A qualified retirement plan can provide for loans to be made to participants under the terms of the plan if the plan provisions comply with the requirements under IRC §72(p)(2). The loan must require repayment within five years, have payments made at least quarterly, and there must be a level amortization (that is, equal payments). If a participant fails to comply with the terms of the loan, the balance is deemed distributed to the participant.

Reg. §1.72(p)-1, Q&A 10 allows a plan to include a “grace period” to allow participants to correct missed payments. Under these provisions a missed payment must be corrected by the end of the calendar quarter after the calendar quarter in which the missed payment took place. While a plan does not have to allow for a grace period, most plans will provide for this since otherwise any sort of problem would trigger a deemed distribution to the beneficiary.

In Chief Counsel Memorandum 201736022 the IRS looks at two situations to determine if the grace period rules have been complied with.

The first situation looks at whether the rule can be interpreted to allow for “shifting payments”.

Situation 1. The participant timely makes installment payments from January 31, 2018, through February 28, 2019. The participant misses the March 31, 2019 and April 30, 2019 installment payments. The participant makes installment payments on May 31, 2019 (which is applied to the missed March 31, 2019 installment payment) and June 30, 2019 (which is applied to the missed April 30, 2019 installment payment). On July 31, 2019, the participant makes a payment equal to three installment payments (which is applied to the missed May 31, 2019 and June 30, 2019 installment payments, as well as the required July 31, 2019 installment payment).

The memorandum concludes that assigning the next regular payment to the oldest unpaid payment does comply with the grace period regulations. The analysis provides:

In Situation 1, under the cure period, the two missed installment payments (March 31, 2019, and April 30, 2019) have separate cure periods because they occur in separate calendar quarters. For the missed March 31, 2019 installment payment, the cure period ends June 30, 2019, and for the missed April 30, 2019 installment payment, the cure period ends September 30, 2019. Each missed installment payment is cured within that missed installment payment’s applicable cure period. The missed March 31, 2019 installment payment is cured by installment payment made on May 31, 2019. Likewise, the missed April 30, 2019 installment payment is cured by the installment payment made on June 30, 2019. However, the May 31, 2019 and June 30, 2019 installment payments are missed because those installment payments are applied to the earlier missed installment payments (March 31, 2019 and April 30, 2019). The missed May 31, 2019 installment payment and the missed June 30, 2019 installment payment have a cure period that ends September 30, 2019. The missed May 31, 2019 installment payment and the missed June 30, 2019 installment payment are cured by the payment made on July 31, 2019 (which is applied to the missed May 31, 2019 and June 30, 2019 installment payments, as well as the required July 31, 2019 installment payment). Accordingly, under § 1.72(p)-1, Q&A-10, the level amortization requirement under § 72(p)(2)(C) is not violated and there is no deemed distribution from the missed March 31, 2019, April 30, 2019, May 31, 2019, and June 30, 2019 installment payments.

The second situation looks at using a new loan to refinance the old while there are still outstanding unpaid installments.

Situation 2. The participant timely makes installment payments from January 31, 2018, through September 30, 2019. The participant misses the October 31, 2019, November 30, 2019, and December 31, 2019 installment payments. On January 15, 2020, the participant refinances the loan and replaces it with a new loan (the replacement loan) equal to the outstanding balance of the original loan (the replaced loan), including the three missed installment payments. Under the terms of the replacement loan, the replacement loan is to be repaid in level monthly installments at end of each month through the end of the replaced loan’s repayment term, December 31, 2022. For purposes of this example, assume that the replacement loan satisfies the requirements of § 72(p)(2)(A) through (C) and § 1.72(p)-1, Q&A-3 and Q&A-20.

Although it may surprise some readers, the memorandum concludes that this arrangement also satisfies the grace period regulations.

In Situation 2, the three missed installment payments (October 31, 2019, November 30, 2019, and December 31, 2019) have the same cure period, which ends March 31, 2020, because they occur in the same calendar quarter. The replacement loan created by the refinancing of the replaced loan on January 15, 2020, pays off the entire outstanding balance of the replaced loan (which includes the three missed installment payments) within the missed installment payments’ cure period. Accordingly, under § 1.72(p)-1, Q&A-10, the level amortization requirement under § 72(p)(2)(C) is not violated for the replaced loan and there is no deemed distribution from the three missed installment payments.

One issue the memorandum does not discuss regarding this fix is that it will only work if the new loan doesn’t violate the maximum loan amount under IRC §72(p)(2). That maximum amount of any new loan is limited to the maximum amount that would otherwise be allowed reduced by the maximum amount of any other plan loans outstanding during the prior one-year period.

As a practical matter, the refinancing option is only going to be available if the amount borrowed was less than ½ of the maximum loan amount (measured at the date of refinancing) for the year before the refinancing.