From the “Be Careful What You Asked for File”: Participant ......From the “Be Careful What You Asked for File”: Participant Loans & Hardship Distributions René J. Avilés,

From the “Be Careful What You Asked for File”:

Participant Loans & Hardship Distributions

René J. Avilés, Esq.

221 Plaza Bldg., 5th Floor

Ponce de León, Ave.

San Juan, PR 00918

(787) 766-7000 – Ext. 240

[email protected]

Disclaimer

The contents of this presentation has been prepared for

educational purposes only. It is not intended as, and it does not

constitute, legal advice. It is recommended that anyone who reads

this presentation obtains legal advice from their attorney or financial

advisor prior to performing any of the transactions described herein.

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Summary of Topics to be Covered

• Participant Loans

o ERISA Considerations

o Income Tax Considerations

o Best Practices

o Errors and Corrections

• Hardship Distributions

o PR Code Requirements

o Income Tax Considerations

o ERISA Considerations

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PARTICIPANT LOANS

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ERISA Prohibited Transactions and Exemption for Retirement Plan Participant Loans

• As a general rule, ERISA prohibits certaintransactions between a “Plan” and a “Fiduciary”, orbetween a Plan and a “Party in Interest”. See ERISASection 406.

• These transactions are generally known as“Prohibited Transactions”

• However, under ERISA Section 408, certaintransactions are exempted from being treated as“Prohibited Transactions”.

• One of such statutory exemptions deals with“participant loans”.

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Retirement Plan Participant Loan Requirements – ERISA 408(b)(1)

“(b) Enumeration of transactions exempted from section 406 prohibitions.

The prohibitions provided in section 406 shall not apply to any of the followingtransactions:

1) Any loans made by the plan to parties in interest who areparticipants or beneficiaries of the plan if such loans (A) are availableto all such participants and beneficiaries on a reasonably equivalentbasis, (B) are not made available to highly compensated employees(within the meaning of section 414(q) of the Internal Revenue Codeof 1986) in an amount greater than the amount made available toother employees, (C) are made in accordance with specificprovisions regarding such loans set forth in the plan, (D) bear areasonable rate of interest, and (E) are adequately secured. A loanmade by a plan shall not fail to meet the requirements of thepreceding sentence by reason of a loan repayment suspensiondescribed under section 414(u)(4) of the Internal Revenue Code of1986.”

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Retirement Plan Participant Loan Requirements –ERISA 408(b)(1) (Cont.)

A. Reasonably Equivalent Basis.

Loans will not be considered to have been made available toparticipants and beneficiaries on a reasonably equivalent basis unless:

i. Such loans are available to all plan participants and beneficiarieswithout regard to any individual's race, color, religion, sex, ageor national origin;

ii. In making such loans, consideration has been given only to thosefactors which would be considered in a normal commercialsetting by an entity in the business of making similar types ofloans. Such factors may include the applicant's creditworthinessand financial need; and

iii. An evaluation of all relevant facts and circumstances indicatesthat, in actual practice, loans are not unreasonably withheld fromany applicant.

Reference: DOL Reg. 2550.408b-1(b)(1)

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Retirement Plan Participant Loan Requirements – ERISA 408(b)(1) (Cont.)

Practice Question: Can you establish a participant loan programwith different rates for different personsunder the same financial conditions at thesame point in time?

Answer:No.Reference: DOL Reg. 2550.408b-1(b)(3) Example (1)

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Practice Question:

Can you establish a participant loan program witha specific minimum amount of a loan?

Answer:

Yes, but the minimum cannot be higher than$1,000. (it can be lower, though).

Reference: DOL Reg. 2550.408b-1(b)(2)

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(B) Highly Compensated Employees.

(1) Loans will not be considered to be made available to highly compensatedemployees, officers or shareholders in an amount greater than the amount madeavailable to other employees if, upon consideration of all relevant facts andcircumstances, the program does not operate to exclude large numbers of planparticipants from receiving loans under the program.

(2) A participant loan program will not fail to meet the requirement in paragraph(c)(1), of this section, merely because the plan documents specifically governing suchloans set forth either (i) a maximum dollar limitation, or (ii) a maximum percentageof vested accrued benefit which no loan may exceed.

(3) If the second alternative in paragraph (3)(c) of this section (maximum percentageof vested accrued benefit) is chosen, a loan program will not fail to meet thisrequirement solely because maximum loan amounts will vary directly with the sizeof the participant's accrued benefit.

