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On Dec. 3, 2002, the Internal Revenue Service issued final regulations that address issues relating to loans from qualified employer plans to plan participants or beneficiaries. The final regulations are substantially similar in substance to the proposed plan loan regulations issued almost two and a half years ago. The issues addressed include the effect of refinancing a loan from a qualified plan, the suspension of loan repayments during a leave of absence for service in the military, multiple loans from employer plans and the effect of a new loan following a “deemed distribution” of a prior loan. CODE SECTION 72(P) Section 72(p)(1) of the Internal Revenue Code of 1986, as amended generally provides that if a participant or beneficiary of a qualified employer plan receives a loan from the plan, the amount of the loan will be treated as having been received by such individual as a distribution under the plan (“deemed distribution”). The amount of a deemed distribution will have to be included in the individual’s gross income for the year in which the loan is received. However, Code � 72(p)(2) exempts certain loans from the application of Code � 72(p)(1) if the loan satisfies certain conditions, including those relating to the term of the loan, the repayment schedule and the amount of the loan. In general, Code � 72(p)(1) would not treat a loan from a qualified employer plan as a deemed distribution if it is required to be repaid within five years (longer for certain home loans) in substantially level installments paid not less frequently than quarterly. To avoid treatment of a loan as a deemed distribution the loan, if when added to the outstanding balance of all other loans from the plan, must not exceed the lesser of: (i) $50,000, reduced by the excess of the highest outstanding balance of loans from the plan during the preceding 12 months over the outstanding balance of loans from the plan, or (ii) the greater of (A) one-half of the present value of the participant’s or the beneficiary’s nonforfeitable accrued benefit under the plan, or (B) $10,000. Under Code � 72(p)(2)(D), loans from all plans of the employer’s controlled group are treated as one loan. For purposes of Code � 72(p), the preamble to the final regulations states that a “qualified employer plan” includes: (i) any plan that qualifies under Code �� 401 (relating to qualified trusts), 403(a) (relating to qualified annuities) or 403(b) (relating to tax sheltered annuities); (ii) any plan (whether or not qualified) maintained by the United States, a state or political subdivision thereof, or an agency or instrumentality thereof; and (iii) any plan which was (or was determined to be) a qualified employer plan or a government plan. On July 31, 2000, final regulations (the 2000 regulations) were issued with respect to the treatment of qualified plan loans under Code � 72(p)(2). At the same time, the IRS issued the proposed regulations addressing certain issues arising under Code � 72(p)(2) that were not covered in the 2000 Regulations. The final regulations issued earlier this month are substantially similar to the proposed regulations except that the final regulations: (i) eliminate the limit on the number of loans that can be made to any participant and (ii) permit the extension of the repayment schedule at the end of a leave of absence for military service, where the original loan had a term of less than five years. The following is a summary of the issues addressed in the final regulations. MULTIPLE LOANS Code � 72(p)(2) does not by its terms prohibit a participant from borrowing money from a plan more than once a year. To address the concern that a participant could take out additional loans to avoid repayment of prior loans, the proposed regulations provided that a deemed distribution occurs if a participant obtains more than two loans in a year. However, according to the preamble to the final regulations, while commentators agreed that these potential abuses should not be permitted, they also stated that most defined contribution plans already contain limitations on the number of loans that may be outstanding at one time and that the $50,000 limitation under Code � 72(p)(2)(A)(i) also inherently limits the number of larger loans that can be made. Commentators further suggested that in certain cases, flexibility was desirable to allow participants with legitimate needs (such as parents with several children in college) to take out more than two loans in one year. For these reasons, the final regulations do not contain any limitations on the number of loans that can be made under Code � 72(p)(2). Therefore, participants may now take out more than two loans in one year which, as pointed out by commentators, would allow participants to use their account balance under a qualified employer plan to establish their creditworthiness for the purpose of obtaining a credit card and a loan from that credit card without generating taxable income through a deemed distribution. MILITARY SERVICE The Proposed Regulations stated that, under Code � 414(u)(4), a plan that permits the suspension of loan repayment during a leave of absence for military service will not result in a deemed distribution, even if the leave of absence exceeded one year (the level amortization requirement of Code � 72(p)(2)(C) generally does not apply suspensions of payments during unpaid or reduced pay leaves of absence not longer than one year), so long as (i) the loan repayments resume upon the completion of the military service, (ii) the amount remaining due on the loan is repaid in substantially level installments, and (iii) the loan is fully repaid by the end of the original term of the loan plus the period of military service. Code � 414(u)(4) permits military service personnel to postpone