reporting and withholding on or after the transition date, must not attribute investment in the contract (tax basis) to the participant or beneficiary based upon the initial default amount.
(iv) This paragraph (c)(2)(iv) applies if —
(A) The plan attributed investment in the contract (tax basis) to the participant or beneficiary based on the deemed distribution of the loan;
(B) The plan subsequently made an actual distribution to the participant or beneficiary before the transition date; and
(C) Immediately before the first actual distribution made on or after the transition date, the initial default amount (or, if less, the amount of the investment in the contract so attributed) exceeds the sum of the participant's or beneficiary's investment in the contract (tax basis) immediately before the transition date plus any increase in the participant's or beneficiary's investment in the contract (tax basis) on or after the transition date. If this paragraph (c)(2)(iv) applies, the plan must treat the excess (the loan transition amount) as a loan amount that remains outstanding and must include the excess in the participant's or beneficiary's income at the time of the actual distribution.
(3) Examples. The rules in paragraph (c)(2) of this Q&A-21 are illustrated by the following examples, which are based on the assumptions described in ASSUMPTIONS FOR EXAMPLES (and, except as specifically provided in the examples, also assume that no distributions are made to the participant and that the participant has no investment in the contract with respect to the plan). Example 1, Example 2, and Example 4 illustrate the application of these rules to a plan that, before the transition date, did not treat interest accruing after the initial deemed distribution as resulting in additional deemed distributions under section 72(p). Example 3 illustrates the application of these rules to a plan that, before the transition date, treated interest accruing after the initial deemed distribution as resulting in additional deemed distributions under section 72(p).
Example (1). (a) In 1995, when a participant's account balance under a plan is $50,000, the participant receives a loan from the plan. The participant makes the required repayments until 1996 when there is a deemed distribution of $20,000 as a result of a failure to repay the loan. For 1996, as a result of the deemed distribution, the plan reports, in Box 1 of Form 1099-R, a gross distribution of $20,000 (which is the initial default amount in accordance with paragraph (c)(2)(ii) of Q&A-21 of this section) and, in Box 2 of Form 1099-R, a taxable amount of $20,000. The plan then records an increase in the participant's tax basis for the same amount ($20,000). Thereafter, the plan disregards, for purposes of section 72, the interest that accrues on the loan after the 1996 deemed distribution. Thus, as of December 31, 1998, the total taxable amount reported by the plan as a result of the deemed distribution is $20,000 and the plan's records show that the participant's tax basis is the same amount ($20,000). As of January 1, 1999, the plan decides to apply Q&A-19 of this section to the loan. Accordingly, it reduces the participant's tax basis by the initial default amount of $20,000, so that the participant's remaining tax basis in the plan is zero. Thereafter, the amount of the outstanding loan is not treated as part of the account balance for purposes of section 72. The participant attains age 591/2 in the year 2000 and receives a distribution of the full account balance under the plan consisting of $60,000 in cash and the loan receivable. At that time, the plan's records reflect an offset of the loan amount against the loan receivable in the participant's account and a distribution of $60,000 in cash.
(b) For the year 2000, the plan must report a gross distribution of $60,000 on Box 1 of Form 1099-R and a taxable amount of $60,000 in Box 2 of Form 1099-R.
