Recent IRS snapshot regarding assumed distributions for affiliate loans reminds employers of the risk of failure with plan loans
The IRS recently published an issue snapshot (the “snapshot“), Which focus on retirement benefit participant loans and when certain compliance errors could trigger an assumed payout in respect of such loans. Specifically, the snapshot lists the following requirements, the failure of which will result in a participant loan being treated as an accepted distribution:
- Requirement of an enforceable agreement, which generally requires that an affiliate loan be a legally enforceable agreement (which may contain more than one document) and the terms of the agreement demonstrate compliance with applicable requirements of the Code.
- Credit limit limit, which generally limits the maximum amount of a participant loan to the amount set out in the Code. The snapshot also noted that the CARES Act allows changes to the credit limit for certain loans to “qualified individuals”.
- Repayment period, which basically requires that the repayment period of a loan is limited to five years, unless the loan is to acquire the main residence of the participant. The snapshot also noted that the CARES Act allowed for the loan repayment period of certain loans to be extended to qualified individuals.
- Even payment amounts and quarterly payment obligations, which generally require a substantially even repayment over the term of a loan, with payments not being made less frequently than quarterly. The snapshot also found that if a participant fails to make any installment payments when due, an assumed distribution will occur. If a participant fails to make an installment, the plan may include a recovery period that cannot extend beyond the last day of the calendar quarter following the calendar quarter in which the required installment was due.
The publication of this snapshot by the IRS confirms what benefits practitioners are well aware – mistakes in loan planning are not uncommon. To reduce the risk of failure with planned loans, plan promoters should consider reviewing their plan operations with respect to planned loans at least once a year. This review should include a review of (i) the loan application process (including notices to participants regarding loan repayment), (ii) the submission of credit information to the payroll department or provider, and applicable procedures to ensure that the correct deduction is made is entered (especially if it is a manual process), (iii) the process of ensuring the payback period does not exceed five years from the date of loan, and (iv) the third party loan default administrator’s procedures if an employee resigns.
Employers should also review which types of employees are most likely to use credit and consider design changes that may reduce the risk of suspected payouts. For example, if the employer’s workforce fluctuates frequently, the employer may also consider allowing participants to repay loans through ACH (instead of the wage deduction) so that payments can continue after termination to reduce the number of distributions accepted, which occur when employees terminate the employment relationship. An ACH repayment process has both advantages and disadvantages, and employers should consult with their legal counsel and external administrators before implementing ACH as a repayment method.
By carefully designing the plan’s loan program and performing regular tax audits, plan sponsors can reduce the risk of costly compliance errors and help prevent the negative impact that accepted distributions can have on retirement benefits.
The snapshot is available here.