IRS Releases Guidance on Cure Period for Participant Loans:

As background, IRS regulations under Internal Revenue Code Section 72(p), which govern participant loans from certain retirement plans such as 401(k) plans, provide that loan repayments must involve a substantially level amortization of the loan. A participant’s failure to make any installment repayment when due violates that level amortization requirement and generally results in a “deemed distribution” (i.e. a taxable event for the participant) at the time of such failure. However, under an exception to that rule, the regulations provide that a plan administrator can allow a cure period that applies to certain missed loan repayments. The maximum permissible cure period ends on the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.

In IRS Office of Chief Counsel Advice Memorandum 201736022 (the “Memorandum”), released on September 8, 2017, the IRS addressed the cure period by analyzing two factual situations. For both factual situations, the IRS assumed the following: (1) the taxpayer receives a proper loan from his or her 401(k) plan account on January 1, 2018, repayable in five years (with the last installment payment due December 31, 2022); (2) level installment payments are due at the end of each month (with the first installment payment due January 31, 2018); and (3) the plan provides for the maximum permissible cure period.

• Situation #1:  The participant timely makes installment payments from January 31, 2018, to 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). In this situation, the Memorandum concludes that the participant’s missed installment payments do not violate the level amortization requirement because the missed installment payments are cured within the applicable cure period. Therefore, the missed installment payments do not give rise to a deemed distribution.
• Situation #2:  The participant timely makes installment payments from January 31, 2018, to 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 properly 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 replacement loan’s terms, the replacement loan is to be repaid in level monthly installments at the end of each month to the end of the replaced loan’s repayment term of December 31, 2022. The Memorandum concludes that the participant’s missed installment payments do not violate the level amortization requirement because the missed installment payments are cured within the cure period by refinancing the loan. Consequently, there is no deemed distribution in this situation.

Note that the failure to make all participant loan repayments in a timely manner is extremely common. However, even if a repayment is not made within a plan’s cure period (assuming the plan provides for a cure period), the plan sponsor might be able to file an application under the IRS’s Voluntary Correction Program to avoid having the affected participant incur a taxable event. That step can be extremely important in calming a participant’s emotions, particularly in cases where the failure resulted from an error in the plan sponsor’s payroll system. I recently prepared IRS applications for two clients to address this issue, so please let me know if you or your clients have any questions about this.