Example (2). The facts are the same as in Example 1, except that in 1996, immediately prior to the deemed distribution, the participant's account balance under the plan totals $50,000 and the participant's tax basis is $10,000. For 1996, the plan reports, in Box 1 of Form 1099-R, a gross distribution of $20,000 (which is the initial default amount in accordance with paragraph (c)(2)(ii) of Q&A-21 of this section) and reports, in Box 2 of Form 1099-R, a taxable amount of $16,000 (the $20,000 deemed distribution minus $4,000 of tax basis ($10,000 times ($20,000/$50,000)) allocated to the deemed distribution). The plan then records an increase in tax basis equal to the $20,000 deemed distribution, so that the participant's remaining tax basis as of December 31, 1996 totals $26,000 ($10,000 minus $4,000 plus $20,000). Thereafter, the plan disregards, for purposes of section 72, the interest that accrues on the loan after the 1996 deemed distribution. Thus, as of December 31, 1998, the total taxable amount reported by the plan as a result of the deemed distribution is $16,000 and the plan's records show that the participant's tax basis is $26,000. As of January 1, 1999, the plan decides to apply Q&A-19 of this section to the loan. Accordingly, it reduces the participant's tax basis by the initial default amount of $20,000, so that the participant's remaining tax basis in the plan is $6,000. Thereafter, the amount of the outstanding loan is not treated as part of the account balance for purposes of section 72. The participant attains age 591/2 in the year 2000 and receives a distribution of the full account balance under the plan consisting of $60,000 in cash and the loan receivable. At that time, the plan's records reflect an offset of the loan amount against the loan receivable in the participant's account and a distribution of $60,000 in cash.
(b) For the year 2000, the plan must report a gross distribution of $60,000 on Box 1 of Form 1099-R and a taxable amount of $54,000 in Box 2 of Form 1099-R.
Example (3). (a) In 1990, when a participant's account balance in a plan is $100,000, the participant receives a loan of $50,000 from the plan. The participant makes the required loan repayments until 1992 when there is a deemed distribution of $28,919 as a result of a failure to repay the loan. For 1992, as a result of the deemed distribution, the plan reports, in Box 1 of Form 1099-R, a gross distribution of $28,919 (which is the initial default amount in accordance with paragraph (c)(2)(ii) of Q&A-21 of this section) and, in Box 2 of Form 1099-R, a taxable amount of $28,919. For 1992, the plan also records an increase in the participant's tax basis for the same amount ($28,919). Each year thereafter through 1998, the plan reports a gross distribution equal to the interest accruing that year on the loan balance, reports a taxable amount equal to the interest accruing that year on the loan balance reduced by the participant's tax basis allocated to the gross distribution, and records a net increase in the participant's tax basis equal to that taxable amount. As of December 31, 1998, the taxable amount reported by the plan as a result of the loan totals $44,329 and the plan's records for purposes of section 72 show that the participant's tax basis totals the same amount ($44,329). As of January 1, 1999, the plan decides to apply Q&A-19 of this section. Accordingly, it reduces the participant's tax basis by the initial default amount of $28,919, so that the participant's remaining tax basis in the plan is $15,410 ($44,329 minus $28,919) as of December 31, 1999. Thereafter, the amount of the outstanding loan is not treated as part of the account balance for purposes of section 72. The participant attains age 591/2 in the year 2000 and receives a distribution of the full account balance under the plan consisting of $180,000 in cash and the loan receivable equal to the $28,919 outstanding loan amount in 1992 plus interest accrued thereafter to the payment date in 2000. At that time, the plan's records reflect an offset of the loan amount against the loan receivable in the participant's account and a distribution of $180,000 in cash.
(b) For the year 2000, the plan must report a gross distribution of $180,000 in Box 1 of Form 1099-R and a taxable amount of $164,590 in Box 2 of Form 1099-R ($180,000 minus the remaining tax basis of $15,410).
Example (4). (a) The facts are the same as in Example 1, except that in 1997, after the deemed distribution, the participant receives a $10,000 hardship distribution. At the time of the hardship distribution, the participant's account balance under the plan totals $50,000. For 1997, the plan reports, in Box 1 of Form 1099-R, a gross distribution of $10,000 and, in Box 2 of Form 1099- R, a taxable amount of $6,000 (the $10,000 actual distribution minus $4,000 of tax basis ($10,000 times ($20,000/$50,000)) allocated to this actual distribution). The plan then records a decrease in tax basis equal to $4,000, so that the participant's remaining tax basis as of December 31, 1997 totals $16,000 ($20,000 minus $4,000). After 1996, the plan disregards, for purposes of section 72, the interest that accrues on the loan after the 1996 deemed distribution. Thus, as of December 31, 1998, the total taxable amount reported by the plan as a result of the deemed distribution plus the 1997 actual distribution is $26,000 and the plan's records show that the participant's tax basis is $16,000. As of January 1, 1999, the plan decides to apply Q&A-19 of this section to the loan. Accordingly, it reduces the participant's tax basis by the initial default amount of $20,000, so that the participant's remaining tax basis in the plan is reduced from $16,000 to zero. However, because the $20,000 initial default amount exceeds $16,000, the plan records a loan transition amount of $4,000 ($20,000 minus $16,000). Thereafter, the amount of the outstanding loan, other than the $4,000 loan transition amount, is not treated as part of the account balance for purposes of section 72. The participant attains age 591/2 in the year 2000 and receives a distribution of the full account balance under the plan consisting of $60,000 in cash and the loan receivable. At that time, the plan's records reflect an offset of the loan amount against the loan receivable in the participant's account and a distribution of $60,000 in cash.
