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Participant Loans In A Troubled Economy

Participant Loans In A Troubled Economy. SUNGARD Stephen W. Forbes, J.D. LL.M. Taxation requirements (Code §72(p)). Prohibited transaction requirements (Code §4975) and DOL Regs . Loans must comply with both sets of requirements. Two Sets Of Statutory Rules. Plan Documentation.

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Participant Loans In A Troubled Economy

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  1. Participant Loans In A Troubled Economy SUNGARD Stephen W. Forbes, J.D. LL.M.

  2. Taxation requirements (Code §72(p)). Prohibited transaction requirements (Code §4975) and DOL Regs. Loans must comply with both sets of requirements Two Sets Of Statutory Rules

  3. Plan Documentation • Plan must authorize loans • Plan loan provisions may be in more than one document • Plan loan policy

  4. Loan note Irrevocable pledge and assignment Participant Documentation

  5. Regulation Z More than 25 loans Disclosure requirements annual percentage rate finance charge APR includes loan fees Amount financed Total payments Truth In Lending

  6. Regulation Z and participant loans • Federal Reserve Board issued final regulations in January 2009 • Will exempt from Truth in Lending Act and Regulation Z participant-directed loans from employer-sponsored retirement plans • Effective 7/1/10 • Affects • Qualified plans • 403(b) plans • Gov’tal 457(b) plans

  7. Bottom line • Requirements for exemption: • 1. Loan is from fully vested funds from participant’s account (i.e., participant-directed) • 2. Loan is made in compliance with Code (i.e., 72(p).

  8. Bottom line cont’d • Change does not apply to loans that are plan assets, rather than participant-directed • Not many out there • Plan may continue to apply existing rules • Same disclosures as currently apply

  9. Taxation Requirements Code §72(p) • Amount limitation • Enforceable agreement • 5 yr repayment period (home loan exception) • Level amortization • Applies to • Qualified plans • 403(b) plans • Government plans

  10. Violation of 72(p) Taxation Rules • Consequences for violation • Taxable (deemed) distribution to participant • Premature distribution tax if employee is not 59½

  11. Amount Limitation • All outstanding plan loans cannot exceed lesser of: • $50,000 with adjustments; or • Greater of • 50% of vested account balance • $10,000

  12. Reduce $50,000 limit by the amount by which The highest outstanding loan amount within previous 12 month period Exceeds current loan balance If only one loan was outstanding, the adjustment equals the principal paid in the prior 12 months Does not apply to 50% limit $50,000 Limit/Lookback Rule

  13. Lookback Rule • Kathy obtains $50,000 loan on 9/1/08 • On 12/1/09, paid loan down to $41,000 • Kathy requests $9,000 loan on 12/1/09 • First loan paid down to $41,000 • Highest outstanding loan balance in previous 12 months = $48,500 • Kathy’s vested account balance exceeds $100,000

  14. Lookback Rule (cont.) Code §72(p) calculation:$50,000 - 7,500 ($48,500 - $41,000) $42,500 December 1, 2009 Loan limit = $42,500 December 1, 2009 Outstanding loan = $41,000 Available loan limit = $1,500

  15. Level Amortization • Amortize principle and interest at least quarterly • Missed payment will cause 72(p) violation • Most common cause of deemed distributions

  16. Grace (Cure) Period • Plan can provide a grace period for missed payment • Maximum: Last day of following calendar quarter • Plan may use smaller grace period (e.g., 90 days or 30 days) • Good to have some grace period. Otherwise, one day late = deemed distribution

  17. Loan Default Reporting • What is the amount of her deemed distribution? • How should the employer report the loan default? • Does the deemed distribution create a basis in her account? • On 12/31/09, no payments since 8/1/09 • Plan defaults loan on 12/31/09 • Missed payments = $1,100; unpaid balance = $8,000

  18. Reporting Default – 1099R • Outstanding loan amount, not just missed payment • Code L and 1 (if not 59½) in box 7

  19. Deemed Distribution vs. Loan Offset Deemed Distribution Loan Offset • Taxable event • Line 2g, Sch. H and I • Occurs regardless of whether EE is eligible for distribution • Not eligible for rollover • Must maintain loan on books • Affects vesting, TH, future loans • Foreclosure on security interest (i.e., offset against participant’s account) • Offset is actual distribution • Reported as distribution on 5500 • Need distributable event • Eligible for rollover

  20. Post-default (Phantom) Interest • Interest still accrues after deemed distribution • Interest accrues until the loan is repaid or offset • Phantom interest is neither taxable nor reportable • However, phantom interest is still relevant

  21. Conditions for New Loan After Deemed Distribution • After deemed distribution, if old loan not repaid, there is mandatory payroll deduction or additional collateral • Some plans allow only one outstanding loan at a time • Forces borrower to repay defaulted loan in order to get new one

  22. Phantom interest • Kathy - 100% vested participant defaults on $8,000 loan • Plan reports deemed distribution • Plan accrues $1,000 phantom interest after deemed distribution

  23. If she requests a second loan, what is the maximum loan she may receive? • What conditions apply to the second loan?

  24. Tracking Defaulted Loan • For plan accounting and top heavy purposes, what is her account balance? • If she is 80% vested in her account balance, what is her vested account balance? • If she terminated employment the following year (12/1/10), how would the plan report the distribution?

