How Do the 72(p) Proposed Regulations Affect Problem Loans?

By Martin M. Heming

On December 31, 1997 the IRS issued additional Proposed Regulations governing deemed distributions of participant loans under Internal Revenue Code (IRC) §72(p) (Proposed Regulations). For a discussion of what these Proposed Regulations provide, see Michael Pruett's article on page 6.

These Proposed Regulations are effective for any loans made prior to the first January 1st that is six months after the Proposed Regulations are finalized—probably sometime in the 21st Century. Additionally, plans are only permitted to rely on these Proposed Regulations for existing loans that never had a prior deemed distribution, or for which a deemed distribution was recognized in accordance with the Proposed Regulations and timely reported on Form 1099-R. This means that for problem loans in existence before January 1, 1996 the Proposed Regulations can't be used. Thus, for such loans, the governing law is whatever a court determines to be a reasonable good faith interpretation of the statutory language of §72(p).

Many problem loans are based on the failure of the participant to repay the loan in accordance with the terms of the loan agreement. Under the Proposed Regulations, this failure to repay causes the outstanding balance of the loan to be a deemed distribution. However, existing participant loans are not covered by the Proposed Regulations. §72(p)(2)(B) generally provides that loans, if by their terms do not require repayment in even amortization over no more than a five-year period, are deemed distributions. No mention is made of what happens if the loan agreement is appropriately written but the participant does not follow its terms.

The Proposed Regulations Don’t Change the Rule Retroactively
Prior to the release of the first set of Proposed Regulations in 1995, some practitioners believed that the failure of a participant to make payment in accordance with the terms of the loan agreement did not constitute a deemed distribution despite the contrary statement in the TEFRA Blue Book at p. 296. The decision of the Tax Court in Chapman v. Commissioner, T.C. Memo 1997-147 has greatly bolstered this point of view.

Chapman involved loans that were issued prior to the TRA 86 revision of 72(p). In Chapman, the loan agreement was properly drafted to meet the five-year statutory requirement. However, the participant did not repay the loans in accordance with the terms of the loan agreement. The IRS took the position that this failure to repay was a deemed distribution. In addition, the IRS argued that the failure to pay interest after the five-year term expired constituted a separate deemed distribution for the amount of the unpaid interest.

The Court Ruled that unpaid interest after the expiration of the five-year term was not a separate deemed distribution. This was a great victory for the taxpayer. It is possible that this led to the IRS adoption of this same position in the 1997 Proposed Regulations.

Unfortunately, the taxpayer's counsel conceded the most important issue in the case, i.e., whether the failure to repay in accordance with the terms of the loan agreement constituted a deemed distribution under 72(p). As a result, the Court could not rule on this issue but only make a non-binding comment as follows:

"There seems to be a gulf between the language of the statute and the legislative history. In other circumstances (that is, had the taxpayer not conceded the issue), we might be concerned about this disparity which indicates legislation by conference report, rather than by concise statements in the statute. Taxpayers should not be compelled to look at legislative history to determine the tax consequences of their activities." [Emphasis added]

As a result, practitioners who are currently arguing deemed distribution cases involving the failure to repay with the IRS on audit and at appeals should be more likely to settle cases for less. For example, we recently settled a case that spanned the period both before and after the Chapman decision. This case started in 1994 and involved seven participant loans from the early 1980's that were never repaid. The principal amount of these loans was about $200,000, and unpaid interest just prior to settlement in 1998 was over $300,000. The IRS took the position that even though the loans were not covered by 72(p) when written, they became deemed distributions in 1991 and 1992 when they were not paid in accordance with their terms. The IRS had included unpaid interest both before and after the notes were due in 1991 and 1992 as part of the deemed distribution. The IRS also asserted that the continuation of the loans after their original due date constituted a prohibited transaction because from that point forward, the loans were unsecured. Accordingly, the IRS also assessed first tier excise tax, interest and penalties of about $100,000.