(b) In accordance with paragraph (c)(2)(iv) of Q&A-21 of this section, the plan must report in Box 1 of Form 1099-R a gross distribution of $64,000 and in Box 2 of Form 1099-R a taxable amount for the participant for the year 2000 equal to $64,000 (the sum of the $60,000 paid in the year 2000 plus $4,000 as the loan transition amount).
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
[FR Doc. 97-33983 Filed 12-31-97; 8:45 am][85]
The basic principal of §72(p)(1) is that all loans, assignments or pledges to a participant or beneficiary from a plan that is or ever was a qualified plan., a government plan or a 403(b) plan, are distributions, and hence, taxable.[86] However, an exception to the 72(p)(1) rule is set forth in §72(p)(2) for certain qualified loans.
This is another of those lesser of the greater of rules. An otherwise qualified loan can always be for $10,000 (if adequate security can be found). A qualified loan can never exceed $50,000. For loans that are greater than $10,000 but not greater than $50,000, the loan, in order to be qualified, must not exceed half the participant’s vested accrued benefit. Further, there is a look-back rule that requires the $50,000 limit to be reduced by the highest outstanding loan balance in the last 12 months.
The $50,000 limit to be reduced by the excess of the highest outstanding loan balance in the last 12 months over the outstanding balance at the time the new loan is to be made.
(A) General rule. Paragraph (1) shall not apply to any loan to the extent that such loan (when added to the outstanding balance of all other loans from such plan whether made on, before, or after August 13, 1982), does not exceed the lesser of --
(i) $50,000, reduced by the excess (if any) of --
(I) the highest outstanding balance of [all] loans from the plan during the 1-year period ending on the day before the date on which such loan was made, over
(II) the outstanding balance of loans from the plan on the date on which such loan was made, or
Example 1. Assume P’s vested account balance has at all relevant times been over $100,000. P originally borrowed $50,000 and has paid it back in part. At the time P asks for an additional loan, his outstanding loan balance is $35,000. But for the look-back rule P could borrow an additional $15,000. However, P’s highest outstanding loan balance during the last year was $42,000.
Step one is to compute the reduced $50,000 limit. Following §72(p)(2)(A)(i), take $50,000 and reduce it by the excess by which the amount listed in §72(p)(2)(A)(i)(I) exceeds that of §72(p)(2)(A)(i)(II).
There was only one loan outstanding during the preceding 12 months. During this period the highest outstanding balance attributable to this single loan was $42,000. (§72(p)(2)(A)(i)(I).)
The outstanding balance of all loans from the plan on the date on which the new loan is to be made is $35,000 (attributable to this one loan). (§72(p)(2)(A)(i)(II).)
The difference between $42,000 and $35,000 is $7,000. Therefore, the $50,000 limit is reduced to $43,000.
This completes step one. Step two is to take the value of the new loan (to be determined) and add it to the outstanding balance of all other loans. The balance on the only loan outstanding is $35,000. $43,000 (the new limit) - $35,000 is $8,000, which is the amount that P can receive as a new loan.
After the new loan, P will owe the plan $43,000, which is equal to the reduced limit.
Why not just take $50,000 and reduce it by the highest outstanding balance during the 12-month period, and just say that this is the additional amount that can be borrowed? Although this seems to work in the example given, it does not properly take into account the effect of multiple loans during the 12 month period.
