I know there is an exception to the 10% early withdrawal penalty due to death. However, I could not find if the exception applies if the deceased participant has an outstanding loan balance. Any help will be greatly appreciated....

According to the instruction for Form 1099-R, "If a participant’s accrued benefit is reduced (offset) to repay a loan, the amount of the account balance that is offset against the loan is an actual distribution. Report it as you would any other actual distribution."

The deemed distribution with regards to the payment of a participant's loan was triggered due to the death of the participant. An exception to the 10% early withdrawl penalty is a distribution upon the death of a participant. Accordingly, a distribution caused by the death of a participant to satisfy an outstanding loan balance is not subject to the 10% early withdrawl penalty.