This blog provides an overview of potential financial and tax options or consequences to a participant of a qualified retirement plan when the participant has an outstanding qualified plan loan from the account when the plan or employment terminates.

Plan Loan Offset, Generally. A plan loan offset occurs when, pursuant to the plan loan terms, a participant’s benefit is reduced to repay the qualified plan loan.  The terms governing the plan loan to a participating employee may provide that, upon termination of the plan, employee’s account balance is automatically offset by the amount of any unpaid loan balance to repay the outstanding loan. “[T]he term ‘plan loan offset amount’ means the amount by which the participant’s accrued benefit under the plan is reduced in order to repay a loan from the plan.” See 26 U.S.C. § 402(c)(2)(C)(iii).

Tax Cuts and Jobs Act of 2017 (eff. Jan. 6, 2021). These final regulations (26 C.F.R. § 1.402(c)-3) extended the deadline to repay a qualified plan loan offset when an employee’s employment is terminated or if the plan terminates. Previously, there was generally a 60-day window to pay the outstanding balance. The Treasury Regulations extend that time frame until the due date of the employee’s federal income tax return, including filing extensions, but a 60-day period still exists for plan offsets that is not a qualified plan loan offset amount.

26 C.F.R. § 1.402(c)-3(a)(2)(ii)—Rollover period for a plan loan offset amount –

• (A) Plan loan offset amount that is not a qualified plan loan offset amount. A distribution of a plan loan offset amount that is an eligible rollover distribution and not a qualified plan loan offset amount may be rolled over by the employee (or spousal distributee) to an eligible retirement plan (as defined in § 1.402(c)-2, Q&A-2) within the 60-day period set forth in section 402(c)(3)(A).
• (B) Plan loan offset amount that is a qualified plan loan offset amount. A distribution of a plan loan offset amount that is an eligible rollover distribution and that is a qualified plan loan offset amount may be rolled over by the employee (or spousal distributee) to an eligible retirement plan within the period set forth in section 402(c)(3)(C), which is the individual’s tax filing due date (including extensions) for the taxable year in which the offset is treated as distributed from a qualified employer plan.

The terms governing the plan loan to employee may provide that, upon termination of the plan, employee’s account balance is automatically offset by the amount of any unpaid loan balance to repay the outstanding loan. Pursuant to the recent Treasury Regulations, the offset occurs, but the employee may roll over up to the amount of the qualified plan loan offset amount to an eligible retirement plan within the period that ends on employee’s tax filing due date (including extensions) for the taxable year in which the offset occurs.

Basically, a plan participant can avoid paying taxes on the plan loan offset amount by timely rolling that amount over to another qualified retirement plan listed in 26 U.S.C. § 72(p)(4)(A)(I)-(III)).

Options to Repay Qualified Loan Offset Amount. The funds for the rollover must come out-of-pocket so that the rollover amount can extinguish the loan liability. The participant can also use qualified loan proceeds to pay all or some of the rollover amount, so, depending on the participant’s account balance and outstanding loan balance, a “new” qualified loan could be taken from the new qualified plan after rolling over the balance from the prior plan. That new loan would be subject to repayment within 5 years (with limited exception for loan for a dwelling). See 26 U.S.C. § 72(p)(2)(B). But, the “new qualified loan” option would allow more time to pay off the new loan versus paying the rollover loan offset amount by the tax-filing deadline for the applicable tax year.  Alternatively, the participant can obtain and use a bank loan, employer loan, or other outside funding source to fund and pay the rollover offset amount.

Considerations for Employer Loans. An employer may want to assist an employee with respect to satisfying a rollover amount payable for a loan against a qualified plan. In these circumstances, a formal written loan agreement and note are required, and 26 U.S.C. § 7872 – Treatment of loans with below-market interest rates – is relevant. Section 7872 applies to gift loans – being any below-market loan where the forgoing of interest is in the nature of a gift – compensation-related loans between employer and employee, and below-market tax-avoidance loans (i.e., a below-market loan the principal purpose of which is to avoid federal income tax).

For loans covered by section 7872 and that are $10,000 or greater in amount, the interest rate on the term loan should be at least the Applicable Federal Rate (AFR) in effect as of the date of the loan.  For loans under $10,000, the interest rate may but need not be at least the AFR, unless one of the principal purposes of the loans is to avoid federal taxes.

If the interest rate is less than the required AFR, the difference between the interest that would have been paid using the applicable AFR and the interest at the rate actually used will constitute taxable compensation income to the employee. See 26 U.S.C. § 7872 (a), (e)(1)-(2) (defining below-market loan and foregone interest), (f)(6) (defining term loan). And, in the case of below-market term loans, the employee will recognize taxable compensation and the employer will recognize compensation expense on the date the loan is made. Id. at § 7872(b).