Example 2. Assume that
after borrowing the additional $8000, P asks, the next day, to borrow some more
money. (His new outstanding balance is $43,000.) If we simply took $50,000 and
reduced it by the highest 12 month balance ($43,000), we would think that P
could borrow another $7000. This would allow P to always maintain a $50,000
outstanding principal loan, that would, in effect, never get repaid. This is
the reason for the complicated methodology employed by the statute.
Step one is to compute the reduced $50,000 limit. Following §72(p)(2)(A)(i), take $50,000 and reduce it by the excess by which the amount listed in §72(p)(2)(A)(i)(I) exceeds that of §72(p)(2)(A)(i)(II).
There were two loans made during the preceding 12 months. During this period, the highest outstanding balance of the first was $42,000. The highest outstanding balance of the second (the loan just made the day before) was $8,000. Together these loans total $50,000. (§72(p)(2)(A)(i)(I).)
The outstanding balance of all loans from the plan on the date on which the new loan is to be made is $43,000 ($35,000 on the original loan and $8000 on the first new loan, just made the day before). (§72(p)(2)(A)(i)(II).)
The difference between $50,000 and $43,000 is $7000 (once again). Therefore, the $50,000 limit is reduced to $43,000.
The completes step one. Step two is to take the value of the new loan (to be determined) and add it to the outstanding balance of all other loans. The combined value cannot exceed the new limit, $43,000. The outstanding other loans are $43,000. $43,000 (the new limit) - $43,000 (the current outstanding balance) is $0, which is the amount that P can receive as a new loan.
As a general rule, the loan, by its terms, must be required to be repaid within 5 years in order to avoid tax.[87] Note that this is not on the 5th anniversary, but “within 5 years.” It is possible to argue that a note made on January 1, 2000, which was due January 1, 2005 (instead of December 31, 1994), is not payable “within” 5 years. However, the Blue Book[88] (a source of helpful insight, if of dubious legal precedent) tells us that the five years is measured from the first loan installment date, if the loan requires periodic payments, the first of which is due within the first two months of the loan.
The fact that a participant actually repays a loan within 5 years will not keep the loan from being taxed if the loan, by its terms, was not repayable within that period.[89]
An important exception to the 5 year repayment rule exists for “any loan used to acquire any dwelling unit which within a reasonable time is to be used (determined at the time the loan is made) as the principal residence of the participant.”[90]
The home mortgage interest deduction is one of the few personal deductions left. However, if the participant is a key employee, he may not deduct interest on any loan to the plan.[91] See below. This is one of the principal reasons that home loans are not attractive to key employees.
The Conference Committee Report discusses another exception for residential mortgage investment program, but as yet we have little guidance on this subject.[92]
In order to be qualified, the loan must provide for substantially level amortization (with payments not less frequently than quarterly) over the term of the loan.[93]
Interest deductions for personal loans are not generally deductible anymore.[94] An exception (one of few) exists for home mortgage loans. However, interest on a participant loan will not be deductible, even if it otherwise would be (a rare event) if the provisions of §72(p)(3) apply. IRC §72(p)(3) operates to deny an interest deduction to key employees[95] (as defined in IRC §416(i), or to loans secured by amounts attributable to elective deferrals under a 401(k) or 403(b) plan (described in IRC §402(g)(3)(A) or (C)).[96]
IRC section, §72(p)(5), provides:
“any amount received as a loan under a contract purchased under a qualified employer plan (and any assignment or pledge with respect to such a contract) shall be treated as a loan under such employer plan.” (Emphasis added.)
Received by whom, one might ask. The meaning of 72(p)(5) is unclear, but it is to be noted that pre-TEFRA IRC §72(m)(4)(B) had a similar rule applicable in cases where a plan borrowed against a life insurance contract on the life of an owner-employee participant.
Perhaps a more reasonable interpretation is that this section applies in a case where a participant or beneficiary received a distribution in the form of a non-transferable annuity contract, and then borrowed against it.
