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Advanced Loan and Hardship Issues(Workshop 70)

David Schultz, JD, APM

FIS/Relius

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Agenda

• Legal & Regulatory Requirements

– Participant Loans

– Hardship Distributions

• Plan Document Requirements

– Participant Loans

– Hardship Distributions

• Recent Commentary from the IRS

Legal and Regulatory Requirements:

Participant Loans

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Loan Requirements – Tax

• IRC §72(p)(2)(A)– Limitation of amount to lesser of:

• $50,000, or

• 50% of vested account balance

• IRC §72(p)(2)(B)– 5-year repayment period– Home loan exception

• IRC §72(p)(2)(C)– Level amortization– At least quarterly payments

• Legally enforceable agreement

Loan Requirements - DOL

• A participant loan is not a Prohibited Transaction, if:

– Available to participants on a non-discriminatory basis

– Made per the terms of the plan

– Bears a reasonable rate of interest

– Is adequately secured• Labor Reg. §2550.408b-1

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What is a plan loan failure?

• The failure of a plan loan to comply with 72(p) taxation rules– Whether or not it is a violation of plan terms

• Consequences– Deemed distribution or plan loan offset (unless

forgiven in VCP)

– If violation of plan terms:• Operational failure (self-correctible)

• ERISA fiduciary breach– DOL VFCP correction: Correct under VCP with IRS

How can you have a plan loan failure

• Employee doesn’t pay on time

• Employer fails to withhold repayments from wages

• Plan loan as written:

– Exceeds Code §72(p) limit (generally $50,000 or ½ vested account)

– Doesn’t require at level payments at least quarterly

– Exceeds 5 years (except for principal residence purchase)

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Case Study: 5-Year Rule• Participant requests $10,000 loan. Paid monthly, on the 15th of the

month.

• Last payment due by July 13, 2017

• Last payment scheduled for July 15, 2017

• Q: What should you do if the error discovered on or before July 13, 2017?

• Q: What should you do if the error discovered after July 13, 2017?

Loan Requested/Paperwork Signed July 1, 2012

Check Issued July 14, 2012

First Payment Made August 15, 2012

Five Year Period Ends July 13, 2017

Case Study: 5-Year Rule

• Q: Participant’s vested account balance is $100,000, on 1/15/16 he borrows $50,000, amortized over 10 years (the participant requested the loan to acquire his principal residence). It is discovered on 6/1/16 that the participant did not use the funds to purchase a residence.

• Q: Same facts as above; however, the participant applies $30,000 of the loan proceeds to purchase his primary residence. The remaining $20,000 used for vacation.

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Case Study: Bona Fide Loan

• Dr. Owen, age 50, is the sole HCE at Dr. Ima Owen, MD, PC, and the sole Trustee of his practice’s 401(k) Plan– Doesn’t receive a regular salary, he takes periodic

distributions – mostly at year-end.• 10 other employees are on payroll.

– Plan balance = $200,000, all deferrals and earnings– Borrows $50,000 on February 1, 2015

• 5 years, 5% interest, quarterly amortization

– In 2016, TPA discovers that Dr. Owen never made any payments

Case Study: Bona Fide Loan

• Q: How should the loan be treated if it is discovered that Dr. Owen never intended to repay the loan (but called it a loan to avoid the distribution restrictions on deferrals)?

• Q: What if Dr. Owen wanted to repay the loan, but didn’t know where (or if) she’d get the cash-flow to make payments until his year-end distribution in December?

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Case Study: Phantom Interest

• Q: Plan permits one participant loan at a time. Bob defaults on a participant loan and deemed distribution occurs. Plan fails to track defaulted loan and issues Bob a second loan which exceeds both the one loan limit and maximum loan amount (due to defaulted loan with phantom interest).

• Q: Plan allows for two outstanding loans. Bob is issued a second loan (amount complies with maximum loan amount), but no payroll deduction and loan is secured by account balance.

Case Study: Interest Rates

• Dilbert requests a participant loan from the Main Street Bank 401(k) Plan. Dilbert is known by the bank to have severe credit problems (home foreclosure; garnishments; high debt; low credit score)– Q: Loan is issued to Dilbert at a 2% interest rate

– Q: Loan is issued to Dilbert at a Prime + 2% interest rate (5.25%), but bank would only lend to a similar retail customer at 10%.

