Taxpayer Failed to Make Delinquent 401(k) Loan Repayments Within Grace Period

(Parker Tax Publishing August 2019)

The Tax Court held that a taxpayer who temporarily stopped repaying a loan he took out from his 401(k) plan and did not resume making the payments within the cure (grace) period provided in Reg. Sec. 1.72(p)-1, Q&A-10(a), was therefore liable for income tax and the additional tax under Code Sec. 72(t) on the deemed distribution of the outstanding loan balance. The court found that, in addition to failing to resume payments within the cure period, the taxpayer also did not cure the default by making a lump-sum payment to cover the many payments (with accrued interest) that he had failed to remit earlier in the year. McEnroe v. Comm'r, T.C. Summary 2019-21.

Background

Gerard McEnroe worked for 15 years in the Office of Inspector General for the New York City School Construction Authority (SCA). As an SCA employee, McEnroe participated in the New York City Employees Retirement System (NYCERS), a qualified trust forming part of an employer-sponsored pension plan within the meaning of Code Sec. 401(a).

In July 2014, McEnroe borrowed $26,045 from his NYCERS retirement account to help pay college tuition expenses for one of his children. He immediately began to repay the loan through biweekly payroll withholding. On May 15, 2015, McEnroe left SCA for a private sector job. However, he quickly grew disillusioned with his new position and returned to SCA in September 2015. McEnroe did not make loan payments to NYCERS after he left SCA. When he returned, McEnroe learned that NYCERS had determined that his outstanding loan balance was a deemed distribution.

McEnroe contacted the SCA human resources (HR) office in search of a solution. On November 12, 2015, the HR office sent an email to NYCERS stating that McEnroe wished to reinstate his loan with installment payments to be effective immediately. The email said that after McEnroe left the SCA and payments were no longer being withheld, a notice of distribution was sent to his home. The email explained that McEnroe was once again an active SCA employee and wanted to avoid having his loan be treated as a distribution and that McEnroe wanted to repay the loan in biweekly payroll deductions. NYCERS responded with an email confirming that it would process a revision as of November 20, 2015.

In early December 2015, McEnroe resumed making loan payments to NYCERS through biweekly payroll withholding. NYCERS issued a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc., reporting that in 2015 McEnroe had received a distribution of $22,284 (the outstanding balance of the loan as of June 24, 2015). McEnroe was unaware that the Form 1099-R had been issued until May 2017.

McEnroe filed a Form 1040 for 2015 but did not report any income attributable to pension or annuity payments. The IRS determined a deficiency of $9,638 and applied a penalty of $1,928. McEnroe contested the deficiency and penalty before the Tax Court.

Code Sec. 402(a) provides that, in general, any amount actually distributed by a Code Sec. 401(a) qualified employer plan is subject to income tax under Code Sec. 72. Under Code Sec. 72(p)(1)(A), if a participant receives a loan from a qualified plan, the loan is generally treated as a distribution. However, under an exception provided in Code Sec. 72(p)(2), the loan is not treated as a distribution if it is either required to be repaid within five years or used to acquire the participant's principal residence. Under the exception, the participant is required to make substantially level payments at least quarterly over the term of the loan. In the event of an overdue payment, Reg. Sec. 1.72(p)-1, Q&A-10(a) permits a plan administrator to allow a cure period (i.e., a grace period). The cure period cannot continue beyond the last day of the calendar quarter following the calendar quarter in which the missed payment was due.

McEnroe argued that he should not be considered to have received a taxable distribution because he successfully reinstated the loan and resumed loan payments in December 2015. He also contended that it would be inequitable to impose tax on a deemed distribution because NYCERS did not provide timely notice that his loan was in default. He further asserted that in any event, he acted reasonably and in good faith when he resumed making payments in December 2015.

Analysis

The Tax Court held that McEnroe defaulted on his loan and the entire loan balance at the time of the default was therefore correctly reported as a deemed distribution. The court found that McEnroe was liable for income tax and the 10-percent penalty tax under Code Sec. 72(t) on the deemed distribution.

The court observed that McEnroe failed to make loan payments that were due over a roughly six-month period stretching from June to December 2015. According to the court, McEnroe first defaulted on a payment that was due in June 2015, which fell in the second calendar quarter, so any grace period would have had to expire no later than September 30, 2015, the last day of the third calendar quarter. But the court noted that McEnroe did not resume making loan payments until December 2015. Moreover, the court found that when McEnroe did resume making loan payments, he did not cure the earlier default by making a lump-sum payment to cover the many payments (with accrued interest) that he had failed to remit earlier in the year.

The court also found that there was no authority in the Code or caselaw for an equitable or hardship exception to the imposition of the income tax and penalty tax under Code Sec. 72(t) on early distributions from a retirement account. The court said that it could not add an exception to the Code by judicial fiat and that it had to apply the law as written.

For a discussion of qualified plan loans treated as distributions, see Parker Tax ¶131,535.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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