A participant loan that fails to satisfy the taxation requirements (Code §72(p)) is taxable to the participant as a distribution. However, for rollover purposes, the plan must determine whether the loan is taxable to the participant as a “deemed distribution” or as a “distribution of a loan offset.” Treatment of a participant loan as a deemed distribution is merely a tax reporting event and does not affect the participant’s account balance (i.e., the loan continues to part of the participant’s account balance). A deemed distribution also is not an eligible rollover distribution. The IRS, on the other hand, considers a distribution of a loan offset as an actual distribution because the offset reduces the participant’s account balance.

The distribution of a loan offset is an eligible rollover distribution. The participant effects the rollover of a loan offset by contributing the amount of the loan offset to an IRA or plan within the requisite 60-day period.

Example. Assume a plan declares a loan due upon severance from employment. Assume further, Jill severs employment with an $8,000 outstanding loan. Since Jill has incurred a distributable event, the plan offsets the loan and does not treat the loan as a deemed distribution. Accordingly, Jill may avoid the tax consequences of the offset by contributing $8,000 to an IRA or plan within 60 days. The plan would report the offset as an actual distribution and Jill may report on her Form 1040 a taxable amount of “0” for the distribution if she makes the rollover contribution.

A plan treats a participant loan as a deemed distribution if: (1) the terms of the loan fail to meet the taxation requirements (i.e., amount limitations, amortization and enforceable agreement); or (2) the participant’s loan repayment fails to satisfy the amortization requirement (i.e., the participant fails to make the loan payments) and the plan is unable to offset the loan. For example, if the participant obtains a loan that exceeds the 50% limitation or provides for a repayment period that exceeds the 5-year limitation, a deemed distribution occurs when the loan is made. A participant who fails to make his/her loan payments and defaults on the loan either will have a deemed distribution or a loan offset, but not both. If the participant incurs a distributable event when he/she defaults on the loan, the plan will offset the loan. However, if the participant defaults on the loan when there is no distributable event, the plan will treat the loan as a deemed distribution. Since the deemed distribution is merely a tax reporting event, the plan must continue to treat the defaulted loan as part of the account balance for vesting, top heavy and qualification for future loans. The plan also must continue to accrue interest on the loan. However, since the plan does not report the subsequent interest on a Form 1099-R, practitioners often refer to this interest as phantom interest.

Example. Assume the same facts as in the previous example except Jill does not sever employment and a loan default is not a distributable event. Assume further Jill fails to make her required loan payments. As of the close of the cure period, the plan will default the loan and report the loan as a deemed distribution. Jill may not make a rollover contribution because the deemed distribution is not an eligible rollover distribution.

A plan later will offset a defaulted loan treated as a deemed distribution when a participant incurs a distributable event (e.g., severs employment). However, a loan offset of an amount previously treated as a deemed distribution is not an eligible rollover distribution because it is not a distribution of a loan offset. Rather, the subsequent offset is merely a legal transaction that permits the plan to close its books on the loan. Furthermore, the offset of the phantom interest that accrued subsequent to the deemed distribution is not eligible for rollover because it also is not a distribution of a loan offset.

Some practitioners indicate that a participant may roll over any loan offset. The regulations permit a participant to roll over a distribution of a loan offset. In other words, to be eligible for rollover, the loan offset must qualify as a distribution and be reported as a distribution. A loan offset that does not qualify as a distribution will not sustain a rollover. However, a loan offset that is reported as an actual distribution will permit a rollover.

Once the plan treats a loan as a deemed distribution, the plan disregards the loan for Code §72 purposes (i.e., disregards the loan for distribution and for rollover purposes). The regulations make it clear that the participant does not report the subsequent offset or the phantom interest on the Form 1099-R. The subsequent offset also is not reported on the Form 5500 as a distribution. If the participant attempts to roll over the subsequent offset and the phantom interest, the non-reporting of the transaction on the Form 1099-R would not provide a distribution amount that would support a rollover. Furthermore, when the financial institution reports the rollover contribution, the IRS will not find a corresponding Form 1099-R that would support the distribution.

Example. Tim defaults on a $10,000 participant loan in 2004. The plan treats the defaulted loan as a deemed distribution because Tim is still employed when he defaults on the loan. The plan reports the defaulted loan on a 2004 form 1099-R with a codes “L” and “1” in box 7. In 2006, Tim terminates employment and the plan offsets the loan and the $1,500 of interest that accrued on the loan subsequent to the deemed distribution. The plan distributes and reports the $40,000 distribution of his non-loan account balance. However, the plan does not report the distribution of the loan offset. Accordingly, only the $40,000 distribution is an eligible rollover distribution.

A plan may accept the rollover of a participant loan (i.e., loan note) that has not been treated as a deemed distribution or offset. The participant only may effect the rollover of a loan to another plan by way of a direct rollover and only if both plans agree to the transaction. The distributing plan would affect the rollover by assigning the loan note to the other plan’s trustee. Because of the additional paperwork required for a rollover of a loan note, very few plans are willing to accept such rollovers.

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.