A recent Tax Court case addresses this issue. Since nearly all employers require the use of payroll deduction to repay participant loans, most practitioners have or will confront this issue. The employer’s failure to withhold loan payments raises two issues:
- the tax consequences to the participant, and
- whether the employer has any liability.
The case dealt with only the first issue, but the results suggest a possible answer to the second question.
In this particular case, a participant obtained a loan that was to be repaid through payroll deduction. A few days after he obtained the loan, the participant transferred to another division of the employer. Because of the transfer, the company never withheld any of the loan payments. Prior to the close of the loan grace period, the company sent a letter to the participant informing the participant of the missed payments and indicating that the plan would treat the loan as a deemed distribution unless he made-up the missed payments. However, the plan used incomplete address information. The plan later treated the loan as a deemed distribution and issued a Form 1099-R, using the same incomplete address information. Later, the IRS assessed the taxes and the 10% premature distribution tax on the deemed distribution. The participant contended that he should not be taxable on the deemed distribution because he never received
- his quarterly benefit statements,
- the letter notifying him of the delinquent payments, and
- the Form 1099-R.
The court concluded that even if it accepted all of the participant’s arguments, the participant nonetheless failed to comply with the quarterly amortization requirement and did not make-up the payments within the permitted grace period for missed loan payments.
The case illustrates the IRS’s and the court’s strict interpretation of the loan taxation rules. The IRS appears unwilling to accept any excuses or retroactive corrections of missed payments (beyond the plan’s grace period). Therefore, if the loan payments have not been withheld (irrespective of who is at fault) and the participant has not made-up the missed payments within the plan’s grace period, the loan is taxable to the participant either as a deemed distribution (because there is no distributable event) or as a loan offset (because there is a distributable event).
The second issue (the employer’s possible liability for the failure) was not before the court. However, the IRS and the court indicated that they felt the participant was primarily responsible for determining whether the loan payments have been withheld since he was subject to the tax consequences and was in the best position to monitor his paycheck. Employers who fail to withhold loan payments may nevertheless feel responsible for the error and may wish to assist the participant with his/her tax consequences, particularly where the participant has brought the error to the employer’s attention. However, even employers who feel responsible for the error may feel that at some point the responsibility shifts to the participant. Leonard v. Commissioner, T.C. Summary Opinion 2004-11 (2004).
In our half-day specialty seminar, Participant Loans, we provide examples of modifications to loan forms practitioners can make to place the responsibility for determining whether loan payments are being withheld on the participant. The inclusion of such provisions may reduce the number of these types of errors and should resolve the issue of responsibility for the error. |
