Loan

A participant took a loan from a k plan in feb 2002, and completed all the applicable paperwork, etc...

The employer never took payroll dedcutions.....is the loan in default? Or can the Employer begin deductions now?

The plan admin has a problem if no payroll deduction is made by the employer as required by the plan/note. One solution is to recind the note and commence the loan as of Dec 2002 with a new note since the participant cannot make up the deductions for 10 months at this time. However, the new loan and note must be executed before the end of 2002 to keep the recission in the same tax year. There is no official correct answer but the participant should not be taxed on the loan because the er failed to make the withholding.

We were thinking of doing new paperwork, but thought that technically the loan is in default and therefore would be in violation if we didn't default and issue a 1099-r.

is there some cite or IRS/DOL guidance you could provide that would provide some back up to your suggestion?

I respectfully disagree with mbozek. I don't see any authority for rescinding the loan to avoid the default.

no- other than it is egregious to tax the plan participant for the amount of the loan because of the employer's failure to commence withholding. I think the employee has a claim for the taxes due because of the negligence of the employer. Therefore it is in the interest of the Plan admin and employer to recind the note under the theory that the loan needs to be reformed. The employee should repay the loan amount and the plan admin should reissue the loan.

The authority for recinding the loan is mutual mistake- the participant never intended to recieve a distribution instead of a loan and the plan admin never intended that withholding not be made since the note required withholding. Therefore the loan can be rescinded and a new loan issued to the participant.

The loan is in default. The ultimate responsibility for repaying the loan is on the participant. Payroll deduction is a convenience - not a requirement.

If the participant agreed to have payments withheld by salary deduction as a condition of the loan it is not a convenience but a term of the loan. Most notes require witholding by payroll deduction to prevent default. The failure to withhold makes the loan invalid from inception and permits recission. If you want to hold the loan in default then who will pay the taxes - the participant, the plan admin or the employer? Recission offers an option to clean up an inequitable result because of an oversight by the employer.

What may have been an oversight by the employer was probably not an oversight by the employee. He should have taken steps to correct this error just as he would any other error affecting his paycheck. Don't you think the participant just thought he had a stroke of good luck? My position would be to issue a 1099-R for a defaulted loan and let the participant and employer argue over who pays the taxes and penalties.

If the employee has a claim against the employer for creating a tax burden from the default - Isn't it still the responsibility to the employee to mitigate damages?

I would have to believe that if the employee waited 10 months before notifying their employer that they forgot withholding, then it could be argued that the employee did not mitigate the damages and should be held responsible.

Without knowing more facts and getting the testimony of all sides it is impossible to know what happened and what the employee was told. Feel free to ask and answer those questions.

There was a loan. The employee did not repay it in the manner required by Section 72(p) and the regulations, including the grace period rules (I assume). Therefore, there was a default triggering a deemed distribution. Case closed.

Does employee have a claim for damages? Maybe; who knows.

The default is contingent on the existance of a valid contractual loan before default. The advance of the funds to the employee does not mean that a loan existed if the terms of the loan were not complied with because of the failure to initiate payroll withholding. Hence the employee had no legal right to recieve the funds. Employees are not taxed on an advance of money that they have no legal right to recieve if the funds are returned to the party who advanced the funds before year end. See Rev. Rul. 79-311.

The payroll deduction is not the consideration that makes this a vaild loan. It is the loan note and promise to repay. The payroll deduction is just a method to accomplish repayment.

This is a clearly valid loan.