Employer's Failure to Deduct 401(k) Loan Payments from Employee's Pay While on Leave Resulted in Taxable Distribution

A participant in a qualified employer retirement plan may, if the plan allows it, borrow funds from the plan.  However, such borrowing is subject to a number of specific provisions in federal law and regulations.  Violation of the provisions regarding repaying the loan results in its treatment as a distribution from the plan, taxable to the participant.  That’s true even though the participant remains liable to repay and does actually repay the loan to the plan.

In the case of Frias v. Commissioner, TC Memo 2017-139 there was little question the written terms of the loan had not been followed—but the failure had been due to a failure by the employer to fulfill its obligation to withhold the payment from Ms. Frias’s checks she received while was on maternity leave.

Ms. Frias was a participant in Glen Island’s 401(k) plan.  Ms. Frias was getting ready to go on maternity leave and on July 27, 2012 borrowed $40,000 from the plan.  The loan provided that Glen Island would withhold the payment amounts from Ms. Frias’s biweekly paychecks, with the first payment to be taken from her August 10, 2012 paycheck.  The amount of each payment was to be $341.79.  Under the terms of the loan, should Ms. Frias end up in default for such a payment, she could correct the shortfall by the end of the month following the month in which the default occurred.

Glen Island’s 401(k) plan was being administered by Mutual of America Life Insurance Company.  Any payments Glen Island were to withhold from Ms. Frias’s pay were to be forwarded to Mutual of America to apply against the loan.  Mutual of America was also responsible each year for preparation of any required Forms 1099R for the plan.

Ms. Frias began her maternity leave three days after the loan was taken out.  During her leave of absence Ms. Frias continued to receive some paychecks based on her sick and vacation time.  However, her employer mistakenly failed to withhold the required payments on her 401(k) plan loan from these checks.  Ms. Frias returned to work on October 12, 2012.

After she returned to work she was informed by her employer that they had neglected to deduct the payments from any of the checks she received while on leave, thus putting her in violation of the loan agreement. 

Upon learning of this error, Ms. Frias made a payment of $1,000 on November 20, 2012.  She also instructed her employer to increase the payments they were withholding from her paycheck to $500 per pay period through July 15, 2013.  After that date, the payments reverted to the original amount, with all payments being made until the loan had been fully repaid in July of 2014.

However, the Tax Court noted that while all may appear well, the regulations under IRC §72(p) created a problem in this situation:

Although a loan originally may satisfy the section 72(p) requirements, “a deemed distribution occurs at the first time that the requirements * * * of this section are not satisfied, in form or in operation.” Sec. 1.72(p)-1, Q&A-4(a), Income Tax Regs. If “payments are not made in accordance with the terms applicable to the loan, a deemed distribution occurs as a result of the failure to make such payments.” Id.; see Duncan v. Commissioner, T.C. Memo. 2005-171; Molina v. Commissioner, T.C. Memo. 2004-258. The plan administrator may provide the participant with an opportunity to cure the failure, and a deemed distribution does not occur unless the participant fails to pay the delinquent payment within the cure period. Sec. 1.72(p)-1, Q&A-10(a), Income Tax Regs.; see Owusu v. Commissioner, T.C. Memo. 2010-186.

While Ms. Frias may not have been aware of this law provision, the plan administrator was not only aware of it but issued a 2012 Form 1099R to Ms. Frias.  However, the Form 1099R was delivered online (that is, not sent by mail) and Ms. Frias, although she had access to the website where the Form 1099R was uploaded, did not access or review it.  The Court also noted that the record before the Court did not disclose whether Ms. Frias was given notice that a Form 1099R had been issued.  In any event, Ms. Frias clearly did not believe that any distribution or other taxable event had taken place until the IRS came calling—and that belief is clearly a reasonable one for anyone who doesn’t have a detailed understanding of the qualified plan loan provisions in the law and regulations.

The IRS position was that a distribution took place because Ms. Frias violated the terms of the loan on August 24, 2012 when the first payment due was not made and then did not correct the violation by September 30, 2012, the last date allowed for her to make such a corrective payment under the terms of the plan loan.

