Frias v. Comm’r, T.C. Memo. 2017-139 (2017)
A 401(k) plan participant took a loan from her account just before she took a leave of absence. The loan agreement required biweekly loan payments to be deducted from her pay and provided that a missed payment not made up during a specified “cure period” would result in a default of the entire loan amount and a taxable deemed distribution. While on leave, the participant was paid accrued sick, personal, and vacation time, but the employer failed to deduct any loan payments from that pay. When she returned to work and learned of the error, her employer allowed her to make up the missed payments and resume biweekly deductions until the loan was paid in full—even though the cure period for the first missed payment had already expired. The plan’s recordkeeper continued to bill and account for her loan payments, but it issued an electronic Form 1099-R reporting a taxable distribution of the full loan amount as of the end of the first missed payment’s cure period. Unaware of the electronic Form 1099-R, the participant did not report the deemed distribution on her federal tax return. The IRS issued a notice of deficiency, assessing income taxes on the deemed distribution, the 10% additional tax on early distributions under Code §72(t), and a 20% “accuracy-related” penalty for underpayment of income taxes.
The participant petitioned the tax court for a redetermination of the IRS’s assessment, arguing that she qualified for the exception to the deemed distribution rule for a “bona fide leave of absence” without pay or at a rate of pay less than the required loan payment. She also argued that the amounts were not “pay” under the exception because the paychecks received during her leave were for paid time off. The court disagreed, noting that the amounts the participant received during a portion of her leave were sufficient for the loan payment deductions and that her arguments about what constitutes “pay” were not applicable to plan loans. Thus, the court upheld the IRS’s determination that the participant had received a taxable deemed distribution when the first loan payment was not made by the end of the cure period and that the additional tax on early distributions applied. The court waived the accuracy-related penalty, however, finding that the participant had acted in good faith and had reasonable cause for underpaying her income taxes for the year: She had reasonably relied on her employer to withhold the loan payments from her paychecks, immediately took steps to correct the delinquency when she learned of the error, and relied on the recordkeeper’s continued accounting of her loan payments.
EBIA Comment: This is a cautionary tale of how a poorly administered participant loan program can result in adverse tax consequences to participants. While this participant’s reasonable reliance on the employer and recordkeeper allowed her to avoid the accuracy-related penalty, it did not protect her from the deemed distribution. We note that the cure period in this case was short (the end of the calendar month following the month in which the payment was due) and that more generous cure periods (the end of the calendar quarter following the quarter in which the payment was due) are permitted under the loan regulations (for example, see our Checkpoint article). But not all loan errors can be resolved by using longer cure periods; plan sponsors offering loans should maintain and follow comprehensive loan policies and procedures to protect their plans and plan participants. Errors in administering plan loans can be corrected under the IRS’s voluntary correction program (VCP). For more information, see EBIA’s 401(k) Plans manual at Sections XIV.K (“10% Additional Tax on Early Distributions”), XVI.B.4 (“Requirements for Tax-Free Participant Loans: Level Amortization Requirement for Repayment”), XVI.F (“Consequences of Nonpayment: Default and Taxable Distributions”), and XXXIV.J.4 (“Loan Default: Failure to Repay Loan in Accordance With Its Terms”).
Contributing Editors: EBIA Staff.