March 7, 2017

In one decision, the U.S. Tax Court concluded that the IRS was correct in determining that a taxpayer who failed to make timely payments on loans from her employer’s qualified retirement plan defaulted on the loans and received deemed taxable distributions from the plan. As a result, the taxpayer owed federal income tax and the 10% penalty tax on early retirement plan distributions. (Dora Martinez, TC Memo 2016-182.)

The Basics

A participant in an employer-sponsored qualified retirement plan can borrow money from the plan if it allows loans. The loan amount can’t exceed the lesser of:

  • $50,000, or
  • 50% of the employee’s vested account balance or accrued benefit.

However, a loan of up to $10,000 is allowed even if it exceeds the 50% limit. Plan loans must call for substantially level payments that are made at least quarterly. Except for principal residence loans, plan loans must be repaid within five years. Principal residence loans must be used to acquire a residence that will be used as the plan participant’s (the borrower’s) principal residence, and they can have longer repayment periods.

If the plan participant fails to make a plan loan payment by the due date or within the specified grace period, however, it can trigger a loan default and a deemed taxable distribution equal to the outstanding loan balance. In other words, the loan is extinguished, but it’s deemed to be paid off with the taxable distribution from the plan. This is problematic from a tax perspective.

To add insult to injury, an early qualified plan distribution, including a deemed distribution caused by a plan loan default, can trigger the 10% early distribution penalty tax. The penalty applies if the plan participant is under age 59 1/2, unless an exception is available.

Facts of the Case

In this case, the taxpayer was employed as a teacher by the Los Angeles Unified School District (LAUSD). To avoid foreclosure on her residence, she borrowed from the LAUSD’s qualified retirement plan. Specifically, she took out two plan loans in 2010 in the amounts of $28,899 and $4,085.

The loans were to be repaid in quarterly installments over five years. The taxpayer signed documents indicating that she understood the loan terms and acknowledging that a loan default would trigger a deemed taxable distribution of the unpaid loan balance. She also acknowledged that the loans weren’t taken out to acquire a principal residence.

Unfortunately, the taxpayer stopped making loan payments in May 2012 and was found to be in default in November 2012. At that time, she was deemed to have received taxable distributions equal to the outstanding loan balances of $20,582 and $2,907, respectively. As a result, the taxpayer was issued a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., that reported these amounts as 2012 taxable distributions from the LAUSD retirement plan.

When the taxpayer didn’t report any income from the deemed distributions on her 2012 federal income tax return, she was audited by the IRS.

The Decision

The question before the Tax Court was whether the taxpayer’s failure to make plan loan payments within the allowable grace period resulted in loan defaults that, in turn, triggered taxable deemed distributions from the retirement plan in November 2012. The Tax Court sided with the IRS, classifying the defaults as taxable distributions.

The Tax Court rejected the taxpayer’s somewhat plausible argument that she couldn’t have defaulted on the loans, because they were existing obligations. She argued that she had continued to receive quarterly payment notices after the claimed November 2012 default date.

The court also rejected the taxpayer’s argument that the general plan loan requirement that level payments must be made over no more than five years didn’t apply to her loans, because the loan proceeds were used for her principal residence (to avoid a foreclosure of the residence). Therefore, according to the taxpayer, the loans weren’t in default in 2012. The Tax Court opined that, while principal residence loans can have a term of more than five years, they still must have level payments.

Moreover, the taxpayer specifically affirmed in both loan agreements that the loans weren’t principal residence loans. So, the five-year repayment period and the level payment requirement were both mandatory. As a result, the Tax Court ruled that the taxpayer defaulted on the loans in November of 2012.

Finally, the Tax Court concluded that the taxpayer owed the 10% early distribution penalty tax, because the deemed retirement plan distributions caused by the plan loan defaults occurred before the taxpayer had reached age 59 1/2. She also failed to show that she qualified for any exception to the 10% penalty.

Lessons Learned

Taking out retirement plan loans can make sense in the right circumstances, but borrowers must understand that defaulting on plan loans can trigger adverse tax consequences. If you have questions or want more information about plan loans, contact your tax advisor.

© 2017