Presumably, any loan described by (p)(5) would not be a qualified loan, and therefore would be treated as a distribution.
Prior to the issuance of the proposed regulations (1.72(p)-1), it could not be said with certainty that default on an otherwise permissible loan would not automatically result in immediate income taxation to the participant-debtor. (However, the default then and now may evidence an initial intent that the loan never be repaid, and if it really was never intended that the loan be repaid, the loan is not a qualified loan.[97])
The proposed regulations now clearly provide that if “payments are not made in accordance with the terms applicable to the loan, a deemed distribution occurs.”[98] Fortunately, however, the plan administrator may allow for a grace period before treating the loan as in default:
A- 10.(a) Timing of deemed distribution. Failure to make any installment payment when due in accordance with the terms of the loan violates section 72(p)(2)(C) and, accordingly, results in a deemed distribution at the time of such failure. However, the plan administrator may allow a grace period, and section 72(p)(2)(C) will not be considered to have been violated until the last day of the grace period. Any such grace period shall be given effect for purposes of section 72(p)(2)(C) only to the extent it does not continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.[99] [Emphasis added.]
The following discussion does not take the proposed regulations into account.
Immediate income taxation will result if the 72(p)(2) requirements are not met. Query, however, if a participant misses a quarterly payment, is the level quarterly amortization rule violated, resulting in immediate taxation? If the participant does not repay the loan within 5 years, is the 5 year repayment rule violated, resulting in immediate taxation?
The answer to these questions is not entirely clear, but it is worth noting that the statute itself does not require that the loan be repaid in 5 years in substantially level quarterly payments; it merely requires that the “loan, by its terms, is required to be paid within 5 years.”[100] Similarly, the statute itself does not require that the loan actually be paid in substantially equal installments, at least quarterly; rather the statute says that a loan will not be exempt from taxation unless “substantially level amortization of such loan (with payments not less frequently than quarterly) is required over the term of the loan.”[101] (Obviously, a subterfuge will not work, because the ERISA regulations are clear that there must be an intent to repay the loan in accordance with its terms.[102])
Despite the literal wording of the statute, the Blue Book states—
[I]f payments under a loan with a repayment period of not more than 5 years are not in fact made, so that an amount remains payable after the end of 5 years, the amount remaining payable at the end of 5 years is treated as if distributed at the end of the 5-year period.[103]
What is the basis for this assertion? It might be argued that the failure to pay the principal when due constitutes an additional loan. But without applying the 12-month look back rule, one cannot say whether or not a new loan would qualify under §72(p)(2). The Blue Book does say—
“A failure to pay interest when due will constitute an indirect loan for purposes of the Act unless, under the facts and circumstances, such a failure does not constitute an additional loan transaction.”[104]
Further, Notice 88-22 says that if a loan is renewed, extended or renegotiated, it is treated as a new loan.[105]
What is the difference between violating the 5-year rule in operation and missing one quarterly installment? If the participant is one day late in repaying an otherwise qualified 5 year loan, is the participant automatically taxed on the outstanding balance? (Of course, unless the participant is otherwise behind on scheduled payments, all we are really talking about is the last quarterly installment of a 5 year loan, that originally could not have exceeded $50,000.)
In the case of a deemed distribution, the Trustee should issue a Form 1099-R to the participant.
If the plan forecloses on the participant’s account in satisfaction of the loan, an actual distribution will occur at that time, whether or not a deemed distribution has already occurred.
Foreclosure is an actual event of distribution. Therefore, the plan must allow the distribution before the foreclosure can occur. This can be a problem in a money purchase plan or in that portion of a profit sharing plan subject to the 401(k) restrictions against in-service distributions prior to normal retirement age. A plan such as a profit sharing plan, for which in-service distributions are otherwise generally permissible, may define a default as an event allowing distribution, and hence, foreclosure.
If the participant is under age 591/2 there will be a 10% excise tax due, whether the distribution is actual or deemed.[106]
If the plan does nothing after a default, and waits for (say) 30 years for a distributable event, can the plan still offset the distribution by the amount of the loan? Is federal preemption an issue?