Reference: DOL Reg. 2550.408b-1(c)

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C) Specific Plan Provisions

For the purpose of section 408(b)(1) and this regulation, the Departmentwill consider that participant loans granted or renewed at any time priorto the last day of the first plan year beginning on or after January 1,1989, are made in accordance with specific provisions regarding suchloans set forth in the plan if:

1) The plan provisions regarding such loans contain (at aminimum) an explicit authorization for the plan fiduciaryresponsible for investing plan assets to establish aparticipant loan program; and

2) For participant loans granted or renewed on or after the lastday of the first plan year beginning on or after January 1,1989, the participant loan program which is contained in theplan or in a written document forming part of the planincludes, but need not be limited to, the following:

Reference: DOL Reg. 2550.408b-1(d)

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(C) Specific Plan Provisions (continued).

i. The identity of the person or positions authorized to administer the participant loan program;

ii. A procedure for applying for loans;

iii. The basis on which loans will be approved or denied;

iv. Limitations (if any) on the types and amount of loans offered;

v. The procedure under the program for determining a reasonable rate of interest;

vi. The types of collateral which may secure a participant loan; and

vii. The events constituting default and the steps that will be taken to preserve plan assets in the event of such default.

Reference: DOL Reg. 2550.408b-1(d)

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Census Question:

Where do you see participant plan loan provisions in your plan documents?

Answers:

1. In the Plan document itself?

2. In a Plan loan policy?

3. What Plan loan provisions? 😊

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(D) Reasonable Rate of Interest.

• A loan will be considered to bear a reasonablerate of interest if such loan provides the planwith a return commensurate with the interestrates charged by persons in the business oflending money for loans which would be madeunder similar circumstances.

Reference: DOL Reg. 2550.408b-1(e)

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Practice Question:

Can you establish a participant loan program with a fixed rateof interest (e.g., 8%)?

Answer:

It is dangerous to use a fixed rate of interest IF such rate cannotbe adjusted over time to be commensurate with interest ratecharged by persons in the business of lending money for loansunder similar circumstances.

Recommendation:

– Use rates of interest that can vary with changingmarket conditions (e.g., prime rate plus 1%)

– Reference: DOL Reg. 2550.408b-1(e) Example (1)

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(E) Adequate Security.

• A loan will be considered to be adequately secured if the securityposted for such loan is something in addition to and supporting apromise to pay (i.e., the promissory note), which is so pledged to theplan that it may be sold, foreclosed upon, or otherwise disposed of upondefault of repayment of the loan, the value and liquidity of whichsecurity is such that it may reasonably be anticipated that loss ofprincipal or interest will not result from the loan.

• The adequacy of such security will be determined in light of thetype and amount of security which would be required in the case of anotherwise identical transaction in a normal commercial setting betweenunrelated parties on arm's-length terms.

• A participant's vested accrued benefit under a plan may be used assecurity for a participant loan to the extent of the plan's ability to satisfythe participant's outstanding obligation in the event of default.

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(E) Adequate Security (continued).

For these purposes:

(i) no more than 50% of the present value of a participant'svested accrued benefit may be considered by a plan as security forthe outstanding balance of all plan loans made to that participant;

(ii) a plan will be in compliance with paragraph (f)(2)(i) of thissection if, with respect to any participant, it meets the provisions ofparagraph (f)(2)(i) of this section immediately after the originationof each participant loan secured in whole or in part by thatparticipant's vested accrued benefit; and

(iii) any loan secured in whole or in part by a portion of aparticipant's vested accrued benefit must also meet therequirements of paragraph (f)(1) of this section.

Reference: DOL Reg. 2550.408b-1(f)(2)

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Common Type of Adequate Loan Security Provision

• The documents governing plan P provide forthe establishment of a participant loanprogram in which the amount of any loanunder the program (when added to theoutstanding balances of any other loans underthe program to the same participant) does notexceed the lesser of (i) $50,000, or (ii) one-halfof the present value of that participant's vestedaccrued benefit under the plan.

Reference: DOL Reg. 2550.408b-1(c)(4) Example 1

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Common Type of Adequate Loan Security Provision (Cont.)

Practice Question:

Do retirement plan participant loans requirespousal consent?