loan repayments while performing military service, but it does not prevent the accrual of interest or alter any conditions under Code � 72(p)(2). The proposed regulations provided that upon return from military service, a plan lender may permit a participant to elect to either increase the payment amount or keep the payment amount the same and instead make a balloon payment at the end of the original term equal to the balance. The final regulations adopted this provision substantially as proposed, with two modifications: (i) an example was changed to reflect the application of a maximum 6 percent interest rate during the military leave of absence and (ii) a modification was made to clarify that loan repayments can be revised at the end of a military leave to extend the repayment schedule if the loan originally had a term of fewer than five years. EXTENSION The proposed regulations provided that if a loan is treated as a deemed distribution to a participant or beneficiary under Code � 72(p) and has not yet been repaid, then, unless certain conditions are satisfied, any further payments made to the participant or beneficiary thereafter will not be treated as loans under Code � 72(p). The proposed regulations provided that for such further payments to be treated as loans, the plan must enter into an agreement with the participant which provides either that repayments will be made through payroll withholding or the plan must obtain adequate security for the additional loan (in addition to the participant’s accrued benefit). Commentators voiced concerns regarding the difficulties certain plan lenders may have in determining whether an individual has defaulted on a plan loan thereby having a deemed distribution (for example, individuals often hold Code � 403(b) annuity contracts with more than one issuer). A subsequent loan to the defaulting participant could subject the plan lender to penalties. However, the issuer of any loan under Code � 72(p) must inquire about other loans made from other plans before extending a loan in order to ensure satisfaction of the limitations on the maximum amount that may be loaned under Code � 72(p)(2)(A). The issuer may simply condition the new loan on the participant’s disclosure of such prior loans and then rely on the participant’s disclosure so long as the issuer has no reason to doubt its truth. Accordingly, the final regulations adopted this provision as it was proposed. LOAN REFINANCING Under the proposed regulations, a loan may be refinanced so long as the refinancing arrangement satisfies the requirements of Code � 72(p)(2)(B) and (C). Accordingly, the loans must be repaid over a period not in excess of five years (longer for certain home loans) in substantially level installments paid not less frequently than quarterly. Such a refinancing is treated as a continuation of the prior loan, plus a new loan to the extent of any increase in the loan balance. Therefore, a refinancing loan can be repaid over a five-year period from the date the refinancing occurs to the extent the refinancing loan exceeds the prior loan amount. However, in order for the prior outstanding loan not to be considered a deemed distribution, it must continue to be repaid in substantially level installments over a period not longer than the original term remaining on the prior loan. A refinancing can also satisfy the requirements of Code �� 72(p)(2)(B) and (C) if the refinanced loan is repaid within the original term remaining on the prior loan. If any part of the refinancing loan has a later repayment date than the original term remaining on the prior loan, then both the prior loan and the refinancing loan will be treated as outstanding at the time of the refinancing for purposes of the Code � 72(p)(2) limitations on the maximum amount that may be loaned from plans of the employer. The final regulations adopted this provision generally as proposed, modified only to take into consideration the suggestion from commentators that refinancings should accommodate a prior loan with a term of less than five years that is refinanced to a date that is five years from the date of the prior loan. A similar modification was made for repayments made following a leave of absence for military service. ELECTRONIC SIGNATURE The 2000 regulations require that the terms of a plan loan be set forth in an enforceable agreement which may be in an electronic medium that satisfies standards that are based on the standards for an electronic consent to a distribution. The IRS and the Treasury Department noted recently that they are considering the extent to which notices under various Code requirements relating to qualified retirement plans can be provided electronically, taking into account the effect of The Electronic Signature in Global and National Commerce Act (ESIGN). They anticipate issuing proposed regulations regarding these issues, and invite comments on these issues. The final regulations apply to assignments, pledges and loans made on or after Jan. 1, 2004. However, they do not apply to loans made under an insurance contract that is in effect on Dec. 31, 2003 if the insurance carrier is required to offer loans to contractholders that are not secured (other than by the participant’s or the beneficiary’s benefit under the contract). Commentators suggested that in certain cases, flexibility was desirable to allow participants with legitimate needs (such as parents with several children in college) to take out more than two loans in one year. Donald P. Carleen is a partner at Fried, Frank, Harris, Shriver & Jacobson ( www.friedfrank.com). Adam Scoll, an associate with the firm, assisted in the preparation of this article. If you are interested in submitting an article to law.com, please click herefor our submission guidelines.

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