The Paradox of Participant Loans in Default: A Taxable Distribution of a Loan Balance Still Considered to Remain Outstanding

Posted by Maria T. Hurd, CPA

Disclaimer: All blog posts are valid as of the date published.

Taxable Distribution of Participant Loans - Delaware 401k Audit Keeping two sets of books often means that someone is hiding something from the taxing authorities. However, keeping two sets of books is sometimes a legitimate practice, required precisely to comply with IRS rules that regulate different aspects of each set of books. For example, the difference between deemed distributions of loans in default and the actual loan offset requires a double set of books.

General Rule

Distributions out of a retirement plan to a plan participant generally trigger a taxable event reported on a Form 1099-R. However, participant loans allow plan participants the opportunity to take proceeds out of a plan without triggering a taxable event, so long as the repayments comply with the terms of the plan document and Internal Code Section 72(p). Therein lies the rub!

When loan repayments stop for any reason and missed payments remain unpaid as of the last day of the quarter following the quarter when they stopped, the loan is considered to be in default and must be considered a taxable, cashless, deemed distribution reported on a Form 1099-R and on the Form 5500.  Like a regular distribution that decreases the assets reported on the Form 5500, one would think that such a taxable event means that there has also been a permanent reduction to the participant’s account balance. However, if the loan is secured by the 401(k) or 403(b) participant account, or if the participant is not entitled to an in-service distribution, the recordkeeper cannot formally offset the loan, which continues to be theoretically part of the participant’s account balance and also a plan asset. The theoretical loan continues to accrue theoretical interest that mathematically and realistically increases the participant’s account balance, even though this accrued interest will never be distributed to the participant or reported for tax purposes.

The full account balance including the defaulted loans plus accrued interest are used for top-heavy testing and also used to determine the amount available for future loans. The Form 5500, however, reports the distribution when it is reported on Form 1099-R, so two sets of books must be maintained when plans have defaulted loans that cannot yet be offset. When the recordkeeper finally offsets the loan when there is a distributable event, the Form 5500 will not also reflect a distribution.

From time to time, a participant who had stopped loan repayments and received a Form 1099-R for the deemed distribution, recommences loan repayments. This poses another logistical difficulty because the participant has already paid taxes on the deemed distribution and subsequent repayments will essentially create basis in the participant’s account. The participant should inquire as to the recordkeeper’s ability to keep track of the basis.  Additionally, the Form 5500 will need to report a negative amount on the deemed distribution column and add the loan to the end of the year asset balances in the year of repayment.

In this case, two sets of books is not indicative of an Al Capone-style tax evasion scheme. It’s actually quite the opposite. The first set of books is needed to comply with the taxable distribution rules and the second one to comply with the top-heavy test and the maximum available loan computations. Who would have thought that two sets of books would be necessary, not to beat the tax man, but instead, to comply! Double books, not double trouble!

Photo by Jonas Tegnerud (License)