  25. Repayment of Defaulted Loan • To repay entire loan, EE must repay loan + phantom interest • EE obtains basis for repaid defaulted loan • Not after-tax EE contributions — not subject to ACP test

  26. Offset Following Deemed Distribution • If plan cannot offset, loan remains on the books • However, not on 5500 financials • When distributable event occurs, plan may offset • Plan does not report offset on 1099-R • Not eligible for rollover

  27. Taxation of Offset • Kathy terminates 3/1/09 • 12/31/07 – deemed distribution • Non-loan a/b = $22,000 • loan receivable = $9,100 ($8,000 defaulted loan + $1,100 accrued interest) • May the plan offset the defaulted loan? • How does the plan report the distribution and the offset?

  28. Loan Refinancing • Employee uses replacement loan to repay another loan • Replacement loan has repayment date more than 5 years after original loan • Regs make clear that date can be extended up to 5 years after original loan, or longer for a home loan • Even though one loan replaces other loan • Employee considered to have two loans • Two loans may not exceed limits

  29. Loan Refinancing • Jim has $30,000 vested account balance • Outstanding loan: • Paid down to $8,000 • 3.5 years left in repayment period • Jim requests $15,000 w/ 5 year repayment • Will use loan proceeds to pay off $8,000 loan

  30. Special Amortization • First loan disregarded if new loan due 5 years from original loan • First loan disregarded if EE repays first loan within original 5 year period, and repays replacement loan during normal repayment period

  31. Amortized as Two Loans • Mary borrows $10,000 @ 8% on 5/1/05 due 5/1/10. Payment $203 • 5/1/06 balance is $8,300. Mary ($25,000 a/b) wants new loan • Mary borrows $12,500 @ 7%, paying old loan and taking $4,200 cash. New loan due 5/1/10. Pays $282 until 5/1/10, and thereafter $83. • Do the two loans violate the 50% limit?

  32. Valuation Date • Determine loan limit • Use latest valuation date for loan limit • Adjust for distributions and contributions between valuation date and date of loan • Subsequent events will not cause violation

  33. 50% Limit in a Falling Market • 50% limit under Code §72(p) limit • Use latest valuation date to apply limit • Notice 82-22 • Benchmark date should be the date the loan proceeds issued, not application date • Adequate security requirement • 50% of vested account balance • Also, use latest valuation date • May want to alert participants to the rule in loan policy or website

  34. 50% Limit • SPL maintains a 401(k) plan • Daily valuation • Plan considers loans participant directed • Ted requests a $40,000 loan on 2/18/09 • Vested a/b on 2/18/09: $80,000 • Plan issues loan check on 2/25/09: a/b = $70,000 • What loan amount should the plan provide Ted? • Assume the plan is valued annually and the 12/31/08 value of his a/b was $80,000. What loan amount should the plan provide?

  35. Hardship Distribution Does Jim’s loan violate amount limitations under Code §72(p)? • Jim takes a $20,000 loan from his $40,000 a/b on 11/1/09 • Jim obtains hardship distribution one week following loan

  36. Leave of Absence • Plan may suspend loan payments for leave of absence • One year maximum suspension • Interest continues to accrue • Does not extend 5 year repayment period • Participant must repay within 5 years from original loan • Can extend to full 5 years • Balloon payment or reamortization

  37. Plan may suspend for military service Entire period of military service, not just 1 year Military service does not count against 5 year repayment period Employee must repay loan and accrued interest by end of 5 year period not counting the military service. Can use full 5 years even if original loan was shorter Can use same payments with a balloon at the end Can increase payments to avoid balloon Military Leave of Absence

  38. Military Interest Rate • During the period of military service, a plan cannot charge more than 6% compounded annually on loan to serviceman made prior to entering the service. Serviceman must give notice to plan to claim this rule. • The 6% limit includes all service or maintenance charges. • If you want to charge a higher rate, it requires a court order.

  39. Home Loan • Loan to acquire participant’s principal residence • May exceed 5 year repayment period • Commercially reasonable period • No need to secure by home

  40. Principal Residence • Includes house, condominium, mobile home not used on transient basis • Vacation home does not qualify • Applies to construction of home

  41. Rollover of Loan Offset • EE may roll over loan offset • Procedure: EE contributes rollover amount out of his/her pocket

  42. Rollover of Loan Note to New Plan • May roll over loan note to a plan if loan is not offset • Direct rollover • Plan may accept • Plan must permit loan • Assignment of loan

  43. Withholding Rules (Loan Offset) • Loan offset is eligible rollover distribution • Subject to 20% withholding to extent distribution includes cash in addition to offset • Withholding cannot exceed cash to participant

  44. Loan Offset – Taxation • Susan terminates employment with $100,000 account balance, including $20,000 loan • If Susan receives a distribution of her entire account balance and the plan offsets the loan, what is the taxable amount reportable on the Form 1099-R? • If Susan does not roll over any of the distribution, how much should the plan withhold?

  45. Withholding/Reporting • If she rolls over directly the $80,000 to an IRA and the plan offsets the loan, how should the plan report the distributions? How much should the plan withhold? • If she rolls over $50,000 and the plan offsets the loan and distributes the balance of her account, how much should the plan withhold from the distribution?

  46. Partial Rollover • May she roll over her entire vested account balance (including the loan note) to another plan? IRA? • Must the recipient plan accept the rollover of the loan note? Must the receiving plan permit participant loans to accept the rollover of the loan note?

  47. Partial Rollover cont’d • May she use the 60-day rollover rule to effect a rollover of the participant loan note? • How does a plan effect a rollover of a participant loan note?

  48. Prohibited Transaction (PT) Requirements • Loan is a PT because it is a transaction between plan and party-in-interest • Statutory exemption to the PT rules

  49. Exemption Requirements • Available on reasonably equivalent basis • Not available to HCEs in greater amounts • Plan provisions • Reasonable interest rate • Adequate security

  50. Reasonably Equivalent Basis • Limit by percentage of account balance is not a violation • Can take credit worthiness into account

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