Answer:

Spousal consent is not required if the plan or theparticipant is not subject to the Qualified Joint andSurvivor Annuity Rules.

Reference: Treas. Reg. 1.401(a)-20 Q&A 24(a).

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Common Type of Adequate Loan Security Provision (Cont.)

Practice Question:

Can I eliminate a participant loan program afterI set it up in my retirement plan?

Answer:

Yes, because a retirement plan loan program isnot a “protected benefit” under ERISA’s anti-cutback rule.

References: ERISA Section 204(g) and Treas. Reg. 1.411(d)-4 Q&A 1(b).

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Income Tax Implications of Participant Loans from Retirement Plans

• General Rule: the grant of a participant loanthat complies with PR Code required terms ISNOT a taxable event to the participant.

• Exception: failure to pay back the loan underthe loan terms IS a taxable event to theparticipant.

• Failure to pay back the loan is treated as a“deemed distribution”, subject to ordinaryincome tax rates.

References: PR Treasury Reg. 8324 Articles1081.01(b)-2(b)(ii) & (c); and 1081.01(b)-4.

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PR Code Requirements for Participant Loans under Tax Qualified Retirement Plans

• The loan, per its terms (and in its operation)must be paid back in substantially similarpayments at least quarterly.

• The loan, per its terms (and in its operation)must be paid back in a term not to exceed 5years, or in the case of participant loans for thefinancing of a principal residence, may notexceed the term provided in the Plandocument.

• Reference: Section 1081.01(b)(3)(E) of PRInternal Revenue Code of 2011, as amended.

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Timing of Taxation of Participant Loans Upon Failure To Pay Loan Back

• General Rule: loan is taxable to theparticipant upon due date to make theapplicable payment that causes thedefault.

• Exception: If the Plan or Plan’s loanpolicy provides with a cure period tocorrect the default, the loan is taxable tothe participant upon exceeding the cureperiod without making the propercorrection.

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Timing of Taxation of Participant Loans Upon Failure To Pay Loan Back

• Example: If pursuant to a participant’s separation ofemployment the participant stops making payrollpayments to his participant loan as of November 30,2019, the outstanding balance of the loan becomes ataxable distribution to the participant as ofNovember 30, 2019.

• However, if the Plan’s loan procedure provides a 3-month cure period, then the outstanding balance ofthe loan becomes a taxable distribution as ofFebruary 29, 2020.

Reference: PR Treasury Reg. 8324 Article 1081.01(b)-2(c).

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Type of Tax Treatment of Participant Loans Upon Default

• If the loan default occurs in the same year theparticipant receives a lump sum distribution,then the loan default is treated as part of thelump sum distribution, and the tax withholdingon the defaulted loan is charged against theremaining portion of the distributions.

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Type of Tax Treatment of Participant Loans Upon Default (Cont.)

• Example 1: Upon separation from service a participant hasa $30,000 account balance, which includes an outstandingloan in the amount of $5,000. The participant does not payback the loan and it is defaulted. If the participantwithdraws the remining $25,000 in that year, theparticipant is treated as having received a $30,000 lumpsum. If such amount is subject to a 20% withholding atsource, the paying agent will withhold $6,000 ($30,000 *20%) from the remaining $25,000 balance, and issuepayment to the participant for the remaining $19,000($25,000 - $6,000), while reporting the full amount of$30,000 as a lump sum distribution with a $6,000withholding at source in Form 480.7C.

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• However, if the loan default occurs in ayear in which the participant does NOTreceive a lump sum distribution, then theloan default is treated as a partialpayment, subject to ordinary income taxrates.

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• Example 2: Upon separation from service a participanthas a $30,000 account balance, which includes anoutstanding loan in the amount of $5,000. Theparticipant does not pay back the loan and it isdefaulted. If the participant does NOT withdraw theremining $25,000 in that year, the participant is treatedas having received a deemed distribution in the amountof $5,000. No withholding would be made at source, andthe paying agent will treat such distribution as a partialdistribution in form 480.7C.

References: PR Treasury Reg. 8324 Articles 1081.01(b)-2(c)(4) & (5) and 1081.01(b)-5(c)(4).

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Impact of Participant Loan Default on Plan Rollovers

• Loan defaults do not impact aparticipant’s right to make a rolloverof the remaining balance to anothertax qualified plan.

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Impact of Participant Loan Default on Plan Rollovers (Cont.)