When the case started in 1994, the strongest argument was that in 1991 and 1992, the original loans were simply modified from 10-year term loans to demand notes. Therefore, they were still secured by the participant's account balance and were, thus, adequately secured and not prohibited transactions. It was likely the taxpayer could prevail on this theory. In contrast, based on the law in 1994, it was probable that the IRS would win its argument that the failure to repay the old grandfather loans in 1991 and 1992 constituted a deemed distribution. In addition, it seemed likely that they would prevail in their position that the unpaid interest, which had accrued after such dates, constituted additional deemed distributions.

From 1994 to 1997, the case proceeded through the initial audit, the IRS Appeals Division and finally to the filing of a petition in the Tax Court. During this period, the fact that no IRS Regulations were adopted that applied to the case as well as to the issuance of the Chapman decision strengthened the taxpayers negotiation position with the IRS. Finally, in 1998, the case was settled by dropping the prohibited transaction portion of the case, terminating the plan and paying the IRS a total of $100,000 in taxes and interest. This settlement was based roughly on the amount of income tax that the participant would have paid on a distribution of the principal amount of the unpaid loans in 1991 and 1992. This example illustrates how tenacity and the changing state of the law can affect settlement negotiations.

Participant Loans from Pooled Investments Are Trouble
Another way the Proposed Regulations affect problem loans is demonstrated by the different way that unpaid loans are treated depending on whether plans use a pooled investment approach to all investments including loans, or whether participant loans become an individual investment of the borrowing participant's account.

Under the Proposed Regulations, if a loan becomes a deemed distribution because it is not repaid in accordance with its terms, then it is treated as if it were distributed for income tax purposes. Thus, for tax purposes, as soon as the loan becomes a deemed distribution, no interest will continue to accrue and no repayment of the principal of the loan is required. When the participant eventually terminates employment, only the portion of the account reflecting non-loan assets is subject to tax. The unpaid loan and any interest after the date of the deemed distribution is ignored for tax purposes. When the loan is an individual investment of the borrowing participant, this works well. However, if the loan was a pooled investment of the plan and there are other participants whose accounts are affected by the unpaid participant loan, something must be done to make sure that those innocent participants do not lose a portion of their account. If they were required to take the loss, it could arguably constitute both a IRC 411(d)(6) violation and an ERISA Title I breach of fiduciary duty. Accordingly, the principal of the unpaid loan, as well as all unpaid interest both before and after the date of the deemed distribution, must be taken from the borrowing participant's account to the extent that no other participants suffer a loss as a result of the borrower's failure to repay. The Proposed Regulations don't answer the question of whether the amount taken from the borrower's account for this purpose constitutes a taxable distribution to the borrowing participant. They also do not address the fiduciary breach problem that could arise if the borrowing participant's account is not sufficient to repay the other participants.

By adopting a rule that permits participant loans to be ignored after they become deemed distributions, the Proposed Regulations indirectly affect problem loans that have been issued as part of pooled investments. The most important effect is that plan sponsors generally should not offer loans unless they are made an individual investment of the borrowing participant's account. This is because after the Proposed Regulations are final, participant loans from pooled accounts are likely to cause extra administrative expense and increase the risk of a fiduciary breach.

Conclusion
The Proposed Regulations are not effective for existing loans. Nevertheless, the Proposed Regulations have several indirect effects on existing problem loans. First, to the greatest extent possible, administrators are likely to apply the new rules to existing loans because there are more advantages in administering problem loans. Second, if a loan was written in accordance with its terms and simply not timely repaid, it is possible to argue that it is not a deemed distribution despite contrary language in the Proposed Regulations with respect to future loans. Finally, the generous rule in the Proposed Regulations about ignoring a loan after it is a deemed distribution will influence plan sponsors to avoid plan loans unless they are made an individual investment of the borrowing participant.

© 1998 from the NIPA Education Foundation, National Institute of Pension Administrators, 401 North Michigan Avenue, Chicago, Illinois 60622-4267, (800) 999-NIPA. Article originally appeared in Plan Horizons, Vol. XIV, Issue 4, Fall 1998.

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