Participant loans from 401(k) plans must satisfy certain rules under section 72(p) of the Internal Revenue Code (the “Code”) to prevent the loan from being treated as a taxable distribution (sometimes called a “deemed distribution”). The amount of the loan generally cannot exceed 50% of the participant’s vested account balance up to a maximum of $50,000 (with reductions for certain previous outstanding loans), the participant must be required to make level amortized payments at least quarterly, and the loan term may not exceed five years from the date the loan is funded unless the participant uses the loan to purchase his or her primary residence (in which case a longer period from the date of funding is allowed).
It is not uncommon for plan sponsors to discover that one or more of these rules have not been followed in administering the plan. Failures to follow the terms of the plan document and the requirements of Code section 72(p) can result in the loan being treated as a taxable distribution to the participant as well as resulting in the potential disqualification of the plan.
When such a mistake is discovered, what can be done? Under certain circumstances, the Internal Revenue Service (“IRS”) permits this type of plan loan failure to be corrected under the Employee Plan Compliance Resolution System (“EPCRS”). To obtain relief from the negative tax treatment under Code section 72(p), a submission under the Voluntary Correction Program (“VCP”) is required. Such relief cannot