Plan loan final regs. ease some restrictions.

The IRS issued final regulations under Sec. 72 (TD 9021) on loans to participants in qualified retirement plans. While the final rules provide greater flexibility, taxpayers should still ensure that a loan from their qualified plan does not become a deemed distribution, resulting in taxable income. The final regulations generally apply to assignments, pledges and loans made after 2003.

Background

Under Sec. 72(p)(2), qualified plan loans are not treated as distributions if they meet the following conditions:

* The loan must be repaid within five years (except home loans);

* The payments must be substantially equal and made at least quarterly;

* The total outstanding balance of all loans cannot exceed the lesser of (1) the greater of half of the present value of the employee's vested benefits or $10,000; or (2) $50,000, reduced by the difference between the highest outstanding loan balance in the preceding 12 months and the current balance (12-month rule).

If the loan does not meet all three requirements, the proceeds will be treated as a deemed distribution includible in taxable income and potentially subject to the Sec. 72(t) 10% penalty as a premature distribution.

New Rules

Multiple loans: In proposed regulations issued July 2000 (TD 8894), the IRS capped qualified plan loans at two per year; it was concerned that plan participants might take additional loans to pay prior ones. Commentators objected to this rule, on several grounds. First, they argued that there were already provisions to protect against such abuse. For example, many plan documents limit loans to two per year; in addition, the 12-month rule provides sonic protection. Commentators also cited several examples in which a participant could legitimately need more than two loans. In the final regulations, the IRS removed the annual limit on the number of plan loans a participant can take.

Repayment after leave of absence: Under Regs. Sec. 1.72(p)-1, Q&A-9(a), an employer can suspend loan repayment during an employee's leave of absence for up to one year, but interest must continue to accrue during the leave and the loan balance must be repaid within five years. The latter can be accomplished either by making larger payments after the employee returns to work, or the employee can continue to pay the same amount as prior to the leave, then make a balloon payment at the end.

If the original loan repayment term is less than five years, the taxpayer can extend the term to five years from the loan date. This extension of time does not mean that the employee can make smaller payments.

Repayment after military leave: Regs. Sec. 1.72(p)-1, Q&A-9(b), clarifies that loan repayments can be suspended for periods of longer than one year for leaves of absence for military service. While interest must accrue during that time, the interest rate is limited to 6% annually.

When the taxpayer's military service ends, loan repayment must recommence and the loan balance must be paid in substantially equal amounts. On resuming repayment, a lender may permit the participant to choose to increase the amount of the payments, or to make payments at the previous rate, with a balloon payment due at the loan's end.

For loan repayments after a military leave, the original loan term can be extended to five years (assuming it was less than five years), plus the time for the military service.

Loans after deemed distributions: According to Regs. Sec. 1.72(p)-1, Q&A-4(a), if a loan is deemed to be a distribution, all subsequent loans will also be deemed to be plan distributions, unless (1) the taxpayer and the employer agree that loan payments will be made via withholding or (2) the plan receives adequate security (besides the taxpayer's accrued benefit) for the new loans.

Commentators were concerned that an employer might be unaware that a previous loan had been determined to be a deemed distribution and that a subsequent loan could subject the employer to penalties. The IRS responded that loan issuers are required to ask employees about other employer loans, so that the maximum allowable loan limits are not violated. In addition, the IRS suggested that an employer condition a new loan on the employee's disclosure of prior loans. The employer can rely on an employee's statements for purposes of this provision, unless the employer has reason to believe that the employee is not being truthful.

Refinanced loans: Under Regs. Sec. 1.72(p)-1, Q&A-8(a), a qualified plan loan may be refinanced without becoming a deemed distribution if the loan is repaid at least quarterly, in substantially equal payments and within five years (longer for home loans). Under the final regulations, a refinanced loan may be treated as two loans in one--a continuation of the prior loan, plus a new refinancing loan equal to the difference between the prior loan balance and the refinanced amount. Regs. Sec. 1.72(p)-1, Q&A-8(b), illustrates when both loans are considered outstanding at the same time. In such case, the combined balances could exceed the maximum loan limit and result in a deemed distribution.

The amount attributable to the new refinancing loan must be paid within five years of the refinancing date. The amount attributable to the prior loan balance must be repaid by the end of the original term, unless it was less than five years. If the prior loan's original term was shorter than five years, the final regulations allow the taxpayer participant to extend the time to five years from the original loan date.

FROM REBECCA WILLIAMS, J.D., NEW YORK, NY