• Example: Participant with a $30,000 accountbalance and a $5,000 outstanding loan that getsdefaulted after separation from service due tolack of payment. Even though the $5,000 loandefaulted is treated as a distribution (andreported in a Form 480.7C), the remaining$25,000 can be rolled over to another taxqualified retirement plan without incometaxation impact in such year.

Reference: PR Treasury Reg. 8324 Article 1081.01(b)-2(f)(2)(i)(E).

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Impact of Participant Loan Default on Installment Payments

• Loan defaults do not impact aparticipant’s right to treat remainingpayments as installment payments.

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Impact of Participant Loan Default on Installment Payments (Cont.)

• Example: Participant with a $30,000 account balanceand a $5,000 outstanding loan that gets defaultedafter separation from service due to lack of payment.Even though the $5,000 loan defaulted is treated as adistribution (and reported in a Form 480.7C), theremaining $25,000 can be distributed as periodicpayments (i.e., installments) if the plan otherwiseallows for such periodic payments (and theparticipant is eligible for annual $11k/$15k incometax exemption on such installment distributions).

Reference: PR Treasury Reg. 8324 Article 1081.01(b)-3(a)(5)(vii).

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Best Practices for Establishing and Maintaining Participant Loan Programs

• Formalize authorization of loan programs(employer authorization and planamendments).

• Establish a plan loan program or policy thatsets forth the specifics of the loan program.

• Disclose loan availability to participants andeligible beneficiaries.

• Have recordkeeping in place for (i) payrollrepayment; and (ii) establish loandocumentation to participants (promissorynotes and amortization schedules).

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But Even if I Follow Best Practices, Could Something go Wrong with Participant Loans?

• Failure to set up or receive participantloan payments.

• Failure to default loans when participantsstop paying (termination, retirement,leaves).

• Excessive loan term (i.e., beyond terms ofthe loan program) or amount.

• Too many loans (more than the maximumnumber of loans permitted).

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Is there a Loan Correction Procedure in Place for PR Tax Qualified Plans?

• PR Treasury does NOT have a correctiveprocedure for fixing plan loans.

• Many plan administrators use the IRSEmployee Plans Compliance ResolutionSystem (“EPCRS”) procedures asanalogous method for correcting plan loanerrors.

• Most recent version of EPCRS available inIRS Revenue Procedure 2019-19.

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Common Corrections under EPCRS

• Defaulted Loans: Either (i) single-sum correctivepayment equal to the amount that the affectedparticipant would have paid to the plan if there hadbeen no failure to repay the plan plus interest on themissed payments; or (ii) re-amortize the outstandingbalance of the loan, including accrued interest over theremaining schedule of the original term of the loan orthe maximum permitted term; or (iii) a combination of(i) and (ii).

• Plan Loan Term in excess of the Maximum LoanTerm: Re-amortize loan balance over the remainder ofthe maximum permitted loan period as of the originaldated of the loan.

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Common Corrections under EPCRS (Cont.)

• Plan Loan In Excess of Maximum LoanAmount: Corrective payment to the planbased on the excess of the loan amount overthe maximum loan amount.

• Number of loans exceeds plan limitation:retroactive amendment of the plan to allowfor the number of loans that were madeavailable.

Reference: Rev. Proc. 2019-19, Part III, Section6.07.

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Watch-Out with Deemed Distributions under EPCRS

• General Rule under EPCRS: if a loan failure istreated as a deemed distribution, the distributionis recognized in the year of the correction(instead of the year of the failure) in IRS Form1099-R. See Rev. Proc. 2019-19, Part III, Section6.07.

• Watch out for PR Plans: The default has to beaccounted in the year of the failure (or the yearwhen the “cure period” ends), not in the year ofthe correction.

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HARDSHIP

DISTRIBUTIONS

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PR Code Requirements for Hardship Distributions under Tax Qualified Retirement Plans

• Apply in the context of cash or deferred arrangements:a/k/a CODA, a/k/a pre-tax participant contributions.

• As a general rule, pre-tax contributions may NOT bedistributed to the participant while employed.

• As a matter of exception, they may be distributed onoccasion of “hardship”.

Reference: Section 1081.01(d)(2)(B)(vi) of PR InternalRevenue Code of 2011, as amended.

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What is a “hardship” for In-Service Distribution Purposes under a PR Tax Qualified Plan?

