A loan that is treated as a deemed distribution is not considered as a distribution for purposes of 401(a). The section 436 limitations are referenced in 401(a)(29). A loan offset is a distribution. But, if the distribution restrictions would not allow the participant with a defaulted loan to receive a distribution, I think that would prevent the plan from offsetting the loan and the loan default would be a deemed distribution instead.
1.72(p)-1
QUOTE
Q-12: Is a deemed distribution under section 72(p) treated as an actual distribution for purposes of the qualification requirements of section 401, the distribution provisions of section 402, the distribution restrictions of section 401(k)(2)(B) or 403(b)(11), or the vesting requirements of §1.411(a)-7(d)(5) (which affects the application of a graded vesting schedule in cases involving a prior distribution)?
A-12: No; thus, for example, if a participant in a money purchase plan who is an active employee has a deemed distribution under section 72(p), the plan will not be considered to have made an in-service distribution to the participant in violation of the qualification requirements applicable to money purchase plans. Similarly, the deemed distribution is not eligible to be rolled over to an eligible retirement plan and is not considered an impermissible distribution of an amount attributable to elective contributions in a section 401(k) plan. See also §1.402(c)-2, Q&A-4(d) and §1.401(k)-1(d)(5)(iii).
Q-13: How does a reduction (offset) of an account balance in order to repay a plan loan differ from a deemed distribution?
A-13: (a) Difference between deemed distribution and plan loan offset amount. --(1) Loans to a participant from a qualified employer plan can give rise to two types of taxable distributions --
(i) A deemed distribution pursuant to section 72(p); and
(ii) A distribution of an offset amount.
(2) As described in Q&A-4 of this section, a deemed distribution occurs when the requirements of Q&A-3 of this section are not satisfied, either when the loan is made or at a later time. A deemed distribution is treated as a distribution to the participant or beneficiary only for certain tax purposes and is not a distribution of the accrued benefit. A distribution of a plan loan offset amount (as defined in §1.402(c)-2, Q&A-9(b)) occurs when, under the terms governing a plan loan, the accrued benefit of the participant or beneficiary is reduced (offset) in order to repay the loan (including the enforcement of the plan's security interest in the accrued benefit). A distribution of a plan loan offset amount could occur in a variety of circumstances, such as where the terms governing the plan loan require that, in the event of the participant's request for a distribution, a loan be repaid immediately or treated as in default.
(b) Plan loan offset. In the event of a plan loan offset, the amount of the account balance that is offset against the loan is an actual distribution for purposes of the Internal Revenue Code, not a deemed distribution under section 72(p). Accordingly, a plan may be prohibited from making such an offset under the provisions of section 401(a), 401(k)(2)(B) or 403(b)(11) prohibiting or limiting distributions to an active employee. See §1.402(c)-2, Q&A-9(c), Example 6. See also Q&A-19 of this section for rules regarding the treatment of a loan after a deemed distribution.