Let’s say you have a new client who took a loan from her 401(k) last year. Before going on maternity leave, your new client made arrangements for her employer to pay the loan back from her salary. The employer failed to deduct the required payments, which your client discovered once she returned from maternity leave.
Your new client immediately made a lump-sum payment, then had the maximum amount allowable withheld from her paychecks to pay the remainder of the loan. The employer remitted the payments to the plan administrator, who maintained the loan on the plan books and billed your client each month until the loan was repaid in full.
At year end, to reflect the loan and the payments, the plan administrator issued a digital Form 1099 that could only be accessed online.
Your new client says she did not know about the Form 1099, and filed her tax return without including the information reported on that form.
Now your new client has received an IRS notice telling her the repaid loan should be treated as taxable income. The IRS also assessed an early withdrawal penalty of 10%, and a 20% penalty for substantial understatement of income tax.
You know that under internal revenue code section 72(p), loans from qualified plans are generally treated as distributions, unless the loan agreement satisfies internal revenue code requirements relating to the terms, the repayment schedule, and the amount.
Those requirements include
A repayment term of not more than five years
Substantially level installments that include principal and interest
A loan amount that is the lesser of $50,000 (subject to certain reductions), or 50% of the participant’s or beneficiary’s nonforfeitable benefit (or $10,000 if greater)
In this case, the loan agreement meets the requirements, and you’re satisfied the loan was not a distribution at the time your new client received it.
However, the IRS says the loan became a deemed distribution when your client did not make her first loan payment on time and did not correct the failure within the “cure” period. At that point, the IRS says, your client defaulted due to the “substantially level” amortization requirement (called “substantially level installments” in the second requirement above).
You learn from your research that according to income tax regulation 1.72(p)-1, the failure to make any installment payment when due violates the substantially level amortization requirement. However, the substantially level amortization requirement is not violated so long as a payment, even if delinquent, is made within the designated cure period.
According to your client, the first loan payment was due August 24, and the cure period expired September 30. Your client returned to work on October 12, and made her first payment on November 20.
Based on those dates, the initial loan payment was made after the due date and the delinquent payment was made after the cure period expired. You determine your client defaulted under the loan agreement.
As a result, you tell your client the IRS is correct, and the outstanding balance of the loan as well as any accrued interest became a deemed distribution that was taxable to her.
In addition, since no exceptions apply to the deemed distribution, you tell your client she also owes the 10% early withdrawal penalty. You believe you can get the 20% substantial underpayment penalty abated due to reasonable cause and good faith, since your client immediately took corrective action, and reasonably relied on her employer and the plan administrator regarding the repayment of her loan.
WHAT OTHER CONSOLATION CAN YOU OFFER YOUR CLIENT?
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Case reference: T.C. Memo. 2017-139 (Frias)
Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.
This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.
You can tell your client she now has basis in her 401(k).
Loans are generally considered distributions unless taxpayers strictly comply with the code and applicable regulations.
However, because your client paid off a loan that no longer was a loan but rather a deemed distribution, regulation 72(p)-1 provides that she has tax basis in any cash repayments to her plan account.