Long-awaited regulations proposed on loans from qualified plans.

As a result of the tremendous tax burden associated with early distributions from qualified retirement plans, many employers have added provisions that allow participants to borrow from retirement plans with no tax consequences. However, Sec. 4975(d) (1) contains strict rules to be certain that these loans are not prohibited transactions subject to the Sec. 4975 excise tax. In addition, Sec. 72(p) treats loans as distributions for income tax purposes, unless the exception provided by Sec. 72(p) (2) is met.

On Dec. 20, 1995, Regs. Sec. 1.72(p)-1 was proposed. The proposed effective date of the final regulations would be for loans made three months after the final regulations are published in the Federal Register; for additional information, see Tax Clinic, "IRS Issues Participant Loan Guidance," TTA, Mar. 1996, p. 152.

Enforceable Agreement Requirement

The loan must be evidenced by a legally enforceable agreement set forth in writing. The agreement must specify the loan's amount, term and repayment schedule.

Deemed Distribution

If the loan's terms do not require repayments that satisfy the repayment term requirement or the level amortization requirement, or the loan was not evidenced by an enforceable agreement satisfying the requirement of the proposed regulations, the entire amount of the loan would be a deemed distribution at the time the loan was made. If the loan satisfies the enforceable agreement requirement, except that the amount loaned exceeds amounts permitted under Sec. 72(p) (2), the amount of the loan exceeding this limitation would be a deemed distribution at the time the loan was made.

To satisfy the repayment term requirement, the loan, by its terms, must be repaid within five years--unless the loan is used to acquire a dwelling unit which, within a reasonable time, will be used as the participant's principal residence (Sec. 72(p) (2) (B)).

To satisfy the level amortization requirement, substantially level loan amortization (with payments not less frequently than quarterly) must be required over the loan's term (except as provided in regulations) (Sec. 72(p) (2) (C)).

Timing of Deemed Distribution

Failure to make any installment payment when due in accordance with the terms of the loan results in a deemed distribution of the entire outstanding loan balance at the time of such failure. The plan administrator may allow a grace period (not beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due).

Difference Between Deemed Distribution and Plan Loan Offset Amount

A deemed distribution occurs when Sec. 72(p)'s requirements or the enforceable agreement requirement described above 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. It is not a distribution of the accrued benefit, only the remaining loan amount. A distribution of a plan loan offset amount occurs when, under the terms governing a plan loan, the accrued benefit of the participant or beneficiary is reduced (offset) to repay the loan (including the enforcement of the plan's security interest in the accrued benefit).

Principal Residence Plan Loan

The requirement that a plan loan be repaid within five years does not apply to a loan used to acquire a dwelling unit that will be used as the principal residence of the participant within a reasonable time.

A principal residence has the same meaning as under Sec. 1034. The proposed regulations also state that, to satisfy the requirements for a principal residence plan loan, 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. However, for the interest to qualify as deductible mortgage interest, the loan must be secured by the residence.

On the other hand, for a plan loan not treated as a distribution, no interest deductions are allowed (under Sec. 72(p) (3)) during the period:

* On or after the first day on which the borrower is a key employee (as defined in Sec. 416(i); or

* The loan is secured by amounts attributable to elective deferrals under a qualified cash or deferred arrangement or tax-sheltered annuity.

Leave of Absence

Sec. 72(p) (2) (C)'s level amortization requirement does not apply for a period (not longer than one year) during which a participant is on a leave of absence, either without pay from the employer or at a rate of pay less than the amount of the installment payments required under the loan's terms. However, under the proposed regulations, the loan must be repaid by the latest date permitted (five years, unless a principal residence plan loan) 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 loan's terms.

Reporting and Withholding 

The amount includible in income as a result of a deemed distribution under Sec. 72(p) (1) must be reported on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. To the extent that a loan, when made, is a deemed distribution or an account balance is reduced to repay a loan, the amount includible in income is subject to withholding. If a deemed distribution or a loan repayment by benefit offset results in income at a date after the date that 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.

Residential Mortgage Investment Programs

Residential mortgage loans made by a plan in the ordinary course of an investment program are not subject to Sec. 72(p), if the property acquired with the loans is the primary security for such loans and the amount loaned does not exceed the property's fair market value. 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. If loans mature on a participant's termination, or if the loans are only made available to (or any loan is earmarked for) any participants or beneficiaries in the plan, the loan will not be considered as made under an investment program. Also, if a loan benefits an officer, director or owner of the employer maintaining the plan, or his beneficiaries, it would not be treated as made under an investment program.