A recent IRS internal memorandum provides helpful guidance on methods to “cure” missed participant loan payments.
- First, the IRS endorsed the practice of “shifting” loan payments by applying a later payment to an earlier missed payment to avoid deemed distribution.
- Second, the IRS confirmed that refinancing an existing loan to include missed payments can allow a participant to avoid a deemed distribution if the replacement loan is made within the cure period.
Cure Periods Generally. A failure to make any installment payment on a plan loan when due may result in a deemed taxable distribution at the time of the failure. However, the plan may allow a cure period to avoid a deemed distribution as long as the missed payment is made within the cure period. The maximum cure period allowed by the IRS is the end of the calendar quarter following the calendar quarter in which the required payment was due.
Shifting Loan Payments. Later payments may be applied to earlier missed payments if the later payments are made within the cure period for each missed payment.
Example: After missing monthly loan payments for March and April, a participant began repaying again in May and June and then made a lump sum payment equal to three loan payments in July. The May payment may be applied to the missed March payment, the June payment to the missed April payment, and the three July payments to May, June, and July. Since all payments were made prior to the end of the calendar quarter following the calendar quarter in which each payment was due, there would be no deemed distribution.
Refinanced Loan. A participant who misses loan payments can refinance the loan to include the missed payments as long as the loan is refinanced before the end of the cure period for the missed payments.
Example: A participant missed loan payments for October, November, and December, all of which have a cure period ending in March (the end of the calendar quarter following the calendar quarter in which the payment is due). The participant refinanced the loan in January and replaced it with a new loan for the outstanding balance, including the missed loan payments. The replacement loan can be treated as the repayment of the original loan, including the missed payments, within the cure period so that there was no deemed distribution due to missed payments.
The IRS’s conclusion that future payments may be applied to cure previously missed payments is consistent with most practitioners’ existing interpretation of IRS regulations. The IRS’s conclusion that missed loan repayments could be cured through refinancing was much less certain, since the missed payments are not actually made within the cure period.
What Does This Mean for Employers? There are many circumstances in which loan payments may be temporarily delayed, including administrative errors, payroll and recordkeeper transitions, and corporate mergers and acquisitions. This guidance provides plan sponsors with opportunities to avoid the harsh tax consequences of loan defaults.
- Develop a process to identify missed loan payments timely, at least once each calendar quarter.
- Review their plan document or loan polices to ensure the plan provides for a cure period.
- Consult with their plan recordkeeper to determine how loan payments are applied and the process for re-amortizing loans.
- Ensure loans that are “cured” through refinancing continue to meet the other IRS requirements to avoid becoming deemed distributions. Meeting these requirements is generally easier if the repayment schedule under the refinanced loan does not extend beyond the final payment date under the payment schedule for the original loan.