Deemed Distribution Took Place on Last Day of Prior Year, Not Date Plan Administrator Sent Letter of Distribution to Participant

There was no question that the taxpayer in the case of Gowen v. Commissioner, TC Summ. Op. 2017-57 had defaulted on the loan he received from his former employer’s 401(k) plan and, as well, that he did not correct the default prior to the cure period allowed under the plan.  But the taxpayer argued that the actual deemed distribution did not take place in 2012, the year the deemed distribution was reported by the plan custodian on a Form 1099R, but rather at some point in 2013.

The facts leading up the default were summarized in the opinion as follows:

On March 8, 2012, petitioner borrowed $50,000 from his KPMG section 401(k) retirement plan account administered by Merrill Lynch (a unit of Bank of America N.A.). The terms of the loan required petitioner to make 120 semimonthly payments of $451.72, beginning on March 30, 2012, and ending on March 15, 2017. Petitioner initially made the required payments, but after he lost his job at KPMG, he stopped making payments, beginning with a missed payment due on August 30, 2012. Merrill Lynch sent petitioner a notice dated October 23, 2012, stating: “Our records indicate that your loan payment is past due. Your loan is in danger of being defaulted.”

The plan administrator’s notice also informed Mr. Gowen that the administrator was required to treat the defaulted loan balance as a distribution to Mr. Gowen unless he corrected the default before the end of the cure period.  The period for curing this default would be the end of the calendar quarter following the calendar quarter when the payment was missed.

Merrill Lynch sent Mr. Gowen additional notices on November 26 and December 26, reminding him he was in default and warning him that if the issue was not corrected he would be subject to tax on the deemed distribution.  Mr. Gowen took no action regarding those notices.

Merrill Lynch processed the deemed distribution shortly after what they regarded to be the expiration date of the period to fix the default, December 31, 2012.  As the default took place in August 2012, the administrator treated the default as occurring in the calendar quarter ended September 30, 2012.  Thus, the end of the calendar quarter following the quarter when the payment as missed would be December 31, 2012.

Merrill Lynch reported a deemed distribution of $46,703, the defaulted portion of the $50,000 loan, on a Form 1099R that was sent to both the IRS and the taxpayer.  Mr. Gowen claims he never actually received that Form 1099R, but admitted he did receive a distribution statement sent by Merrill Lynch dated January 7, 2013 that reported the $46,703 deemed distribution.

When he filed his return for 2012 he did not include the deemed distribution on that return.  He claimed he did so because he did not receive the Form 1099R from Merrill Lynch for 2012 and, per the statement sent by Merrill Lynch, the distribution took place on January 7, 2013.

The taxpayer argued the amount was not properly taxable in 2012.  The opinion notes:

Petitioner concedes that the balance of the loan outstanding as of the expiration of the cure period is deemed to be a taxable distribution. However, petitioner maintains that the cure period expired in 2013 and thus the distribution is deemed a taxable event for that year, not for 2012 as respondent asserts. Petitioner maintains that the loan notices sent on October 23, November 26, and December 26, 2012, informed him “that your loan was ‘in danger of being in default’” and that it was not until January 7, 2013, that Merrill Lynch issued him a distribution information statement reporting the deemed distribution from his default.

The taxpayer argued that the regulations did not establish a maximum cure period and that since he was told by Merrill Lynch the cure period was six months he could not have failed to cure the default, triggering the distribution, until well into 2013.  As well, he reasonably relied upon the notice from Merrill Lynch that he claimed showed an actual deemed distribution date of January 7, 2013.

First, the Court notes that Mr. Gowen is in error that the regulations do not provide for a maximum cure period.  As the opinion notes:

Petitioner’s position is not correct. The applicable regulation does, in fact, designate a “maximum cure period”. Section 1.72(p)-1, Q&A-10(a), Income Tax Regs., provides:

Failure to make any installment payment when due in accordance with the terms of the loan violates section 72(p)(2)(C) and, accordingly, results in a deemed distribution at the time of such failure. However, the plan administrator may allow a cure period and section 72(p)(2)(C) will not be considered to have been violated if the installment payment is made not later than the end of the cure period, which period cannot continue beyond the last day of the calender [sic] quarter following the calendar quarter in which the required installment payment was due.

The Court rejected Mr. Gowen’s interpretation of the regulation to allow a full six-month cure period.  He had argued that the period to cure the default should not depend on when you lost your job—so a participant defaulting on September 30 should not end up with nearly three months less time to correct a default than a participant defaulting on June 1.  In his view, the quarter of default was made up of August, September, and October, with the quarter following the quarter of default being November, December, and January.  The Court found this interpretation clearly at odds with the plain language of the regulation—that calendar quarters means quarters based on staring with quarter one on January 1 of the year in question.

The opinion notes the following example from Reg. §1.72-1 Q&A-10(c) supports the interpretation of the plan administrator:

(i) On August 1, 2002, a participant has a nonforeitable account balance of $45,000 and borrows $20,000 from a plan to be repaid over 5 years in level monthly installments due at the end of each month. After making all monthly payments due through July 31, 2003, the participant fails to make the payment due on August 31, 2003 or any other monthly payments due thereafter. The plan administrator allows a threemonth [sic] cure period.

(ii) As a result of the failure to satisfy the requirement that the loan be repaid in level installments pursuant to section 72(p)(2)(C), the participant has a deemed distribution on November 30, 2003, which is the last day of the three-month cure period for the August 31, 2003 installment. The amount of the deemed distribution is $17,157, which is the outstanding balance on the loan at November 30, 2003. Alternatively if the plan administrator had allowed a cure period through the end of the next calendar quarter, there would be a deemed distribution on December 31, 2003 equal to $17,282, which is the outstanding balance of the loan at December 31, 2003.

What about that statement from Merrill Lynch?  The court noted that while the letter was dated January 7, 2013, nowhere on the statement did it indicate the date the distribution occurred. 

As the Court concluded:

In sum, petitioner received a taxable retirement distribution of $46,703 in 2012.