Reporting defaulted participant loans is one of the more challenging aspects of plan administration. In order to report a defaulted loan properly, a practitioner must understand the difference between a defaulted loan treated as a deemed distribution and a defaulted loan that the plan offsets. Code §72(p) and the plan’s loan policy will dictate the events that constitute default. Generally, a default occurs because the participant fails to make loan repayments. The plan may provide a grace period in which a participant may make up the missed payments, but the grace period may not extend beyond the last day of the calendar year quarter beginning after the missed payment. Once the grace period has expired, the loan is in default and the plan must report the defaulted loan on a Form 1099-R.

A defaulted loan will be considered either a deemed distribution or a loan offset, but not both. If the participant defaults on a loan when a participant has a distributable event, the plan will offset the loan (i.e., reduce the participant’s account balance), the loan is discharged and is no longer part of the participant’s account balance. The IRS considers a loan offset as an actual distribution, so the plan will report the offset on a Form 1099-R (using codes “1” or “7”) and on the Form 5500 (line 2(e) of Schedules H or I) as such. The plan also subtracts the loan offset from the plan assets (Sch. H, line 1c(8); Sch. I, lines 1a and 3e).

A plan often is unable to offset a defaulted loan of an actively employed participant either because the plan does not permit in-service distributions or because the loan is secured on account balances that do not permit in-service distributions (e.g., 401(k) deferrals, 401(k) contributions subject to distribution restrictions [QNECs, QMACs and safe harbor contributions], or pension plan contributions). However, an employer may provide for in-service distributions for profit sharing plan and matching contributions upon stated events, such as loan default. Therefore, if the plan secures the loan with the profit sharing or matching contributions, the plan could offset the loan upon default if the plan provided for an in-service distribution upon a loan default. However, because it is difficult to allocate security for a loan in a 401(k) plan to the “nonrestricted” portion of the account, many practitioners do not take advantage of this option.

If a participant defaults on a loan when the participant does not have a distributable event, the plan may not offset the loan but must report the defaulted loan as a deemed distribution. The plan reports the deemed distribution on a Form 1099-R with a code “L” in box 7 and a code “1” if the participant is subject to the 10% premature distribution tax. For purposes of the Form 5500, the plan will report the deemed distribution on line 2g of Schedule H or I, and will reduce the plan assets as of the end of the year by the amount of the deemed distribution (Sch. H, line 1c(8); Sch. I, lines 1a and 3(e)). Even though the deemed distribution no longer is part of the plan assets for Form 5500 reporting purposes, the defaulted loan continues to be a plan asset for purposes of vesting, top heavy and qualification for future loans. Accordingly, the plan must continue to accrue interest (“phantom” interest) on the loan until the plan offsets the loan. The additional interest, however, is not reported on a Form 1099-R or on the Form 5500.

Later, when the participant incurs a distributable event, the plan will offset the loan. However, when the deemed distribution precedes the loan offset, the plan does not report the later offset on a Form 1099-R nor on the Form 5500. The plan merely reduces the account balance paid to the participant by the amount of the loan.

Example. On May 1, 2004, Bill (age 42) obtains a $5,000 participant loan from his company’s profit sharing plan with a five-year repayment period. The plan treats a loan default as an in-service distribution event. On May 1, 2005, Bill stops making loan payments while still employed by the company. As of September 30, 2005 (the close of the plan’s grace period), the unpaid loan principal is $4,200 and the accrued interest is $100 (5/05 through 9/05). The plan offsets the loan against Bill’s account balance and reports the offset ($4,300) as an actual distribution on a Form 1099-R (code 1 in box 7) and on the Form 5500.

Example. Assume the same facts except Bill participates in a 401(k) plan that does not provide for distribution until the earlier of (1) severance from employment, or (2) attainment of age 59½. Since Bill has not incurred a distributable event when he defaults on the loan, the plan reports the defaulted loan as a deemed distribution and it is not permitted to offset the loan. The plan reports the deemed distribution on a Form 1099-R with a codes L and 1 in box 7. For Form 5500 purposes, the plan (a “small” plan) subtracts the deemed distribution from Schedule I lines 1a(b) and 3e as of the end of the year and reports the amount of the deemed distribution on line 2(g). Since the loan is not offset, the plan will continue accruing interest. However, the plan will not report the phantom interest on a Form 1099-R. In 2007, Bill severs employment with a loan balance of $4,700 and a non-loan balance of $24,000. The plan offsets the loan and reports the $24,000, but not the loan offset, on the Form 1099-R.

SunGard Corbel will present a half-day Participant Loans Specialty Workshop. The program will cover all aspects of participant loans. This half-day program will be offered in May and June at locations throughout the country. To view the agenda and register for the program, go to www.sungardcorbel.com/products/seminarspension.asp and click on the Participant Loans Specialty Workshop.