During these economically challenging times, employees participating in the tax-qualified plans of their employers may seek ways to obtain funds that have been contributed to these plans. Plans that permit loans offer an avenue for obtaining available funds from these plans.

Employers that sponsor and maintain plans that permit loans should be particularly careful in the administration of these plans to avoid violating the terms of the plans with respect to loans and to avoid circumstances where plan loans to participating employees cause taxable distributions.

The U.S. Tax Court, in Marquez v. Commissioner of Internal Revenue, T.C. Summary Opinion 2009-80 (May 20, 2009), addressed two issues regarding loans from a tax-qualified plan to a plan participant: (1) to what extent proceeds of a loan the participant received from his employer provided pension plan were taxable in 2005; and (2) whether the participant was liable for the 10% additional tax pursuant to Internal Revenue Code (IRC) § 72(t) on a deemed distribution of the loan.

The participant worked for the City of New York as an emergency medical technician and participated in the New York City Employees’ Retirement System (NYCERS). He applied for and received several loans from his NYCERS account, consistently selecting the maximum loan amounts, as well as the minimum repayment amounts, allowed by the NYCERS. On May 23, 2005, the participant signed an application to refinance his loans. The loan processing authorization document, which the participant signed the same day, explicitly stated that the refinancing option would likely result in income taxable to the participant. The document also offered two other options that would not result in income: (1) an additional loan on the original terms; or (2) a new loan for a smaller amount. The participant chose the refinancing loan of $12,346.95. If the participant had borrowed on the “original terms,” as he had done in 2004, he would have had to repay the $12,346.95 in 77 payments. Instead, the replacement loan reset the number of remaining payments to the maximum of 130.

The NYCERS issued a Form 1099 R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the tax year 2005, reporting a distribution of $10,032, with no federal income tax withheld. The participant filed his 2005 Form 1040 and did not report this $10,032 as income.

IRC § 72(p)(i)(A) provides a general rule that proceeds of a loan from a tax-qualified employer plan to a plan participant are treated as a taxable distribution in the year in which the loan proceeds are received. However, § 72(p)(2) provides an exception to this general rule. The loan proceeds are not treated as a taxable distribution if: (1) the principal amount of the loan (when added to the outstanding balance of all other loans from the same plan) does not exceed a specified limit, as provided in § 72(p)(2)(A); (2) the loan, by its terms, must be repaid within five years of inception (unless the loan financed the acquisition of a home that is the principal residence of the participant), as provided in § 72(p)(2)(B); and (3) the loan has substantially level amortization with quarterly or more frequent payments required over the term of the loan, as provided in § 72(p)(2)(C). The Tax Court stated that Treasury Regulations

§ 1.72(p)-1, Q&A 20(a)(2), states that where a loan that satisfies § 72(p)(2) is replaced by a loan that has a later repayment date, then both loans are treated as outstanding on the date of the transaction. If the sum of both loans, as well as all other outstanding loans, exceeds the limit of § 72(p)(2)(A), then the replacement loan results in a deemed distribution in the amount that is above that limit.

In 2005, the participant applied for and received a loan that refinanced and therefore replaced the loans that he had previously taken from his NYCERS account. Because he chose to repay in 130 biweekly installments instead of 77, this replacement loan effectively extended by two years the repayment terms of the loans being replaced. The replacement loan, when added to the sum of the loans replaced, exceeded the § 72(p)(2)(A) limitation by $10,032. The NYCERS advised the participant of the probable tax consequences of his decision to refinance the loan, and the participant acknowledged these consequences when he signed the loan processing authorization agreement.

Because the refinancing resulted in the participant’s exceeding the § 72(p)(2)(A) limit by $10,032, the Tax Court held that the participant received a deemed distribution of $10,032 in 2005, which was includable in income. The Tax Court also ruled that the participant was subject to the § 72(t) additional 10% tax.

The importance of this decision is that the requirements of IRC § 72(p) must be satisfied with respect to the terms of a plan loan in the event any loan or loans are to be refinanced during these economically challenging times.