– Q: Loan is issued to Dilbert at Prime + 2%, but bank would not lend to a similar retail customer due to default risk

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Legal and Regulatory Requirements:

Hardship Distributions

Hardship Distributions• Two primary requirements:

1. The distribution must be on account of an immediate and heavy financial need

2. The distribution must be necessary to satisfy that need

• Regulations provide a “safe harbor” relating to each part

• No exception to 10% premature distribution penalty tax

• Not eligible for rollover

• Must suspend all deferrals for at least six months following a hardship distribution

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Safe Harbor Financial Need

• The regulations deem a distribution to be on account of an immediate and heavy financial need if it is for one of 6 reasons

• Three are for participant only:

1.Costs directly related to purchase of the participant’s principal residence (not mortgage payments!)

2.Amount necessary to avoid eviction from or foreclosure on participant’s principal residence

3.Expenses for casualty loss to participant’s principal residence (disregard 10% AGI floor)

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Three Events for Broader Group4. Medical expenses of the employee, spouse,

dependent or beneficiary (disregard 7.5% AGI floor)

5. College tuition, room and board and related expenses for employee, spouse, children, dependents or beneficiary (12-months)

6. Funeral expenses for deceased parent, spouse, child, dependent or beneficiary

• Beneficiary hardship is not mandatory (per PPA)

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What is “Necessity”?• A distribution is not necessary to the extent it exceeds

the amount of the need or may be satisfied from other resources reasonably available to the participant

• The amount of the distribution may include income taxes and penalties reasonably anticipated

– For example, I need $20,000:

• 10% penalty tax, 25% state and federal tax

• I take a roughly $30,000 distribution (to net $20,000)

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Possible Sources to Satisfy Financial Need

• Plan should consider whether the participant has other sources of funding or assets to satisfy the financial need:

– Insurance (health or property/casualty)

– Sale of assets

– Cessation of deferrals into the plan

– Distribution of plan assets (to the extent permitted by the plan)

– Participant Loans

– Commercial Loans

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Participant’s Written Representation is Acceptable

• The 401(k) regs allow the Plan Administrator to reply on the participant’s written representation that the financial hardship (need) cannot be satisfied from any other sources– Unless the PA or ER has actual knowledge to the

contrary– Only applies for the limited purpose of verifying the

necessity – not the need itself

• Makes sense – can’t prove the negative– No gold or $ under the mattress

Case Study: Hardship Distributions• Harry requests a hardship distribution from the HDL

Corp 401(k) Plan. Harry satisfies the need and necessity requirements and is issued a distribution– Q: It is subsequently discovered that the Plan does not

permit hardship distributions– Q: It is subsequently determined that Harry was eligible to

take a plan loan that would have been sufficient to meet his needs

– Q: Harry is a >5% shareholder. The plan is amended to allow hardship distributions based on Harry’s request, employees are never informed, and is amended two months later to eliminate hardships. Only Harry received a hardship.

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Case Study: Hardship Distributions• Q: Helene requests a $20,000 hardship

distribution from the Zoo Corp 401(k) Plan.

– Helene provides the PA copies of medical bills for her daughter and provides the PA with a statement that a hardship distribution is necessary to pay the bills.

– Two weeks later the PA discovers (overheard at the water-cooler) that the medical bills had already been paid and Helene intended/used the hardship proceeds to buy a boat.

• What should the PA do in response to this revelation?

Hardship Distributions – 6 Month Suspension of Deferrals

• Treasury Regulations require that recipients of hardship distributions be prohibited from making salary deferral contributions for at least 6 months after receipt of the hardship distribution

– Must be part of plan terms or other enforceable agreement

– Treas. Reg. §1.401(k)-1(d)(iv)(E)(2)

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Case Study: Suspension of Deferrals

• Q: Joffrey receives a hardship distribution from the Baratheon 401(k) Plan on 3/15/16. In early 2017, it is discovered that Joffrey’s 401(k) deferrals were never suspended

• Q: Joffrey receives a hardship distribution from the Baratheon Profit Sharing Plan on 3/15/16. In early 2017, it is discovered that Joffrey’s deferrals into the Lannister 401(k) Plan (part of controlled group) were not suspended

• Q: Joffrey’s deferrals are properly suspended as of 3/15/16, but his deferrals are not resumed as of 9/15/16

Hardships: Common Questions• Can a plan issue a hardship distribution so that:

– Q: A participant may travel to the funeral of a parent?

