U.S. Tax Court Decides 401(k) Participant Loan Case:

I have provided an article below titled “ERISA Litigation Update,” which includes brief descriptions of recent cases in the retirement plans arena.  However, I am devoting a full article here to discuss the recent case of Salomon v. Commissioner of Internal Revenue because it deals with an extremely common 401(k) plan administrative matter that is not litigated frequently: the always-challenging administrative task of having participant loans comply with applicable law and plan terms, and the common result of 401(k) plan participants bearing the brunt of noncompliance.

In this case, Ms. Salomon received a $40,000 loan from her 401(k) plan account on July 27, 2012, which was three days before she began a leave of absence. Her loan repayments were scheduled to begin in August of 2012, via biweekly payroll deductions. Under the governing documents, if a payment was missed, Mrs. Salomon could pay the delinquent amount up to the last day of the calendar month following the calendar month in which the delinquent payment was due (i.e. the cure period). Further, if Ms. Salomon did not pay any delinquent amount within the cure period, then: (1) the entire outstanding loan amount would be in default and considered a taxable distribution; and (2) the plan’s administrator would report the outstanding loan amount as a taxable distribution to her via IRS Form 1099-R.

Ms. Salomon received regular paychecks during her leave of absence, each in an amount significantly more than each required loan repayment. However, her employer failed to deduct loan repayments from those checks. The corresponding pay stubs reflected that failure, but Ms. Salomon did not become aware of the failure until she was informed by her employer upon returning from her leave of absence.  When she became aware of her employer’s failure, she immediately began making loan repayments (in an amount that exceeded the biweekly repayment amounts specified in her loan documents) until her missed repayments were caught up. At that point, Ms. Salomon continued to make the originally-required loan repayment amounts until the loan was fully repaid in 2014.

The plan administrator issued a Form 1099-R to Ms. Salomon for 2012, which reported a taxable distribution of $40,065. Documents the court reviewed did not indicate whether Ms. Salomon timely received that Form 1099-R. In any event, she did not report the loan on her 2012 federal tax return. On October 6, 2014, the IRS issued a notice of deficiency to Ms. Salomon for 2012, stating that she was liable for the loan’s distributed amount plus interest (i.e. $40,065), as well as tax penalties.

In its July 11, 2017 ruling, the U.S Tax Court began its analysis by citing the following language from IRS regulations under Internal Revenue Code Section 72(p): 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.” The court then stated that because Ms. Salomon’s first loan payment was not made by the due date or before the cure period expired, she defaulted under the loan agreement. Therefore, the loan’s outstanding balance, plus accrued interest, became a deemed distribution in 2012 that was taxable to Ms. Salomon. However, the court also ruled that Ms. Salomon exercised good faith when she attempted to remedy the missed payments. Consequently, she is not subject to the IRS’s proposed tax penalty of $3,188.

Note that if the 401(k) plan involved here had provided for the maximum cure period under IRS regulations (the end of the calendar quarter following the calendar quarter in which the delinquent payment was due), Ms. Salomon would not have incurred this taxable event. Her adverse tax consequences, and this litigation itself, could also have been avoided if her employer had filed an application on her behalf under the IRS’s Voluntary Correction Program. I frequently assist clients with this issue, which includes minimizing employees’ potential tax burdens, so please let me know if you have any questions in this regard.

The court’s opinion can be viewed here: https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=11327