The opportunity that wasn't.

• Author: Foss, Mary Kay
• Position: Federal Taxes - Brief Article

The 2001 Tax Act exempts qualified plan loans to owner from the prohibited transactions rules. Previously, these loans could subject the plan to excise taxes or plan disqualification. Sole proprietors, partners who own more than a 10 percent interest in the partnership, IRA owners and more than 5 percent owner employees of S corps all have been subject to the loan prohibition.

For years beginning after Dec. 31, 2001, only IRA participants and beneficiaries will be prohibited from plan loans. A similar amendment was made to the parallel ERISA provision.

Given this new opportunity, should owner employees make qualified plan loans? Probably not.

CONSIDER THIS

If your client is contemplating borrowing from a qualified plan, consider the following. Does the plan allow borrowing by an owner employee? When these loans were prohibited, most qualified plans were written to exclude such loans. The qualified plan must follow its own document as well as the IRC. Most plans covering sole proprietors, partnerships and S corps require an amendment to allow loans.

Does your client realize that the plan loan's interest won't be deductible? If lending sources are available that yield tax deductions for interest payments, those loans may be preferable. To make the interest deductible, more plan amendments and legal services will be required.

RIGID RULES

The income tax rules that apply to qualified plan loans are rigid. Loans cannot be made available on a basis that discriminates in favor of highly compensated employees. The loan must carry a reasonable interest rate and have a reasonable repayment schedule. Final regulations and new proposed regulations were issued in 2000 dealing with plan loans.

Loans are considered to be a deemed distribution from a plan unless they meet the exceptions in IRC Sec. 72(p). The requirements include limits on the amount to borrow: a $50,000 limit considering all loans outstanding during the year and 50 percent of the accrued benefit (or $10,000 if greater than the 50 percent limit); loan terms (5 years unless used to purchase or improve the principal residence); and, they must be amortized in level payments made at least quarterly.

Spousal consent is necessary to secure a plan loan for a married participant. In addition, if the loan does not meet the exceptions initially or on an ongoing basis and is treated as a distribution, it still must be repaid to the qualified plan. The repayment creates basis within the retirement plan...