Loans as Prohibited Transactions
Rev. 06/21/10; E-mail Alert 2010-9

The IRS recently published findings regarding their examination of small plans and participant loans, with the results indicating a significant amount of non-compliance.  The IRS’s Learn, Educate, Self-Correct, and Enforce (LESE) examination project #2 sampled 50 plans with Form 5500s that reported 10 or fewer participants and loan amounts in excess of $100,000.  It was discovered that 17 out of the 50 plans were involved in prohibited transactions.  The examinations resulted in a total of 47 Form 5330 returns being filed, excise taxes being paid, and restorative loan repayments with interest deposited into the plans to bring the loans back into compliance.  

This article will cover the correction methods available for some of the most common errors involving the administration of participant loans.  Plan sponsors that voluntarily correct errors as soon as they are discovered can avoid being subject to penalties and civil investigations in the future.

Many employers make loans available to plan participants.  The two Internal Revenue Code sections that must be met involving participant loans within a qualified plan are:

• §72(p), the taxability of participant loans
• §4975(d), prohibited transactions

A participant loan will become taxable if it fails to meet these statutory requirements.  The IRS offers correction methods that plan sponsors must use in order to properly fix loan violations, ultimately bringing a plan back into compliance and helping the participant to avoid taxation.

IRS loan corrections under EPCRS Rev. Proc. 2008-50
The following three types of errors must be corrected through the IRS’s Voluntary Correction Program (VCP), which involves the filing of VCP documentation with the IRS and paying the appropriate VCP fee.  These loan corrections cannot be fixed under the IRS' Self Correction Program (SCP). 

1) Loan in excess of maximum available amount, Rev. Proc. 2008-50, Section 6.07(2)(b)
When a loan is issued in excess of the maximum available amount, EPCRS requires the excess loan amount to be repaid to the plan plus interest.  After the correction is made the loan may be re-amortized over the duration of the original loan.  In the event that loan repayments were made prior to the discovery of the error, the plan administrator must decide how to treat these prior repayments. 

2) Loan not in compliance with maximum repayment schedule, Rev. Proc. 2008-50, Section 6.07(2)(c). When the terms of a loan are in excess of the allowable repayment period, the loan will need to be re-amortized over a remaining period that is in compliance with the original date of the loan.

Example: An individual requests a general loan with repayments of 7 years on June 6, 2010.  In June 2011, while performing the plan’s annual audit, it is discovered that this loan amortization schedule is two years greater than the allowable five-year maximum loan term. 

Required correction:  Re-amortize the loan for five-years, using June 6, 2010 as the starting date.  The loan will need to be repaid by June 6, 2015.

3) Failure to make repayments in accordance with loan terms, Rev. Proc. 2008-50, Section 6.07(3). When repayments are not properly made and the loan terms satisfy the requirements of 72(p)(2) the failure may be corrected by:

• A lump sum repayment equal to the amount of missed payments (plus interest); or
• Re-amortizing the outstanding balance of the loan (including interest) over the remaining period of the loan or the remaining period had the loan originally been amortized over the maximum allowable period; or
• A combination of 1 & 2

Plan Amendment Correction Method, Rev. Proc. 2008-50, Section 6.07(2)(c)
If a plan that does not allow participant loans somehow processes a participant loan request, EPCRS allows for this to be corrected by retroactively amending the plan to provide for participant loans.  This option is permitted only if the amendment satisfies §401(a) and the loan requirements under §72(p) were satisfied at the time the loan was issued.

DOL loan corrections under the EBSA’s Voluntary Fiduciary Correction (VFC) Program
The VFC Program was created to allow plan sponsors the ability to correct specific prohibited transaction violations and avoid penalties imposed under ERISA §502(i).  The VFC Program was updated in 2006, adding “Participant Loans Failing to Comply with Plan Provisions for Amount, Duration, or Level Amortization” and “Default Loans” as additional violation categories available for correction under the program.

The VFC Program allows for the loan violation categories to be corrected using EPCRS VCP.  After a correction is made under EPCRS and the plan sponsor receives a compliance statement from the IRS they must send the IRS compliance statement and proof of payment of any penalties under VCP to the EBSA.  If all of the VCP Program requirements are met the plan sponsor will receive a “no action” letter from the EBSA.

The VFC Program also includes the required correction for the late transmittal of participant loan repayments.  Loan repayments are subject to the same deposit deadlines as elective deferrals.  Click here for our article that discusses the deposit deadlines.

Prohibited transaction correction in addition to VCP correction
Many plan sponsors that correct loan violations through VCP may not be aware that if the loan violation involves a disqualified person they will also be responsible for remedying a prohibited transaction violation.

Disqualified persons are officers, directors, 10% shareholders, or highly compensated employees of the plan sponsor (or certain related companies), as well as their family members, fiduciaries, and certain other persons.  Prohibited transaction rules prevent a plan from loaning money to a disqualified person, however a prohibited transaction exemption was created to allow for a disqualified person who is also a participant in a plan to take a participant loan.  In order to be exempt from prohibited transaction violations the loan must:

• Be made available to participants and beneficiaries on a reasonably equivalent basis,
• Not be made available to highly compensated employees in an amount greater than the amount made available to other employees,
• Be made in accordance with plan terms,
• Bear a reasonable rate of interest, and
• Be adequately secured.

Example: The owner of a company takes a participant loan with the intention of paying it back “by the end of the year”.  The loan amount is for 75% of her account balance, no amortization schedule is created, and the interest rate is zero percent.  The plan administrator discovers this violation and complies with the appropriate VCP correction.  Because this error involves a disqualified person the owner will also be responsible for paying a 15% excise tax and filing Form 5330 with the IRS.

Correction of the prohibited transaction violation will require repayment of the excess loan amount, filing of Form 5330, and payment of the 15% excise tax imposed by the IRS.

Plan sponsors should periodically review the operation of their participant loan program to ensure their plan is in compliance with all statutory requirements.  Non-compliance can result in complex administrative corrections, expensive penalties, and adverse tax consequences to plan participants.

For more information, check out our Participant Loan eSeminar by clicking here.