What happens if a participant terminates service and asks for a distribution at a time when the loan is outstanding and not in default?
The loan and pledge agreement had better provide that, if the account balance is the collateral, any distribution will first be used to offset the outstanding balance. Otherwise, the loan probably violates the ERISA regulations requiring adequate security.
It is possible to provide that termination of service is itself an event of default. If the employee remains a participant, then perhaps there is a violation of the requirement that loans by a plan to parties in interest who are participants or beneficiaries be made available “to all such participants or beneficiaries” on a reasonably equivalent basis.[107]
In any event, the foreclosure will result in income tax, and if the participant is under age 591/2 there will, in addition, be a 10% excise tax due.[108] These taxes could impose a substantial hardship on a terminating participant, and may not be necessary to protect the plan, as long as the security agreement provides that the plan will get paid first before any other distributions are made.
l. Repayment of Loan.
If a participant repays a loan that was previously taxed as a distribution, the repayment increases the participant’s basis in the plan.[109] Further, the repayment is apparently not treated as an employee contribution subject to §401(m).[110]
m. Loan Treated As Distribution Does Not Affect Plan Qualification.
The TEFRA loan rules are rules of income taxation and are not a matter of plan qualification. Hence, if a loan is otherwise permissible under ERISA, the fact that it is treated as a distribution under §72(p) should not cause the plan to become disqualified.[111]
n. Withholding Not Required on Loan Treated as a Distribution.
Because a loan that is treated as a distribution is not an eligible rollover distribution, it should not be subject to the mandatory 20% withholding rules.[112] The same is true of a deemed distribution when the loan is in default.[113]
o. Failure to Pay Interest May Be An Indirect Loan.
Both the Senate Finance Report to TEFRA and the TEFRA Blue Book suggest that the failure by a participant to pay an interest installment may itself constitute an indirect loan.[114]
p. Renewal, Extension or Renegotiation of Loan.
If a loan is renewed, extended or renegotiated, it is treated as a new loan.[115]
q. Truth in Lending.
The Truth In Lending Act applies if over 25 loans are made in the preceding year or 26 loans in the current year.[116]
r. Effective Dates.
IRC §72(p) is generally applicable to loans made after August 13, 1982.
The quarterly level amortization rules apply to loans made (or renegotiated, extended or renewed) after December 31, 1986.
The limitation on the deductibility of interest applies to loans made after December 31, 1986.
The 12-month look back rule (under which the $50,000 limit is reduced) applies to loans made (or renegotiated, extended or renewed) after December 31, 1986.
4. Spousal Consent to Loans.
Spousal consent is generally required if the participant’s vested accrued benefit is to be used as security and if the plan is subject to the joint and survivor annuity rules of IRC §417.[117] Consent must be in writing and made within 90 days of the loan, in the same manner as otherwise required for distributions subject to the joint and survivor annuity rules. The exception otherwise applicable to distributions to a participant who has a total account balance not over $3500 applies here as well.
[1]ERISA §406(a)-(b). (Emphasis added.)
[2]IRC §4971(b)(1). (Emphasis added.)
[3]ERISA §3(14). (Emphasis added.)
[4]ERISA §3(15). (Emphasis added.)
[5]IRC §4975(e)(2).
[6]IRC §4975(e)(6).
[7]IRC §4975(e)(2)(F)&(G). Cf., ERSIA §3(14)(F) & (G).
[8]IRC §4975(a).
[9]IRC §4975(b).
[10]IRC §4975(c)(3).
[11]DOL Reg. §2510.3-2(d).
[12]ERISA §201(6) and §301(a)(7).
[13]All references herein to the "IRC" are to the Internal Revenue Code of 1986, as amended, unless otherwise indicated.
[14]IRC §4975(e)(1).
[15]See IRC §4975(e)(2). Note, however, the owner-employee limitation on the statutory exemptions of IRC §4975(d) treats participants and beneficiaries of an IRA as owner-employees.
[16]IRC §408(e)(2)(A)(i) treats this individual as the creator of the account.
