Defaulted participant loans under qualified retirement plans.

• Author: Daum, Timothy A.

The IRS issued Prop. Regs. Sec. 1.72(p)-1 in December 1995. This regulation provided guidance on the proper treatment of defaulted participant loans under qualified retirement plans, including the important distinction between "loan offset amounts" and "deemed distributions." (See "Qualified Retirement Plan Loans," The Tax Adviser, September 1996, p. 539.)

On Dec. 31, 1997, the IRS issued additional guidance by adding two additional Q&As to the 1995 proposed regulation. The two new Q&As are Q&A-19 and Q&A-20 (existing Q&A- 19, dealing with the regulatory effective date, has been modified and redesignated as Q&A-21). This additional guidance provides important answers to some questions left: unanswered in the original proposed regulation.

The most important clarification is that, although it is considered to be part of the outstanding loan balance when determining the permissible amount of any future plan loans, interest that accrues on a defaulted loan after it has been treated as a deemed distribution (and consequently, taxed to the individual) is not taxable to the individual. (This is consistent with Chapman, TC Memo 1997-147.)

The regulation also clarifies that basis is not created at the time of the deemed distribution, but the deemed distribution amount is not taxable under Sec. 72 on the eventual distribution ("loan offset"). Therefore, there is no double taxation of the defaulted loan amount. Basis is created, however, when an individual makes loan payments after the loan has been treated as a deemed distribution. Any such repayments are treated as after-tax contributions for tax purposes, not treated as after-tax contributions for other purposes, such as actual contribution percentage testing under Sec. 401(m) or annual additions testing under Sec. 415.

The proposed regulation is effective for loans occurring on or after the first January 1 at least six months after the publication date of the final regulation in the Federal Register. Although the regulation does not provide any guidance on plans that choose not to...