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The author is chair of the tax and estates department at Fox, Rothschild, O’Brien & Frankel of Philadelphia and serves on the firm’s executive committee. Under �72(p) of the Internal Revenue Code, any amount received by a participant in a retirement plan as a loan from the plan is treated as having been received as a deemed taxable distribution from the plan, unless the loan satisfies certain statutory requirements with respect to the amount of the loan, the repayment terms of the loan and the documentation of the loan. On Dec. 3, 2002, the Internal Revenue Service published final regulations with respect to the rules relating to such loans. In most instances, the final regulations restate the rules for plan loans contained in proposed regulations issued in August 2000. However, certain significant provisions of the regulations were made more liberal in their final form. Generally, a loan from a retirement plan (which includes qualified retirement plans, 403(b) annuity plans and any governmental retirement plan, whether or not qualified) may not exceed the lesser of $50,000, or the greater of 50 percent of the participant’s vested account balance or $10,000. See �72(p)(2)(A). The $50,000 limitation is reduced by the excess of the highest outstanding loan balance on any prior loan during the preceding 12-month period over the outstanding loan balance of such loan on the date of the new loan. For purposes of applying these limits, all plans of related or affiliated employers must be treated as one plan. Loan Repayment In addition to the limitation on the amount of a plan loan, �72(p) also requires that a plan loan must be repaid, together with interest, over a term of not more than five years in substantially level installments. The requirement that a plan loan be repaid within five years does not apply to a loan used to acquire a dwelling unit which will, within a reasonable period of time from the date of the loan, be used as the principal residence of the participant. Neither the code nor the final regulations specify what the maximum term of a principal residence loan may be, nor is there a requirement that a principal residence plan loan actually be secured by the dwelling unit. In addition to the foregoing requirements concerning the terms of a retirement plan loan, the loan must be memorialized in an enforceable agreement. Under the final regulations, a retirement plan loan must be evidenced by a legally enforceable agreement — which may include more than one document — the terms of which must demonstrate compliance with the requirements of �72(p). Accordingly, the loan agreement must specify the amount and date of the loan and the repayment schedule. The agreement does not have to be signed if the agreement is enforceable under applicable local law without being signed. Moreover, the agreement must either be in a written document or in an electronic medium that is reasonably accessible to the participant and that is provided under an electronic distribution system that satisfies other requirements relating to accessibility and confidentiality. Failure To Satisfy In the event that any of the plan loan requirements of �72(p) are not satisfied, in form or in operation, the amounts advanced as a loan will be deemed to be a taxable distribution. The deemed distribution occurs at the time that the plan loan requirements are not satisfied. This may occur at the time the loan is made or at a later date. For example, if the terms of the loan do not satisfy the five-year term or level amortization requirements, or if the loan is not evidenced by an enforceable agreement, the entire amount of the loan is treated as a deemed distribution at the time the loan is made. If the loan satisfies these requirements except that the amount of the loan exceeds the limitations of �72(p)(2)(A), the amount of the loan in excess of the applicable limitation is considered a deemed distribution at the time the loan is made. If the loan initially satisfies the requirements of �72(p) but payments are not made in accordance with the terms of the loan, a deemed distribution occurs as a result of the failure to make such payments at the time of such failure. However, a plan administrator may allow a cure period, and a deemed distribution will not be considered to have occurred if the required payment is made not later than the end of the cure period, which period cannot continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due. If there is a failure to pay an installment payment required under the terms of the loan (taking into account any cure period), then the amount of the deemed distribution will equal the entire outstanding balance of the loan (including accrued interest) at the time of such failure. Any deemed distribution will be subject to regular income tax and may be subject to a 10 percent excise tax on early distributions imposed under �72(t) if the deemed distribution occurs before the participant attains age 59-1/2. The amount that can be included in income as a result of a deemed distribution under �72(p) is required to be reported on Form 1099-R. To the extent that a loan, when made, is a deemed distribution, the amount that can be included in income at such time is subject to income and employment tax withholding. If a deemed distribution of a loan results in the recognition of income at a date after the date the loan is made, withholding is required only if there is a transfer of cash or property to the participant from the plan at the same time. Even where there has been a deemed distribution and the defaulting participant is required to recognize the deemed distribution in income, the participant is still obligated to either repay the defaulted loan back to the plan or, if the plan permits, the participant’s accrued benefit may be offset by the amount of the deemed distribution. The final regulations contain the following examples that illustrate the application of the requirements of �72(p) and the tax consequences of violating said requirements. Example 1 A plan participant has a vested account balance of $200,000 and receives $70,000 as a loan repayable in level quarterly installments over five years. Under �72(p), the participant has a deemed distribution of $20,000 (the excess of $70,000 over $50,000) at the time the loan is made. The remaining $50,000 is not a deemed distribution but is considered a valid loan. Example 2 A participant with a vested account balance of $30,000 borrows $20,000 as a loan repayable in level monthly installments over five years. Because the amount of the loan is $5,000 more than 50 percent of the participant’s vested account balance, the participant has a deemed distribution of $5,000 at the time of the loan. The remaining $15,000 is a valid loan and not a deemed distribution. Example 3 The vested