by Jim Griffin
Greg Gowen is a tax man. He holds a master’s degree in tax and is a CPA. He worked for the biggest international accounting firms, including Ernst & Young, PricewaterhouseCoopers and KPMG. He is an expert in the field of income tax. Gowen v. Commissioner, T.C. Summary Opinion 2017-57 (July 24, 2017).
Despite his expertise, Greg Gowen got tripped up by the tax and ERISA rules that apply to 401(k) plan loans. Admittedly, anything involving tax and ERISA causes a rush of adrenalin in most normal people. The plan loan rules, however, are among the least complex of all the mind-numbing things that fall into ERISA.
Plan loans are available in almost all 401(k) plans. A plan loan allows an employee to borrow from money that she has saved in the 401(k) plan for retirement. The loan is not included in the employee’s income and is not subject to a penalty tax as long as the loan meets the tax law requirements. Those requirements must be met in both form and operation.
The Internal Revenue Code addresses such things as the duration, interest rate, amount and repayment of the loan. Pretty simple. Not rocket science and not a reverse triangular merger!
In March 2012, Greg Gowen borrowed $50,000 from his 401(k) plan account at his employer, KPMG. Greg was supposed to repay his loan over five years. Greg lost his job at KPMG and stopped making loan payments. His first missed loan payment was due August 30, 2012.
The record keeper for the KPMG 401(k) plan sent Greg three separate notices informing him that his loan payments were due and that his loan would go into default if he did not make the past due payments. The notices described the Treasury Regulation that allows a loan default to be avoided if the missed payments are paid before the last day of the calendar quarter after the quarter in which the payments are missed.
Greg did not make the missed payment by the December 31, 2012 deadline. So, the KPMG 401(k) plan issued an IRS Form 1099-R to Greg for $46,703 representing the entire unpaid balance on his loan.
Greg claimed that he didn’t include the income from his loan balance on his 2012 income tax return because he did not receive the Form 1099-R and because he believed that the income would be reportable by him in 2013 instead of 2012. Greg also did not report the 10 percent penalty tax on early distributions even though he was under age 59-1/2 in 2012.
Greg’s argument for including his loan income in his 2013 (not 2012) taxable income was based on his incorrect reading of the Treasury Regulation that defines the loan cure period. Greg argued that his cure period included two full quarters after his first missed payment, effectively giving him a six month cure period. The Tax Court rejected Greg’s interpretation saying that he had ignored the plain language of the Treasury Regulation in making his argument.
Greg tried to escape the 10 percent early distribution penalty tax by arguing that he qualified for a 401(k) hardship distribution. His hardships included the loss of his marriage and his job. The Tax Court again rejected Greg’s position finding that the hardship distribution regulation that he cited did not provide an exception to the 10 percent early distribution penalty tax.
Finally, the Tax Court turned to the 20 percent accuracy-related penalty. The penalty applies to any portion of an underpayment that is attributable to negligence or disregard of rules or regulations or a substantial understatement of income tax. Greg’s education, experience and expertise as a tax man were of no help to him in defeating the IRS’ imposition of the accuracy-related penalty.
Perhaps, Greg should have consulted another tax professional about the tax treatment of his 401(k) plan loan default. But, he did not. The Tax Court noted that Greg relied on his own expertise, which was not enough to avoid the additional 20 percent penalty tax.
The Tax Court decided several cases in 2017 involving 401(k) plan loan problems. The Tax Court is very strict in applying the tax law requirements for plan loans. The Tax Court will not let 401(k) plan loans be used as an end run around income taxes that are due on 401(k) plan distributions.
The best advice on plan loans to avoid a trip to the Tax Court with an outcome like Greg’s is to borrow infrequently and repay on time.
Jim Griffin is a partner at Jackson Walker and can be reached at email@example.com.