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Missed Payment Resulted in Deemed Distribution of Loan from Qualified Profit Sharing Plan

(Parker Tax Publishing August 2017)

The Tax Court held that a taxpayer who took out a loan from her qualified profit sharing plan and failed to make timely payments while on maternity leave from her job received a taxable deemed distribution in the amount of the outstanding balance of the loan plus any accrued interest. While the taxpayer was also liable for the 10 percent additional tax on early distributions, the court found that she qualified for the reasonable cause exception to the 20 percent accuracy related penalty. Frias v. Comm'r, T.C. Memo. 2017-139.

In 2012, Louelia Frias worked as an administrator at Glen Island Center for Nursing and Rehabilitation (Glen Island) in New Rochelle, New York. In July of that year, Frias was granted a leave of absence from work because she was expecting her third child. Frias used her accrued sick, personal and vacation leave which covered approximately five weeks of her leave. The remainder of the leave was unpaid. Frias began her leave in July 2012 and returned to work in October 2012.

Also in July 2012, Frias took out a $40,000 loan from her qualified profit sharing plan. She entered into a loan repayment payroll deduction agreement which called for after-tax salary deductions in each payroll period for the amounts necessary to make the loan repayments. The anticipated biweekly payment was approximately $341, with payments scheduled to begin in August 2012. Under the agreement, if Frias missed a payment, she could pay the delinquent amount up to the last day of the month following the month the payment was due. If she failed to make the payment during that period, the entire loan would be in default and the outstanding amount of the loan would be reported as a distribution to her.

Glen Island failed to deduct and to remit Frias's loan repayments from her paychecks. Frias did not know that Glen Island had failed to withhold her loan payments until she was told by a representative of Glen Island when returned to work. Frias immediately made a $1,000 payment when she learned of Glen Island's failure in November 2012. She then instructed Glen Island to withhold and remit payments of $500 from her paychecks, and continued making payments on the loan until it was repaid in July 2014.

Frias received a Form 1099-R for 2012 showing a taxable distribution of approximately $40,000. Although the form was available online and Frias had access to the website, Frias did not review the form and did not report a distribution with respect to the loan on her 2012 tax return. Frias received a notice of deficiency in 2014. The IRS determined that Frias had received a taxable distribution from her plan account and that she was liable for additional tax under Code Sec. 72(t), which imposes a 10 percent additional tax on early distributions from qualified retirement plans. Frias was also liable for a 20 percent accuracy related penalty under Code Sec. 6662, according to the notice. Frias petitioned the Tax Court for redetermination.

Under Code Sec. 72(p), a loan from a qualified employer plan is not a distribution if the loan (1) is manifested in a legally enforceable agreement, (2) does not exceed the statutory limits, (3) by its terms is to be repaid within five years, and (4) has substantially level amortization over the term of the loan with payments made at least quarterly. A deemed distribution can arise if any of these requirements are not satisfied. The regulations under Code Sec. 72 permit the plan administrator to provide an opportunity for the participant to cure the failure, and a deemed distribution does not occur unless the participant fails to pay the delinquent payment within the cure period. The regulations also provide that a participant is exempt from the substantially level amortization requirement during a bona fide leave of absence for no longer than one year either without pay or at a rate of pay less than the required installment payments.

The IRS contended that when Frias failed to make her first loan payment and did not correct the failure within the cure period, the loan violated the substantially level amortization requirement and resulted in a taxable deemed distribution. Frias responded that she was on a leave of absence without pay and that the substantially level amortization requirement did not apply while she was on leave. Frias claimed that the paychecks she received while on leave were not considered pay and that the use of her accrued sick, personal and vacation time was not pay for purposes of Code Sec. 72 because the Family and Medical Leave Act (FMLA) permits employees on unpaid leave to use accrued paid vacation, sick or personal days for all or part of the FMLA leave. Frias also argued that there was no distribution because (1) all parties to the loan acted as though they agreed to suspend payments, (2) the substance of the repayments should be honored over the form that was required, or (3) Frias corrected the default in accordance with Rev. Proc. 2008-50.

The Tax Court held that Frias received a taxable deemed distribution of the outstanding balance of her Code Sec. 401(k) loan plus any accrued interest when she defaulted on the loan in 2012. Frias was also liable for the 10 percent additional tax under Code Sec. 72(t). She was not, however, subject to the accuracy related penalty under Code Sec. 6662 because she had reasonable cause and acted in good faith under the facts and circumstances.

The Tax Court determined that Frias received a deemed distribution because she failed in August 2012 to make her first loan payment by the due date and did not make a delinquent payment before the expiration of the cure period in September 2012. According to the Tax Court, Frias's failure to make the required payment resulted in a violation of the substantially level amortization requirement, which requires that payments of principal and interest be made in substantially level amounts over the term of the loan. The Tax Court further held that Frias did not qualify for the exception to the substantially level amortization requirement for participants on leave without pay because Glen Island paid Frias compensation for accrued sick, personal and vacation time during the first five weeks of her approved leave from work, and during that time, Frias's paychecks were for amounts greater than the required installment payments.

In the Tax Court's view, the right of an employee during FMLA leave to receive payments for leave earned by the employee did not excuse Frias's failure to make loan payments from compensation she received during the first five weeks of her leave. Frias's argument that there was an agreement by the parties to suspend payments was rejected because, according to the Tax Court, if such an agreement existed, it should have been evidenced by a writing or qualifying electronic medium. The Tax Court also did not find proof that the loan agreement was ever amended, and that Frias's argument for substance over form ignored the express requirements of the loan agreement and applicable regulations. Frias's argument that any default was corrected under Rev. Proc. 2008-50 was also rejected; the Tax Court determined that Rev. Proc. 2008-50 permits plan sponsors to correct noncompliant loans, and requires that the plan sponsor request relief from the IRS. The Tax Court found no evidence that Glen Island requested and received IRS approval, and Frias was therefore not relieved of the substantially level amortization requirement.

The Tax Court also held that the additional 10 percent tax on early distributions under Code Sec. 72(t) applied because Frias presented no arguments that any of the statutory exceptions to the additional tax applied. However, the Tax Court found that Frias qualified for the reasonable cause exception to the accuracy related penalty. Although the fact that Frias did not receive a Form 1099-R was insufficient on its own to constitute reasonable cause, the Tax Court held that it was understandable for Frias to assume her loan payments were being made. Further, Frias showed good faith in the Tax Court's view because immediately on her return to work, she took steps to correct the problem and arranged for increased payments on the loan. The Tax Court reasoned that Frias had no reason to know that this particular loan had tax consequences considering the advice she received from Glen Island and Glen Island's obligation to withhold loan payments under the loan agreement. Further, nothing in the conduct of her employer or the plan administrator during 2012 warned Frias that the loan payment problem had not been properly cured. The Tax Court found that Frias honestly misunderstood the status of her loan at the end of 2012, reasonably relied on her employer and the plan sponsor, and had no reason to question their representations.

For a discussion of qualified plan loans treated as distributions, see Parker Tax ¶131,535.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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