– Q: A participant may repair a crack/leak in the foundation of his principal residence?

– Q: A participant may repair water damage to principal residence from a flood (river/creek)?

– Q: A participant may repair fire damage to a property she rents? Or to a vacation home?

– Q: A participant can pay past due mortgage balance after receiving a late notice?

– Q: A participant can pre-pay his daughter’s 4-year college tuition (to take advantage of discount)?

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Documentation Requirements

Loan Documentation

• Maintain, for each loan:– Evidence of the loan application, review and approval

process

– An executed plan loan note

– If applicable, documentation verifying that the loan proceeds were used to purchase or construct a primary residence

– Evidence of loan repayments, and

– Evidence of collection activities associated with loans in default and the related Forms 1099-R, if applicable

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Verification Loan Proceeds Used for Primary Residence

• Only applicable if plan issues loan for greater than 5 years

– Or if plan limits loans to certain purposes

• Probably do not need to track actual use of loan proceeds

• Would require and maintain copy of closing statement or construction agreement to verify eligibility

– Participant may not self-certify

Evidence of Payment/Collection, Default, Form 1099-R

• Plan should maintain records of all distributions and repayments

• If loan payments stop, document efforts to notify participant and collect past-due balance

• Document treatment of loan in default and failure to cure

• Maintain proof that Form 1099-R was filed for defaulted loans

• Recommend maintaining records for at least 6 years from the date the 5500 is filed in the year the loan is paid in full

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Hardship Documentation

• The 401(k) regs allow an ER to rely on the EE’s representation that he/she qualifies ONLY for the very limited purpose of the facts and circumstances approach to the “necessity” test (and only if the ER doesn’t have actual knowledge to the contrary)

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Immediate and Heavy Financial Need• Recommended

– Maintain copy of:

• Closing Statement for primary residence

• Eviction or foreclosure notice

• Repair estimate for casualty loss

– And a statement from participant that insurance doesn’t cover?

• Medical bills

• Tuition notice and/or support for room/board

• Evidence of funeral expenses

• Pay attention to dates

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Hardship Documentation Requirements

• The plan sponsor should retain these records in paper or electronic format:

– Documentation of the hardship request, review and approval;

– Financial information and documentation that substantiates the employee’s immediate and heavy financial need;

– Documentation to support that the hardship distribution was properly made in accordance with the applicable plan provisions and the Internal Revenue Code; and

– Proof of the actual distribution made and related Forms 1099-R

Statute of Limitations

• Generally: 3 years from date Form 5500 is filed

• ERISA requires records supporting all information on the Form 5500 to be maintained for at least 6 years from the date the Form is filed

– Practically speaking, nearly 8 years from the first day of the PY

• All relevant records should be maintained for at least 6 years from the date the Form 5500 was filed

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Recent Commentary by the IRS

IRS Addressed Documentation in Employee Plans Newsletter

• Focused on the need for the Plan Sponsor to obtain and keep records documenting proper issuance of hardship distributions and loans– TPA and participants are not ultimately responsible– Raised concerns regarding electronic self-certification by

participants• Participant records may not be available on audit

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IRS: It’s Up to Plan Sponsors to Track Loans, Hardship Distributions

• “The plan sponsor must obtain and keep hardship distribution records. Failure to have these records available for examination is a qualification failure that should be corrected using the Employee Plans Compliance Resolution System (EPCRS).

Electronic Self-Certification• “There's a growing trend for plans to grant hardships to

participants who electronically apply for them. Participants use their PIN and self-certify that they meet the hardship criteria. While this seems to be an easy process for the participant, enabling them to quickly receive their distribution, this process doesn’t relieve the plan sponsor’s need for verification and recordkeeping. The agent will still look for the same documentation mentioned above to ensure that the plan made hardship distributions according to its terms and the law.

• We commonly see hardship distribution errors. However, a plan sponsor may reduce or even eliminate these errors by reading the plan, maintaining strong internal controls and having the proper documentation.” (emphasis added)

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Loans Too!

• The IRS highlighted similar issues with regard to participant loans

– Inadequate records maintained by the plan sponsor

– Participants allowed to self-certify that loan proceeds were being used to pay for primary residence

• Loans > 5 years improperly permitted (deemed distribution when issued)