As indicated, section 7872 permits an exception to AFR for compensation-related loans that do not exceed $10,000 and a principal purpose of which is not to avoid federal tax. See id. at § 7872(c)(3)(A)-(B) (“(A) . . . , this section shall not apply to any day on which the aggregate outstanding amount of loans between the borrower and lender does not exceed $10,000. (B) Subparagraph (A) shall not apply to any loan the interest arrangements of which have as 1 of their principal purposes the avoidance of any Federal tax.”). For the exception-to-the-exception for sub-$10,000 loans, tax avoidance is a “principal purpose” of the interest arrangement if it is a principal factor in the decision to structure the transaction as a below-market loan, rather than a loan requiring the payment of interest at a rate that equals or exceeds the AFR and a payment by the employer to the employee. See IRS PLR 202137006 at pg. 5 (non-binding authority).

Also, if the employer decides to defer and not require payment of the interest for a period time (and the terms of the written loan documents provide for such deferral), thus giving the employee an opportunity to payoff the loan without interest, the deferred interest would likely be treated as being below-market. Deferred interest as such would likely be treated as “forgone interest” as that term is used in section 7872 and as defined in 26 U.S.C. § 7872(e)(2).

Insights. These types of transactions are not simple, and, in particular, section 7872 takes a simple concept—a loan—and complicates the matter for employer-to-employee loans and other loans covered by that section. For plan loan offsets, a borrowing participant (and perhaps plan-offering employers) should evaluate the options available for employees to pay off an outstanding qualified plan loan against a qualified plan when the plan or employment terminates. The form loan agreement used for the loan participants and the plan document may have provisions that cover, control, or address this situation (in whole or in part), although the plan terms may be supplemented or even controlled by recently-adopted Treasury Regulations on this subject. The Tax Cuts and Jobs Act of 2017 (eff. Jan. 6, 2021) provides borrowers an opportunity to extend the deadline to repay a qualified plan loan offset when an employee’s employment is terminated or if the plan terminates. Borrowers have options for satisfying that plan loan offset, and each of the options carry with it different financial and tax considerations. For example, and as an initial step, the participant borrower should seek to confirm with the plan administrator or legal counsel that the unpaid plan loan will be treated as a loan offset and not a deemed distribution; the latter usually cannot be rolled over and may be required to be repaid during the 60-day period following the offset. See 26 C.F.R. § 1.402(c)-3(a)(2)(iii)(A) (“A distribution of a plan loan offset amount is an actual distribution, not a deemed distribution under section 72(p).”); 26 U.S.C. § 72(p)(1)-(2).

Resources

26 C.F.R. § 1.402(c)-3 – See Examples 1, 2, and 3. Section 1.402(c)-3, eff. Jan. 6, 2021, regarding 2017 Tax Cuts and Jobs Act that permits an extension beyond the normal 60-day period to roll over the amount of loans from certain retirement plans, such as 401(k) and 403(b) plans, that are offset and treated as distributions.

Federal Register, Rollover Rules for Qualified Loan Offsets – explanation and descriptions regarding Treasury Regulation 1.402(c)-3, eff. Jan. 6, 2021.

26 U.S.C. § 402(c)(2)(C)(i)-(ii) – “Qualified plan loan offset amount For purposes of this subparagraph, the term “qualified plan loan offset amount” means a plan loan offset amount which is treated as distributed from a qualified employer plan to a participant or beneficiary solely by reason of – (i) the termination of the qualified employer plan, or (ii) the failure to meet the repayment terms of the loan from such plan because of the severance from employment of the participant.”

26 U.S.C. § 402(c)(2)(C)(iii) – “For purposes of clause (ii), the term “plan loan offset amount” means the amount by which the participant’s accrued benefit under the plan is reduced in order to repay a loan from the plan.”

26 C.F.R. § 1.402(c)-3(a)(2)(iii)(B) – defining Qualified plan loan offset amount for purposes of 26 U.S.C. § 402(c)). “For purposes of section 402(c), a qualified plan loan offset amount is a plan loan offset amount that satisfies the following requirements: (1) The plan loan offset amount is treated as distributed from a qualified employer plan to an employee or beneficiary solely by reason of the termination of the qualified employer plan, or the failure to meet the repayment terms of the loan because of the severance from employment of the employee; and (2) The plan loan offset amount relates to a plan loan that met the requirements of section 72(p)(2) immediately prior to the termination of the qualified employer plan or the severance from employment of the employee, as applicable.”

26 C.F.R. § 1.402(c)-3(a)(2)(iii)(C) – defining Qualified employer plan for purposes of section 402(c) as a qualified employer plan defined in section 72(p)(4), which includes employer annuity plans under section 403(b).

26 U.S.C. § 72(p)(1) – Treatment as distributions; and subsection (p)(2) – Exception for certain loans; qualifying factors that, if applicable, will except the loan from treatment as a distribution.

Have a question? Contact Cory Halliburton, Freeman Law.