[17]IRC §408(e)(2).
[18]IRC §§408(e)(2)(B) and 408(d).
[19]IRC §408(e)(3).
[20]IRC §408(e)(4).
[21]DOL Advisory Opinion 89-03A.
[22]Preample to Prop. Treas. Reg. §1.401(a)(9)-1, Q&A’s D-5, 6 & 7. (re-Proposed 12/30/97).
[23]IRC §408(e).
[24]IRC §4975(c)(3).
[25]Treas. Reg. §1.408-1(c)(3).
[26]Presidential Reorganization Plan No. 4 of 1978, 3 C.F.R. 332(1979).
[27]Announcement 79-6, 1979-4, I.R.B. 43.
[28]ERISA Opinion Letter 89-03A.
[29]IRC §408(e)(2)-(4).
[30]IRC §4975(c)(1)(A) & (D).
[31](IRC §414(p).
[32]PLR 8820086. PLR 8735032. PLR 8929046. PLR 8007024.
[33]IRC §408(a)(1).
[34]IRC §402(c)(6).
[35]IRC §402(c)(6)(D).
[36]Rev. Rul. 87-77.
[37]Lemishow, 110 T.C. 11 (1998).
[38]See PWPB Opinion Letter, CCH Pension Plan Guide ¶23,677H (March 8, 1985). See attached.
[39]IRC§4975(d)(9).
[40]ERISA §408(c)(1).
[41]Treas. Reg. §1.411(d)-4 Q&A-1(b).
[42]Treas. Reg. §1.411(d)-4 Q&A-2(b)(2)(iii).
[43]Treas. Reg. §1.402(a)-1(a)(1)(iii).
[44]IRC §402(c)(6).
[45]ERISA §404(a)(1).
[46]ERISA §404(a)(1) (A)(i)
[47]IRC §4975(d).
[48]IRC §4975(d) last paragraph, flush language, and ERISA 408(d) last paragraph, flush language. But see also new IRC §4975(f)(6).
[49]IRC §4975(d) last paragraph, flush language.
[50]IRC §408(e)(3) & (4):
(3) Effect of borrowing on annuity contract. If during any taxable year the owner of an individual retirement annuity borrows any money under or by use of such contract, the contract ceases to be an individual retirement annuity as of the first day of such taxable year. Such owner shall include in gross income for such year an amount equal to the fair market value of such contract as of such first day.
(4) Effect of pledging account as security. If, during any taxable year of the individual for whose benefit an individual retirement account is established, that individual uses the account or any portion thereof as security for a loan, the portion so used is treated as distributed to that individual.
[51]The IRA owner is alsmost certainly a disqualified person. DOL Advisory Opinion 89-03A. However, it is hard to say just why. Perhaps the IRA owner is a “fiduciary” under IRC §4975(e)(2)(A).
[52]IRC §408(e)(2):
(2) Loss of exemption of account where employee engages in prohibited transaction.
(A) In general. If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year. For purposes of this paragraph -
(i) the individual for whose benefit any account was established is treated as the creator of such account, and
(ii) the separate account for any individual within an individual retirement account maintained by an employer or association of employees is treated as a separate individual retirement account.
(B) Account treated as distributing all its assets. - In any case in which any account ceases to be an individual retirement account by reason of subparagraph (A) as of the first day of any taxable year, paragraph (1) of subsection (d) applies as if there were a distribution on such first day in an amount equal to the fair market value (on such first day) of all assets in the account (on such first day).
[53]ERISA §406(a)(1)(B).
[54]IRC §4975(c)(1)(B).
[55]ERISA 3(14)(H).
[56]IRC §4975(e)(2). The category of disqualified persons under the IRC is very similar to that of parties in interest under ERISA. However, not all employees are disqualified persons under IRC §4975(e).
[57]ERISA 408(b)(1). (Emphasis added.)
[58]IRC §4975(d)(1). (Emphasis added.)
[59]Section 102 of Reorganization Plan No. 4 of 1978 (43 Fed. Reg. 47713, 10/17/78).
