Defaulted participant loans under qualified retirement plans.

The IRS issued Prop. Regs. Sec. 1.72(p)-1 in December 1995. This regulation provided guidance on the proper treatment of defaulted participant loans under qualified retirement plans, including the important distinction between "loan offset amounts" and "deemed distributions." (See "Qualified Retirement Plan Loans," The Tax Adviser, September 1996, p. 539.)

On Dec. 31, 1997, the IRS issued additional guidance by adding two additional Q&As to the 1995 proposed regulation. The two new Q&As are Q&A-19 and Q&A-20 (existing Q&A- 19, dealing with the regulatory effective date, has been modified and redesignated as Q&A-21). This additional guidance provides important answers to some questions left: unanswered in the original proposed regulation.

The most important clarification is that, although it is considered to be part of the outstanding loan balance when determining the permissible amount of any future plan loans, interest that accrues on a defaulted loan after it has been treated as a deemed distribution (and consequently, taxed to the individual) is not taxable to the individual. (This is consistent with Chapman, TC Memo 1997-147.)

The regulation also clarifies that basis is not created at the time of the deemed distribution, but the deemed distribution amount is not taxable under Sec. 72 on the eventual distribution ("loan offset"). Therefore, there is no double taxation of the defaulted loan amount. Basis is created, however, when an individual makes loan payments after the loan has been treated as a deemed distribution. Any such repayments are treated as after-tax contributions for tax purposes, not treated as after-tax contributions for other purposes, such as actual contribution percentage testing under Sec. 401(m) or annual additions testing under Sec. 415.

The proposed regulation is effective for loans occurring on or after the first January 1 at least six months after the publication date of the final regulation in the Federal Register. Although the regulation does not provide any guidance on plans that choose not to implement the provisions prior to the regulatory effective date, a plan may apply Q&A-19 and -20 to a loan made prior to the regulatory effective date, if there has not been a deemed distribution as to the loan or if certain requirements are met for a loan that has been treated as a deemed distribution.

The first requirement for a loan that has been treated as a deemed distribution is that the plan must have timely reported, in Box 1 of Form 1099-R, an amount not less than the initial default amount. In addition, basis is created if the post-deemed distribution accrued income has been taxed to the individual in the past. In effect, an individual can reduce the taxable portion of his nonloan distribution from the plan by the amount of the post-deemed distribution accrued interest on which he has already paid taxes.

A special requirement applies when (1) basis has been improperly created because of a past deemed distribution, (2) an actual distribution has occurred after the deemed distribution (such as a hardship distribution) and (3) a portion of the actual distribution was not taxed to the individual, due solely to the basis that was improperly created as a result of the deemed distribution. When this situation occurs and the amount of the original deemed distribution is subtracted from the remaining basis, the result is "negative basis" because a portion of the basis was used on the occurrence of the prior hardship distribution. In this situation, the amount of the negative basis must be added to the amount of the future taxable distribution from the plan, because the loan offset amount will not be taxable under Sec. 72.

From Timothy A. Daum, CPC, Oak Brook, IL