If the loans aren’t administered properly, the outstanding balance of the loan becomes taxable to the participant. Participants tend to get distressed when they face a tax consequence for a loan error, especially if they aren’t the responsible party of the error.
IRS Revenue Procedure 2013-12 provides guidance on how to fix the different types of loan errors. If the errors are fixed in accordance with this Revenue Procedure, as part of the process, you can apply to the IRS to ask that the participants not have any tax consequences as a result of the error.
Imagine that Jerry requested a loan four months ago. He asked for $20,000 to be repaid over 5 years. He signed all of the promissory note and the check was promptly issued to him. You were emailed a copy of the promissory note and repayment schedule. However, that was the day when the email server crashed and you didn’t receive the email. Jerry just looked at his pay stub this morning and realized there was no loan repayment taken out. He emailed you to ask what was going on. What do you do?
Under the IRS Revenue Procedure, the answer is to fix the loan by making a payment to the plan of the principal that would have been due and the interest that has accrued. Now Jerry, he should certainly have been paying the principal and part of the interest due for the last four months. However, if you took all three months of payments out of his next paycheck, he’d be one very unhappy employee. If, on the other hand, you do nothing, his loan will become taxable to him as he has likely missed too many payments. Should the company have to pay back the missed payments due to the error?
Whatever way Jerry’s loan problem gets resolved, all loan corrections are required to be submitted to IRS under their Voluntary Correction Program. So, the IRS gets to sign off that the error was properly fixed. There is a user fee based on the number of loans that require correction to obtain that needed IRS sign off.
If you have made loan errors, find an expert in plan corrections and ask them for assistance to correct your plan loans. There rules differ based on the different types of errors, so it’s best to ask a professional for assistance.