Unrepaid Retirement Plan Loan Became Taxable Income
In Lin1, the Tax Court found that funds borrowed from a Section 457 deferred compensation plan were taxable income in the year in which the borrower defaulted on the loan.
The taxpayer was a participant in a Section 457 deferred compensation plan. The taxpayer applied for and obtained a loan from the 457 plan. The promissory note executed by the taxpayer provided that the failure to make a scheduled payment of principal and interest would be an event of default. The promissory note also provided that upon an event of default, if not cured, the total outstanding balance of the loan would be deemed distributed to the borrower which could result in the deemed distribution being wholly or partial taxable. In addition, the promissory note provided that the defaulted amount would be reported to both the borrower and to the IRS as taxable income.
After a single payment, the taxpayer defaulted on the loan and did not cure the default. The plan custodian sent the taxpayer and the IRS an IRS Form 1099-R reporting the defaulted amount as taxable income. The taxpayer did not report the defaulted amount in her taxable income. The IRS audited the taxpayer’s income tax return and issued a notice of deficiency.
The sole issue in this case is whether a loan the taxpayer obtained from a deferred compensation plan, but defaulted on, was taxable income. Section 72(p)(1)(A) provides that if a participant or beneficiary receives directly or indirectly any amount as a loan from a qualified employer plan, then that amount is treated as having been received by such individual as a distribution under that plan. However, Section 72(p)(2)(A) provides that certain loans will not be deemed to be a distribution if the loan meets all of these criteria:
- Does not exceed the greater of one-half of the nonforfeitable accrued benefit of the employee under the plan or $10,000.
- Is repayable within five years.
- Provides for substantially level amortization (with payments not less frequent than quarterly).
Accordingly, if a default occurs, the borrower will have failed the third requirement because the loan will not be amortized on a substantially level basis and, therefore, a deemed distribution will have occurred.
In this case, the court found that there was no dispute that the taxpayer defaulted on the loan because of her failure to make the required payments within the cure period. Thus, the court concluded that pursuant to Section 72(p)(1)(A), a distribution in an amount equal to the outstanding balance of the loan was deemed to have occurred. The court quickly rejected the taxpayer’s argument that the loan should not be taxable because she was merely borrowing her own funds. The court stated that this argument ignores Section 72(p)(1)(A) and the fact that the taxpayer was borrowing pretax dollars that had never been taxed.
The result reached in this case by the court seems inevitable and was most likely not settled earlier because the case was brought by the taxpayer pro se. Nevertheless, the case is useful because it illustrates the three requirements that must be satisfied in order for a loan from a qualified plan to avoid being immediately taxable.
Frank Baldino is an estates and trusts attorney who helps people throughout the greater Washington, DC area protect assets for their families and future generations through careful estate tax planning. For more information, contact Frank at (301) 657-0175 or [email protected].
This article originally appeared in the April 2019 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.