Employee’s Maternity Leave Resulted in a “Deemed Distribution” of 401(k) Plan Loan

A recent Tax Court decision suggests that employers may want to review their 401(k) plan loan programs and payroll practices. In Louelia Salomon Frias and Mervyngil Salomon v. Commissioner, TC Memo 2017-139 (July 11, 2017), the Tax Court held that an employee on maternity leave: (1) defaulted on her 401(k) plan loan; (2) failed to cure the default within the applicable cure period; and (3) as a result, there was a “deemed distribution” of the outstanding balance of the loan plus accrued interest which was taxable to the employee.

As described below, the loan default language in the 401(k) plan loan program documents the failure of the employer to make loan repayments from amounts paid to the employee during her maternity leave were the primary causes of this adverse result.

In July 2012, the employee took a roughly ten-week leave of absence from work for the birth of her child (from July 30, 2012 to October 12, 2012). The employee elected to use accrued sick, personal, and vacation leave to cover approximately four of the six payroll periods occurring during her maternity leave.

On July 27, 2012, the employee borrowed $40,000 from her 401(k) plan. The plan loan documents: (1) required her employer to deduct from her salary in each payroll period the loan repayments and remit the loan repayments to the 401(k) plan; (2) designated August 24, 2012, as the first loan repayment date; and (3) designated the last day of the calendar month following the calendar month that the delinquent payment was due as the date by which all delinquent amounts had to be paid (the “Cure Period”). If a loan was delinquent and all of the delinquent amounts were not paid during the Cure Period, the loan documents provided that the entire loan would be in default. In such a case, the plan loan would be considered a “deemed distribution” and the plan administrator would report the outstanding amount of the loan as a distribution to the employee.

Although the employee received four paychecks during her maternity leave (of which three were paid on or after August 24, 2012 [the first loan repayment date], her employer failed to deduct and remit the loan repayments from these payments. Upon her return from maternity leave, she discovered that her employer had failed to withhold the loan repayments from her paychecks. In response, she made a $1000 loan repayment on November 20, 2012, and instructed her employer to make increased repayments through July 15, 2013, and then revert back to the original loan repayment schedule throughout the remaining term of the loan. While the employer and the 401(k) plan administrator accepted these loan repayments, this cure procedure was not in accordance with the 401(k) plan loan program documents.

In relevant part, Section 72(p)(2) of the Internal Revenue Code provides that a loan from a qualified plan will not be treated as a distribution if the loan: (1) satisfies certain size requirements; (2) is repayable within 5 years; and (3) is amortized on a substantially level basis over the term of the loan (the “Substantially Level Amortization Requirement”). Although a loan may originally satisfy the Code Section 72(p) requirements, a “deemed distribution” occurs at the first time the Code Section 72(p) requirements are not satisfied.

With respect to the Substantially Level Amortization Requirement, the applicable Treasury Regulations provide: (1) the failure to make any installment payment when due violates the Substantially Level Amortization Requirement; (2) the Substantially Level Amortization Requirement is not violated if the delinquent payments are made up (paid in full) within the applicable Cure Period; and (3) a participant is exempt from the Substantially Level Amortization Requirement while he or she is on leave for no longer than a year either without pay or at a rate of pay less than the required loan repayment amounts (the “Leave of Absence Exemption”).

In this case, the Court determined that the loan went into default on August 24, 2012, and that the Cure Period ended on September 30, 2012. Notwithstanding that the employee made an additional payment of $1000 on November 20, 2012, with subsequently increased loan repayments, the Court concluded that this course of action was not a cure authorized under the loan program documents or the Internal Revenue Code.

In addition, because the employee’s accrued leave payments for four of the payroll periods during her maternity leave exceeded the amount of the loan repayments, the Court concluded that the employee did not qualify for the Leave of Absence Exemption from the Substantially Level Amortization Requirement. As such, the Court concluded there was a “deemed distribution” of the loan which was taxable to the employee in 2012. As a result, the employee had taxable income of $40,652 (the loan’s principal and accrued interest) and was subject to the 10% additional tax under Code Section 72(t) for early retirement plan distributions.

One hopes that the “deemed distribution” in this case was a result of a breakdown in plan administration and/or payroll procedures.  However, this case suggests a review of employer 401(k) plan loan programs and/or payroll practices may be warranted.

A number of employer responses readily come to mind.  First, employers may want to review their loan program documents to determine whether the default provisions (and Cure Periods thereunder) are appropriate. Second, employers may want to review the administrative practices of their third party administrators to ensure that the employer and/or employee are timely notified of default of a plan loan (within the Cure Period). Finally, if plan loans are being repaid through payroll deductions, the employer may want to review its payroll practices to ensure that loan repayments begin as of the first required payment date under the loan documents and continue when the employee is on paid leaves of absence.

About the Author

Jonathan H. Nason
Jon is a tax lawyer who advises employers on the design, implementation and administration of employee benefit plans, including ERISA and HIPAA compliance.