[60]DOL Reg. §2550-408b-1(b)(1).
[61]PWBA Op. Letter 89-30A, 10/2/89.
[62]DOL Reg. §2550-408b-1(c)(4).
[63]DOL Reg. §2550-408b-1(b)(2).
[64]DOL Reg. §2550-408b-1(c)(3).
[65]DOL Reg. §2550-408b-1(c)(4), Ex. 1.
[66]DOL Reg. §2550-408b-1(d).
[67]DOL Reg. §2550-408b-1(d)(2).
[68]DOL Reg. §2550-408b-1(e).
[69]DOL Reg. §2550-408b-1(e), Ex. 1-3.
[70]DOL Reg. §2550-408b-1(e), Ex. 1.
[71]DOL Reg. §2550-408b-1(e), Ex. 3.
[72]Rev. Rul. 89-14, 1989-1 C.B. 633.
[73]DOL Reg. §2550-408b-1(f)(1).
[74]DOL Reg. §2550-408b-1(f)(2).
[75]DOL Reg. §2550-408b-1(f)(1), first sentence.
[76]Tex. Labor Code §61.018. [Previously found at Tex. Rev. Civ. Stat. art. 5155, §3.]
[77]DOL Reg. §2550-408b-1(a), Ex. 3-5.
[78]DOL Reg. §2550-408b-1(a), Ex. 7.
[79]ERISA §408(d) and IRC §4975(d)(15).
[80]The Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248.
[81]IRC §72(p). (Emphasis added.)
[82]Notice 82-22, I.R.B. 1982-50.
[83]Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982.
[84]Prop. Treas. Reg. §1.72(p)-1 (Prop. 12/20/95).
[85]Prop. Treas. Reg. §1.72(p)-1 Q&A 19-21 (Prop. 12/31/97).
[86]IRC §72(p)(1)(A).
[87]IRC §72(p)(2)(B)(i).
[88]Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 at p. 296.
[89]TEFRA Conference Com. Rep. p. 619.
[90]IRC §72(p)(2)(B)(i). (Emphasis added.)
[91]IRC §72(p)(3)(B)(i).
[92]Cong. Rept. No. 97-530, p. 620 (8/17/82). Cf. Notice 82-22, I.R.B. 1982-50.
[93]IRC §72(p)(2)(C).
[94]IRC §163.
[95]IRC §72(p)(3)(B)(i).
[96]IRC §72(p)(3)(B)(ii).
[97]DOL Reg. §2550-408b-1(e), Ex. 7.
[98]Prop. Treas. Reg. §1.72(p)-1 Q&A 4 (Prop. 12/21/95).
[99]Prop. Treas. Reg. §1.72(p)-1 Q&A 10(a) (Prop. 12/21/95).
[100]IRC §72(p)(2)((B)(1).
[101]IRC §72(p)(2)(C).
[102]DOL Reg. §2550-408b-1(e), Ex. 7.
[103]Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 at p. 296.
[104]Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 at p. 297. (Emphasis added.)
[105]Notice 88-22, I.R.B. 1982-50.
[106]IRC §72(t). Notice 82-22.
[107]DOL Reg. §2550-408b-1(b)(1).
[108]IRC §72(t). Notice 88-22, I.R.B. 1982-50.
[109]PLR 9122059. Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 at p. 297.
[110]Treas. Reg. §1.401(m)-1(f)(6). Notice 88-22, I.R.B. 1982-50.
[111]Notice 88-22, I.R.B. 1982-50.
[112]Temp. Treas. Reg. §1.402(c)-2T, A-4(c).
[113]Temp. Treas. Reg. §1.402(c)-2T, A-4(d).
[114]S. Report No. 97-494, p. 321. Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 at p. 297. Cf. Rev. Rul. 81-145, 1981-1, C.B. 350.
[115]Notice 88-22, I.R.B. 1982-50.
[116]See Truth-in-Lending Reg. 1; 12 CFR 226 and Reg. Z §226.2(a).
[117]IRC §417(a)(4). Treas. Reg. §1.401(a)-20, Q&A 24.