Participants are Responsible to Verify Plan Loan Repayments – So Says the Tax Court

By: David I Gensler, MSPA, MAAA, EA


A recent tax court ruling, Louelia Salomon Frias v. Commissioner, illustrates the importance of verifying that loan repayments are actually being made. Moreover, it is the participant’s responsibility to do so.

The Facts

The participant, Louelia Salomon Frias was a participant in her employer’s 401(k) plan. On 07/27/2012, she signed a loan agreement to borrow $40,000 from her account, which she would repay over two years through bi-weekly payroll deductions. She then went on an approved maternity leave. During the first five weeks of her leave, she opted to be paid through her paid time off (PTO) of accrued, unused sick, personal and vacation days. The balance of her leave was approved but was unpaid.

Under the terms of the plan, a loan repayment would be timely if it was paid by the last day of the month following that which included the missed payment date. Her first loan repayment was due on 08/24/2012. Therefore, she had until 09/30/2012 to make it before it was deemed a “missed loan repayment.”

When the participant returned to work on 10/12/2012, the participant discovered that no loan repayments had been deducted from her paychecks. On 11/20/2012, she mad a $1,000 payment and directed her employer to increase her loan repayments to $500 through 07/15/2013. After that the original loan repayment of $342 was reinstated. The loan was fully repaid on 07/09/2014.

Despite her best efforts, Mutual of America, the plan’s record keeper in 2012 issued a Form 1099-R reporting the loan as a deemed distribution. In addition, since she was younger than 59 ½, the 10% early distribution excise tax was triggered.

Rather than mailing the 1099-R to her home, Mutual of America posted the 1099-R on the plan’s website. As a result, she did not recognize the deemed distribution on her 2012 income tax return. Accordingly, in 2014, the IRS said that Frias owed $19,129 – $15,941 in income taxes (inclusive of the 10% penalty) plus a 20% penalty for a substantial tax underpayment.

The Tax Court’s Decision

Frias argued that the deemed distribution should not have been reported because she was on unpaid leave. She also argued that the PTO payments did not constitute wages and that she timely corrected the mistake when she came back to work. The Tax Court did not agree with either argument. They did however, agree that they would remove the 20% penalty for substantial under payment of tax because she had “reasonably relied on her employer” to timely deduct the repayments from her paychecks. The fact that she acted quickly to correct the mistake as soon as she learned of it weighed in her favor as well.

Interestingly, under the IRS rules, a loan is considered to be in default on the last day of the quarter following the quarter within which the participant first misses a loan repayment. If the plan had used that language the loan would not have been considered to be in default until 12/31/2012, well after the date that she corrected everything. However, since you must follow the terms of the plan, Mutual of America was technically correct in defaulting the loan and issuing a 1099-R.

Lessons Learned

The rules regarding loan repayments can be quite complicated. Plan sponsors and participants both play a role in making sure that loan programs are properly administered.

The employer should make sure that its loan agreements accurately reflect the terms of the plan and that they provide the borrowers with all of the relevant information on the loan before they sign the loan agreement.

Participants need to be responsible to make sure that loan repayments are being properly deducted from their pay.

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