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Refinancing of Plan Loans May Trigger Taxable Deemed Distributions and Penalties

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July 13, 2009

During these difficult economic times, requests for retirement plan loans have significantly increased. Coincidentally, two recent Summary Opinions by the United States Tax Court serve as a timely reminder of how important the adequate processing and administration of plan loans is to prevent adverse tax consequences and penalties.

In these two opinions (TC Summary Opinions 2009-80 and 2009-86), the Court ruled that the refinancing of previously issued loans from a qualified retirement plan resulted in a taxable distribution, because none of the exceptions of Internal Revenue Code Section 72(p)(2) to the maximum loan amount applied. A 10% additional tax penalty was also imposed in both cases.

Specifically, the Court stressed the fact that, as provided in Q&A 20 of Treasury Regulations §1.72(p)-1, when an existing plan loan is replaced by another loan that has a later repayment date (e.g., refinancing), both loans are regarded as outstanding on the date of the transaction. Consequently, the amount of both loans must be taken into account in the aggregate when considering whether the maximum loan limit (e.g., the lesser of (a) $50,000, or (b) the greater of (i) 50% of the participant’s account balance, or (ii) $10,000) will be exceeded on the date of the transaction.

In each of these cases, the amount of the replacement loan plus the amount of the outstanding loan (the loan being replaced), was greater than the maximum loan limit. Consequently, a taxable distribution was deemed to have occurred in the amount that all loans outstanding on the date of the transaction exceeded the maximum loan limit.

As mentioned, a 10% penalty applied. In one case, because the participant was below the 59½ age threshold and therefore, the loan was deemed an early distribution. In the other, because the taxpayer was unable to show that any of the exceptions of Internal Revenue Code Section 72(t) applied.

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