Employee Plans’ Loan Problems
by Robert V. Lally

We resolved with the IRS a series of issues concerning loans to plan participants in a 401(k) plan. Reproduced below is a communication with the IRS on this matter. This is a useful example of the voluntary correction program.
By FAX: (203) 781-3055

Charles Stewart
NORTHEAST REGION
EP/EO Division Review Staff
Internal Revenue Service
10 Metro Tech Center
625 Fulton Street
Brooklyn, NY 11201

Dear Charles:

I appreciate the time you took with me on the phone today to discuss the use of the Administrative Policy Regarding Self-Correction (''APRSC'') program for my client.

Background Facts:
Our firm is the newly appointed auditor for a company’s 401(k) plan. The plan permits participant loans. In general, the overall rules for participant loans were followed, namely:
A. are available to all participants and beneficiaries on a reasonably equivalent basis;
B. are not made available to highly compensated employees, officers, or shareholders in an amount greater than the amount made available to other employees;
C. are made in accordance with specific provisions set forth in the plan;
D. bear a reasonable rate of interest; and
E. are adequately secured.

However, in the course of our detailed audit work on participant loans we discovered several situations in which the technical rules regarding timely amortization of principal and payment of interest under Prop. Regs. Section 1.72(p)-1, Q & A-10. for participant loans were not strictly followed.
TEXT Proposed Reg. 72(p) Q & A’s
Proposed Reg. 72(p)

Q-10.

If a participant fails to make the installment payments required under the terms of a loan that satisfied the requirements of Q & A-3 of this section when made, when does a deemed distribution occur and what is the amount of the deemed distribution?

A-10.

(a) TIMING OF DEEMED DISTRIBUTION. Failure to make any installment payment when due in accordance with the terms of the loan violates section 72(p)(2)(C) and, accordingly, results in a deemed distribution at the time of such failure. However, the plan administrator may allow a grace period, and section 72(p)(2)(C) will not be considered to have been violated until the last day of the grace period. Any such grace period shall be given effect for purposes of section 72(p)(2)(C) only to the extent it does not continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.

We noted instances in which participants had not made timely interest or principal repayments under the rules outlined above. In some of these instances, when under the technical rules the loan should have been declared in default and a Form 1099 issued, this was either not done or was not done timely.

Corrections:
Participants need to be better informed about their responsibilities to repay plan loans. The Plan Administrator needs to implement procedures to remind participants of loan repayment obligations. The loans which are technically in default should be so categorized. The participant should be notified. Form 1099 should be issued either on a current or amended basis depending on when the default occurred. Current defaults in calendar year 1999, if any, may still be within a grace period and may be cured by participant payment.

Loan balances in technical default will not be written off. They are considered to be deemed distributions, but not actual distributions. Subsequent payments to loans which have been in default should still be applied to the loan balance.

IRS Guidance:
Based on our discussion, we believe that the issues outlined above are appropriate for the voluntary correction program, Administrative Policy Regarding Self-Correction (''APRSC''). Under the guidelines of Rev. Proc. 98-22 and Rev. Proc. 99-13, it would appear that the above mentioned matters are within the scope of Section 8 of Rev. Proc. 98-22.
Section 8 states:

SECTION 8. SELF-CORRECTION OF INSIGNIFICANT OPERATIONAL FAILURES
.01 Requirements. The requirements of this section are satisfied with respect to an Operational Failure if the Operational Failure is corrected and, given all the facts and circumstances, the Operational Failure is insignificant. This section is available for correcting an insignificant Operational Failure even if the plan or plan sponsor is Under Examination.

Any further guidance or confirmation on this matter which you can provide to us is greatly appreciated.

Very truly yours,

Robert V. Lally