account balance of a participant is $100,000 and a $50,000 loan is made to the participant repayable in level quarterly installments over seven years. Here, the entire loan is not valid under �72(p) (except for loans used to acquire certain dwelling units). Accordingly, the participant has a deemed taxable distribution of $50,000 at the time the loan is made. Example 4 A participant has a vested account balance of $45,000 and borrows $20,000 from the plan to be repaid over five years in level monthly installments due at the end of each month. After making 12 monthly payments, the participant fails to make the next payment due. As of the result of the failure to make the monthly installment required under the terms of the loan, the entire balance of the loan is deemed distributed to the participant when the participant fails to pay the installment due (including any applicable cure period). It is also important to note that �72(p) and the regulations thereunder only relate to the income tax treatment of plan loans. ERISA The Employee Retirement Income Security Act of 1974, as amended, also imposes rules applicable to plan loans. Under �408(b) of ERISA, a plan loan will not constitute a prohibited transaction and a breach of fiduciary duty (as an otherwise impermissible extension of credit to a party-in-interest) only if the loan is made pursuant to a plan loan program that provides that plan loans: (1) are available to all such participants and beneficiaries on a reasonably equivalent basis; (2) are not made available to highly compensated employees, officers or shareholders in an amount greater than the amount made available to other employees; (3) are made in accordance with specific provisions regarding such loans as set forth in the plan; (4) bear a reasonable rate of interest; and (5) are adequately secured. Accordingly, not only must a plan loan comply with the income tax requirements of �72(p), it must also comply with the requirements of �408(b) of ERISA or subject the plan’s fiduciary to liability and excise taxes. The major issues relating to plan loans that were clarified or modified in the final regulations relate to rules for the suspension of loan repayments during leaves of absence for military service, the effect of prior defaults on a subsequent plan loan, the effect of refinancing existing loans and the ability to obtain multiple loans. Military Loan Repayment Generally, loan repayments may be suspended for up to one year during an employee’s approved leave of absence, if such absence is either at no pay from the employer or at a rate of pay (after income and employment tax withholding) that is less than the installment payments required under the terms of the loan. However, upon termination of the leave of absence, the loan (including interest accrued during the leave) must be repaid by the latest permissible term of the loan — that is, five years from the original loan date — and the amount of the repayment installments must not be less than the amount required under the original terms of the loan. IRC �414(u)(4), added to the code as part of the enactment of the Uniformed Services Employment and Reemployment Rights Act of 1994, allows a retirement plan to suspend an employee’s plan loan repayment obligation for any period during which the employee is on leave performing service in the uniformed services of the United States. The final regulations provide that a plan that permits suspension of loan repayments during a leave of absence for military service will not cause the loan to be deemed distributed even if the military leave exceeds one year. In addition, the loan balance as of the date of the completion of military service must also be repaid in substantially level installments at least equal in amount to the installments originally required under the terms of the loan, but the repayment date may be extended to the end of the original term of the loan plus the period of the military service. In essence, the final regulations provide the employee returning from a leave for military service with two options for the repayment of outstanding plan loans. The employee can resume making payments under the original amortization schedule with a balloon at the end of the extended term of the loan for any additional interest that accrued during the leave, or the amount of each repayment installment can be increased to provide for a full amortization of the new loan balance over the remaining (extended) term of the loan. The final regulations also allow plans to use the 6 percent annual interest rate provided by the Soldiers and Sailors Civil Relief Act Amendments of 1942 in lieu of a higher interest rate specified in the original loan documents for purposes of determining the interest accruing during any period of leave for military service. Failure To Comply If a loan is deemed distributed to a participant because of failure to comply with the plan loan requirements, then no subsequent loan by the plan to the defaulting participant may be treated as a loan unless the borrower agrees that repayments under the subsequent loan will be made by payroll withholding or the plan has received adequate security for the new loan (in addition to the participant’s accrued benefit under the plan). Moreover, under the final regulations, where a loan is deemed distributed but has not been repaid or offset against the participant’s benefits in the plan, such loan is still considered outstanding for purposes of determining the maximum amount of any subsequent loan available to the participant for purposes of the limitations contained in �72(p)(2)(A). The final regulations do not place a limit on the number of plan loans that a participant may obtain from a plan during the course of any year. The proposed regulations provided that a deemed distribution would occur if a participant obtained more than two loans in a calendar year. The final regulations also reaffirm the ability to refinance an existing plan loan with a new plan loan. However, the refinanced amount of the original loan must be repaid within five years from the commencement date of the original loan (even if the original loan had a term of less than five years), while any new funds advanced can be repaid over a period of up to five years from the date of the refinancing. Complex rules are also provided relating to the aggregation of the outstanding balance of the original loan and the amount of the refinancing loan for purposes of applying the maximum plan loan limitations contained in �72(p)(2)(A). The final regulations provide helpful guidance in structuring plan loans and serve to resolve most of the remaining issues relating to plan loans and their potential taxability. The final regulations are generally effective for plan loans made on or after Jan. 1, 2002.

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