Many 401(k) plans permit employees to take plan loans. These loans, which are governed by the Internal Revenue Code ("IRC") must not exceed specific dollar limits, must not provide for level amortizations over a period longer than 5 years (unless the loan is being used to purchase a primary residence), and must require payments at least quarterly. If a loan does not meet these basic requirements, then the loan will be considered a deemed distribution, which becomes reportable to the IRS and taxable to the employee.
Loan failures are very common. In fact, they often result when employers / plan administrators simply fail to start the employee's loan repayments in a timely manner. Depending on whether a plan loan is still within its cure period (end of the calendar quarter following the quarter in which the payment was missed) or outside the cure period, the plan sponsor can either self-correct for the loan failure or file a loan correction submission under the IRS's Voluntary Correction Program ("VCP"). The facts and circumstances of the loan failure and the plan documents will dictate whether self-correction or a VCP submission is required in order to avoid the adverse tax consequences associated with loan failures.
The good news is that the IRS continues to simplify the VCP correction submission process in order to encourage plan sponsors to voluntarily correct for various plan operational failures, including loan failures. In addition to a streamlined application process, the IRS recently reduced the VCP compliance fees for loan correction submissions and now bases the loan correction compliance fee on the number of loan failures that occurred versus the number of plan participants.
Should you have any questions on 401(k) plan compliance or the correction programs available, please feel free to call. The simplicity of the correction process is not worth the risk of an improper correction or a decision not to properly correct a loan failure.