The IRS Tax Exempt and Government Entities division has published guidelines (TEGE-04-0417-0016) for agents to use to determine if the rules of IRC §72(p)(2) have been followed regarding the maximum amount an employee may borrow from a qualified retirement plan.
Under IRC §72(p)(1) a loan to a plan participant is to be treated as a taxable distribution to the participant. However, if the loan meets the requirements of IRC §72(p)(2) it will not be treated as a taxable distribution. Obviously, since an employee isn’t likely to want a loan on which he/she pays tax on and then still must repay, plans that offer loans generally have terms that require the loan to comply with the provisions of IRC §72(p)(2).
The first basic requirement is the limitation on the amount of any loan. IRC §72(p)(2)(A) provides the following:
(A) General rule Paragraph (1) shall not apply to any loan to the extent that such loan (when added to the outstanding balance of all other loans from such plan whether made on, before, or after August 13, 1982), does not exceed the lesser of—
(i) $50,000, reduced by the excess (if any) of—
(I) the highest outstanding balance of loans from the plan during the 1-year period ending on the day before the date on which such loan was made, over
(II) the outstanding balance of loans from the plan on the date on which such loan was made, or
(ii) the greater of (I) one-half of the present value of the nonforfeitable accrued benefit of the employee under the plan, or (II) $10,000.
For purposes of clause (ii), the present value of the nonforfeitable accrued benefit shall be determined without regard to any accumulated deductible employee contributions (as defined in subsection (o)(5)(B)).
The guidance issued deals with the $50,000 limit noted above, and how it is affected if a loan is made to a participant who has or had another loan outstanding during the 12 months prior to the issuance of the new loan. Such a loan is subject to the “highest balance” test described above.
The guidance notes that:
The reason for adjusting the maximum by the repayment amount was to “prevent an employee from effectively maintaining a permanent outstanding $50,000 loan balance”. H.R. Rept. 99-426 at 735 (1985).
While that may seem simple enough, if there are multiple loans the IRS notes that there are multiple ways the rule might be interpreted under current law:
For example, a participant borrowed $30,000 in February which was fully repaid in April, and $20,000 in May which was fully repaid in July, before applying for a third loan in December. The plan may determine that no further loan would be available, since $30,000 + $20,000 = $50,000. Alternatively, the plan may identify “the highest outstanding balance” as $30,000, and permit the third loan in the amount of $20,000. At this time, the law does not clearly preclude either computation of the highest outstanding loan balance in the above example.
This guidance provides that agents are to accept either of those computations may be used by a plan to compute the highest outstanding balance and, so long as that was done by the plan, the maximum loan requirements will have been met.