The taxpayer argued that she was not actually in violation because, at the time the first payment was due, she was on a leave of absence without pay, which under Reg. §1.72(p)-1, Q&A-9(a), would exempt her from the substantially equal repayment requirements required for such plan loans.  That portion of the regulation provides:

Q-9: Does the level amortization requirement of section 72(p)(2)(C) apply when a participant is on a leave of absence without pay?

A-9: (a)Leave of absence. The level amortization requirement of section 72(p)(2)(C) does not apply for a period, not longer than one year (or such longer period as may apply under section 414(u) and paragraph (b) of this Q&A-9), that a participant is on a bona fide leave of absence, either without pay from the employer or at a rate of pay (after applicable employment tax withholdings) that is less than the amount of the installment payments required under the terms of the loan. However, the loan (including interest that accrues during the leave of absence) must be repaid by the latest permissible term of the loan and the amount of the installments due after the leave ends must not be less than the amount required under the terms of the original loan.

The opinion noted that there was one problem—Ms. Frias did receive some paychecks during that period, using up her accrued sick and vacation time, and certainly the check from which the August 24, 2012 would have been withheld was well in excess of the amount of the payment due.  The Court rejected Ms. Frias’ assertion that such payments were not actually wages, finding that the unpublished Federal District Court memorandum and order cited by her dealt only with the calculation of “wages” for Social Security benefits, not with “pay” under the above regulation.

Ms. Frias contended that, regardless, that the use of accrued sick, personal and vacation time should not count as “pay” because the Family and Medical Leave Act of 1993 allows an employee who is on unpaid leave to use such accrued days as all or part of FMLA leave—and her maternity leave would have qualified as FMLA leave.  The Court rejected this view, noting:

The right of an employee during FMLA leave to receive payments for leave earned by the employee does not excuse Mrs. Frias’ failure to make loan payments from compensation she received during the first five weeks of her leave. Even if we were to accept petitioners’ argument about the FMLA, which we do not, the record is devoid of any evidence that Mrs. Frias was actually on or qualified for FMLA leave. Petitioners have failed to convince us that the FMLA excused petitioners from the substantially level amortization requirement of section 72(p)(2)(C).

But what about the fact that her employer and the plan administrator acted as if the problem had been corrected?  After all, given that Ms. Frias really was, in many ways, a victim of the failure of her employer to fulfill its obligation shouldn’t there be some relief.

Specifically, the Court noted she advanced three theories:

Petitioners also contend that if section 1.72(p)-1, Income Tax Regs., does not apply, there was no distribution because: (1) all parties to the loan acted as though they agreed to suspend payments; (2) the substance of the repayments should be honored over the form that was required; or (3) Mrs. Frias corrected the default in accordance with Rev. Proc. 2008-50, 2008-2 C.B. (Vol. 1) 464, 481.

The Court held that if, in fact, there had been an agreement among the parties to modify the loan, the loan agreement needed to be amended in writing to stay compliant with the regulations.  There was no evidence that such a written amendment was ever made.

The opinion also held that the loan document and the regulations do allow for a “substance over form” treatment of this transaction—Ms. Frias, as a party to the agreement, needed to follow the form that she had agreed to.

Finally, the Court noted that Rev. Proc. 2008-2 allows for a plan sponsor, not a participant, to request relief from the IRS to correct plan loans that do comply with IRC §72(p)(2).  There was no evidence that Glen Island had made such a request.  The revenue procedure does offer an opportunity for a plan participant to seek such relief where the plan sponsor did not seek such relief.

The case is instructive regarding the risks involved both for participants who take out such loans and for plan sponsors who have plans that allow such loans to be taken.  Certainly, it would seem reasonable to believe that Ms. Frias is, at a minimum, somewhat upset with her employer since it was the sponsor’s mistake that started the process that lead to Ms. Frias owning over $15,000 in tax on funds that she had fully repaid to the plan.