Verify Plan Loan Repayments, Tax Court Reminds

A recent Tax Court ruling provides a reminder of the importance of verifying that a repayment of a plan loan has actually been made.

The ruling, Louelia Salomon Frias v. Commissioner, TC Memo 2017-139, demonstrates that the rules for repayment of plan loans “can be quite complicated” and that sometimes loan repayments are not deducted when they should be, for a variety of reasons, notes Katherine Aizawa, special counsel to the law firm of Foley & Lardner LLC.

Facts of the Case

Frias, a participant in her employer’s 401(k) plan, on July 27, 2012 signed a loan agreement to borrow $40,000 from her account, which she would repay over two years through $342 deductions from every biweekly paycheck. She began an approved maternity leave of absence on July 30; during the first five weeks she opted to be paid through her paid time off (PTO) — accrued, unused sick, personal and vacation — days. The rest of her leave was unpaid.

Under the plan, a loan repayment would be on time if it was paid by the last day of the month following the month that included the missed payment date. Frias’ first loan repayment was due Aug. 24, 2012; she had until Sept. 30, 2012 to make it.

The employer did not deduct any of the loan repayments from Frias’ paychecks, which she discovered when she came back to work on Oct. 12, 2012. She made a $1,000 payment on Nov. 20, 2012 and authorized an increase in her repayments to $500 through July 15, 2013; thereafter, the original $342 loan repayment was reinstated. The loan was fully repaid on July 9, 2014.

Nonetheless, Mutual of America, the plan’s record keeper, in 2012 issued a Form 1099-R reporting a deemed distribution because the initial loan repayment was late. The deemed distribution was $40,065, which was additional taxable income for Frias. In addition, the Internal Revenue Code Section 72(t) 10% early distribution excise tax was applied because Frias was younger than age 59½.

Though Frias had access to the Mutual of America website, where the Forms 1099-R were posted, she did not access the site. Accordingly, she did not recognize that $40,065 as additional taxable wages on her 2012 income tax return. In 2014, the IRS said she owed $19,129 — $15,941 in taxes, including the 10% penalty, and an additional 20% penalty of $3,188 for substantial tax underpayment.

Tax Court’s Decision

Frias argued that a deemed distribution should not have been reported because she was on an unpaid leave of absence; the Tax Court did not agree. It also did not agree with her contention that the PTO payments did not constitute wages and that she timely corrected the mistake when she came back to work. The Tax Court did agree with her regarding the 20% penalty for the substantial underpayment of tax because she had reasonably relied on her employer to timely deduct the repayments from her paychecks. “Under these circumstances, it was not fatal that she failed to check her pay stubs,” writes Aizawa. In addition, Frias tried to correct the mistake as soon as she learned of it.

Advice for Plan Sponsors

Aizawa writes that the case demonstrates that the rules for repayment of such loans “can be quite complicated” and that sometimes loan repayments are not deducted when they should be, for a variety of reasons. She has suggestions for plan administrators in light of the court’s ruling:

  • make sure that loan agreements accurately reflect a plan’s terms regarding loans, leaves of absences, repayment methods and cure periods;
  • provide borrowers with all loan terms before they sign the loan agreement and make sure they understand them; and
  • encourage borrowers to make sure that loan repayments are deducted properly.

Add Your Comments

2 Comments

  1. James Farley
    Posted October 3, 2017 at 11:44 am | Permalink

    Just to add a bit more complication, the participant loan repayments are still actually repayments. Since the loan was “deemed” this creates account basis to be reconciled upon distribution and any potential rollover. A plan to plan transfer could be problematic as a new employer’s plan may not be able to accommodate after tax dollars. There is an added burden on the current recordkeeper to recognize this basis, separately track the earnings (losses) and ensure double taxation does not occur.

  2. David J. Kupstas
    Posted October 13, 2017 at 1:47 pm | Permalink

    Did anyone suggest doing a correction under EPCRS before issuing a 1099? Afterwards, did anybody mention that you might want to consider stopping repayment on your loan since you’ve been taxed on it already? I have to believe Ms. Frias got some sort of notification that there was an “important tax document” on the website; if not, that’s terrible. Not the greatest customer service or communication here. A little hand-holding would be in order. I guess it’s a case of you snooze, you lose.

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