The difference between the timing of a deemed distribution and a loan offset causes considerable confusion in reporting defaulted participant loans. The method in which a practitioner reports a defaulted loan also is affected by whether the loan is a participant-directed loan or a general trust fund loan. Since plans generally treat loans as participant-directed, we will focus on the reporting of those types of loans.

If a participant misses a loan payment and does not make-up the payment by the end of the plan’s grace period, the plan must treat the defaulted loan as a deemed distribution. However, if the participant has not incurred a distributable event either because (1) the loan is secured on 401(k) plan elective deferrals (or amounts treated like deferrals [e.g., safe harbor contributions]) or money purchase plan contributions, or (2) the plan does not treat defaulted loans as an in-service distribution event, the plan may not offset the loan. In other words, the defaulted loan continues to be part of the participant’s account balance. The plan also will continue to accrue interest. However, the interest is not reportable for tax purposes. The interest is relevant for purposes of top-heavy determinations and for determining the limits of future loans.

The deemed distribution amount will include interest accrued up until the date the plan treats the loan as a deemed distribution. The plan reports the deemed distribution on a Form 1099-R with a Code “L” in box 7. If the participant is not 59½ as of the end of the grace period, the plan also will include a code “1” which indicates the deemed distribution also is subject to the 10% premature distribution tax. If the participant’s account includes basis, the plan would allocate the appropriate basis to the deemed distribution, which would reduce the taxable amount of the distribution.

For Form 5500 purposes, the plan would report the deemed distribution on line 2g of Schedule H or I. The deemed distribution also would be subtracted from the end of the year balance on line 1c(8)(b) (Schedule H) or line 1a(b) (Schedule I). If the plan is not able to offset the defaulted loan, the plan will have a discrepancy between the plan accounting and the Form 5500 financial statement. The discrepancy is not a problem. The practitioner, however, should recognize it so he/she does not waste countless hours attempting to make an unnecessary correction.

If the plan is not able to offset a defaulted loan when it treats the loan as a deemed distribution, the plan will offset the loan later when a distributable event occurs (e.g., upon termination of employment). When the plan offsets the loan, the offset will not be reportable as a distribution on the Form 5500 nor on the Form 1099-R. The plan simply offsets the loan against the participant’s account balance. Although a participant generally may roll over a loan offset, the participant may not roll over this type of loan offset because there is no reportable distribution.

Example: Jim ceases making payments on his participant loan (participant directed) in February of 2004. The plan treats the loan as a deemed distribution on June 30, 2004 when the outstanding loan balance is $6,200. The plan reports the $6,200 on Form 1099-R with codes “L” and “1” in box 7. The plan also reports the loan on line 2g of Schedule H and subtracts the loan from line 1a(b) of Schedule I. Since the loan is secured on Jim’s 401(k) account balance, the plan is not able to offset the loan. On July 15, 2005, Jim terminates employment with an account balance of $36,580, including an outstanding loan balance of $6,580. The loan balance includes $380 of interest that accrued subsequent to the deemed distribution. The plan offsets the loan but does not report the offset on a Form 1099-R nor on the Form 5500. The plan will report the $30,000 distribution on the Form 1099-R and on the Form 5500.

A participant who recommences payments on a loan treated as a deemed distribution will create basis in his/her account. The plan also will need to reverse the reporting on the Form 5500. The plan will report the loan as a negative amount on line 2g (Schedule H or I) and add the loan to the end of the year balance for that year.

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