For plans that offer loans, there is oftentimes confusion around when a participant loan will default, and even more so around when that loan would be considered a distribution for tax-reporting purposes.
A recent IRS Issue Snapshot affirms that a participant loan is a legally enforceable agreement and terms of the loan agreement must comply with Internal Revenue Code (IRC Section 72(p)(2) and Treasury Regulation Section 1.72(p)-1). The terms of the loan agreement must be explicit in writing or deliverable electronically.
A loan in default is considered to be a deemed distribution. However, plans may offer a cure period during the quarter following the quarter in which the missed loan repayment occurred.
A deemed distribution can occur at the date the loan is made if:
- the participant loan exceeds the maximum dollar amount of $50,000
- the payment schedules do not comport with time or payment amortization requirements, or
- the loan agreement is either not legally enforceable or does not exist.
If any of the above requirements are not met, the loan would be determined to be in default and will be considered a deemed distribution.
A deemed distribution is accompanied by immediate tax consequences to the participant.
The complete IRS Issue Snapshot is at www.irs.gov/retirement-plans/deemed-distributions-participant-loans.