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The opportunity that wasn't. (Federal Taxes).

The 2001 Tax Act exempts qualified plan loans to owner from the prohibited transactions rules. Previously, these loans could subject the plan to excise taxes or plan disqualification. Sole proprietors, partners who own more than a 10 percent interest in the partnership, IRA owners and more than 5 percent owner employees of S corps all have been subject to the loan prohibition.

For years beginning after Dec. 31, 2001, only IRA participants and beneficiaries will be prohibited from plan loans. A similar amendment was made to the parallel ERISA provision.

Given this new opportunity, should owner employees make qualified plan loans? Probably not.


If your client is contemplating borrowing from a qualified plan, consider the following. Does the plan allow borrowing by an owner employee? When these loans were prohibited, most qualified plans were written to exclude such loans. The qualified plan must follow its own document as well as the IRC. Most plans covering sole proprietors, partnerships and S corps require an amendment to allow loans.

Does your client realize that the plan loan's interest won't be deductible? If lending sources are available that yield tax deductions for interest payments, those loans may be preferable. To make the interest deductible, more plan amendments and legal services will be required.


The income tax rules that apply to qualified plan loans are rigid. Loans cannot be made available on a basis that discriminates in favor of highly compensated employees. The loan must carry a reasonable interest rate and have a reasonable repayment schedule. Final regulations and new proposed regulations were issued in 2000 dealing with plan loans.

Loans are considered to be a deemed distribution from a plan unless they meet the exceptions in IRC Sec. 72(p). The requirements include limits on the amount to borrow: a $50,000 limit considering all loans outstanding during the year and 50 percent of the accrued benefit (or $10,000 if greater than the 50 percent limit); loan terms (5 years unless used to purchase or improve the principal residence); and, they must be amortized in level payments made at least quarterly.

Spousal consent is necessary to secure a plan loan for a married participant. In addition, if the loan does not meet the exceptions initially or on an ongoing basis and is treated as a distribution, it still must be repaid to the qualified plan. The repayment creates basis within the retirement plan that is recovered when the participant later receives an actual distribution.


In Clayton W Plotkin (TC Memo 2001-71) an attorney borrowed money from his professional corporation's pension plan. The loan called for repayment in five years with amortization over 15 years and a balloon payment. When the corporate plan was terminated after four years, Plotkin paid tax on the unpaid loan balance with his income tax return. However, the Tax Court ruled that when the loan was made, it was immediately taxable. Plotkin owed income tax and four years of interest on the disqualified loan. Since he was under age 59.5, he owed a 10 percent penalty as well.

The plan loan must qualify when made and at all times thereafter. Loans have been disqualified when the employer went out of business, when the employee left (and the loan was offset against benefits due him) and when the payroll service failed to withhold loan payments.


If the qualified plan is your client's only borrowing source, consider an early plan distribution instead. No interest is due on the distribution and the tax consequences fall in one year. An early distribution penalty may offset the fact that the plan loan interest is not deductible. The $50,000 or 50 percent of the vested benefit limitations do not apply so more may be borrowed. An early distribution to an owner employee also may require the qualified plan to be amended.

For an S-corp shareholder with insufficient basis to deduct corporate losses, a distribution from a qualified plan (or an IRA) could be loaned to the corporation and free up at-risk losses with the only tax cost being the 10-percent penalty. A similar qualified plan loan would require interest payments and more attention.

Borrowing from a qualified plan can be risky and should only be undertaken after evaluating the options and with a thorough understanding of the risks involved.

Mary Kay Foss, CPA is a partner in the Danville-based firm of Marzluft, Giles, Tulis & Foss. She is an Education Foundation instructor, and the incoming chair of CalCPA's Committee on Taxation. Foss can be reached at
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Author:Foss, Mary Kay
Publication:California CPA
Article Type:Brief Article
Geographic Code:1USA
Date:Jun 1, 2002
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