A distribution that is made by reason of animmediate and grave financial need of theemployee, if such distribution is needed tosatisfy such financial need.

Reference: PR Treasury Reg. 5678 Art. 1165-8(d)(2)(i).

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And when is a distribution made by reason of a financial need that is “immediate and grave”?

When it is made by reason of:

• Medical expenses (as described in Section 1033.15(a)(4) ofthe PR Code) for the employee, the employee’s spouse, orthe employee’s dependent;

• The purchase (excluding mortgage payments) of aprinciple residence of the employee;

• Payment of tuition and education expenses for thefollowing 12 months of post-secondary education of theemployee, the employee’s spouse, the employee’s childrenor dependents; or

• Prevent the eviction or foreclosure of the employee’sprincipal residence.

Reference: PR Treasury Reg. 5678 Art. 1165-8(d)(2)(ii)(B).

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Prior to obtaining a “hardship” distribution the Participant Must Assure that such financial need cannot

be satisfied by:

• Reimbursement of compensation by insurance orotherwise;

• Liquidation of employee assets, to the extentsuch liquidation doesn’t cause an immediatefinancial need;

• Ceasing to make participant contributions underthe plan; or

• Other distributions or plan loans.

Reference: PR Treasury Reg. 5678 Art. 1165-8(d)(2)(iii)(A).

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Other Requirements for Obtaining a “Hardship” Distribution

• The distribution is not in excess of the amount of thefinancial need (including income taxes);

• The employee has obtain all other available distributionsand plan loans;

• The plan provides that the participant will be suspendedfrom making pre-tax contributions for the following 12months; and

• The plan provides that the participant may not make pre-tax contributions in the following year in excess of the totalavailable amount for such year less the amountscontributed for the year in which the “hardship”withdrawal is made.

Reference: PR Treasury Reg. 5678 Art. 1165-8(d)(2)(iii)(B).

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Other Requirements for Obtaining a “Hardship” Distribution (Cont.)

Practice Questions:

i. Do you have an internal policy for approvinghardship withdrawals?

ii. Does your plan have a catch-all provision toallow hardship withdraw? (e.g. “Any otherreason that the Administrator determines to bea grave emergency”)

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Puerto Rico Income Taxation of Hardship Distributions

• Treated as ordinary income under the provisions of the PRCode, and subject to the progressive income tax rates (i.e.,no lump-sum taxation treatment, or installment taxationtreatment).

• Example: Participant has a plan account in his retirementplan of $30,000 and requests a $5,000 hardship distributionfrom his pre-tax contribution portion. The paying agentmakes the payment of the $5,000 (minus a 10% withholding= $500) and reports the distribution as “other payments” inthe participant’s 480.7C for said year, which, in turn isincluded as ordinary income in the participant’s income taxreturn for such year.

Reference: PR Treasury Reg. 8324 Arts. 1081.01(b)-4(b) and1081.01(b)-5(f).

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Puerto Rico Income Taxation of Hardship Distributions (Cont.)

Practice Question:

Can you have hardship distributions afteryou are no longer employed?

Answer:

Probably not, but will ultimately depend onthe specific provisions of the plan.

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Puerto Rico Income Taxation of Hardship Distributions (Cont.)

Practice Question:

Are “hurricane distributions” the same as“hardship distributions”?

Answer:

No, they are not. Hurricane distributionsmust be declared by the governor. And mustbe allowed specifically by the plan. And maycover plan accounts in excess of pre-taxcontribution accounts.

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Federal Hardship Withdraw Rules that Do Not apply to PR only Tax Qualified Plan!

1. Disaster related express (new) and homecasualty loss repairs (old). These are optionalin the USA.

2. 6-month rule (old) and the no-month rule(new). Required for US Plans.

3. Loan-first rule out (new). Optional for U.S.Plans.

4. Participant contributing (old) and earnings,QNEC and QMAC (new). Optional for U.S.Plans.

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Thank You

CONTACT INFORMATION:

RENÉ J. AVILÉS GARCÍA, ESQ.221 PLAZA, 5TH FLOOR

PONCE DE LEÓN AVENUE

SAN JUAN, PR 00918(787) 766-7000 EXT. 240

[email protected]

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Documents

From the “Be Careful What You Asked for File”: Participant ......From the “Be Careful What You Asked for File”: Participant Loans & Hardship Distributions René J. Avilés,