Subject to certain limits, a participant may take a loan from his or her account under a 401(k) or other employer-based defined contribution plan, and the receipt of the loan proceeds will not be treated as a taxable distribution to the participant.

In general, a participant may borrow up to either $50,000 or 50% of his or her vested account balance under the plan, whichever is less. The loan must be repaid with interest at least quarterly. Typically, repayments are made automatically through payroll deduction each payroll period or on a monthly basis. Loans must be repaid over a period not longer than five years (although the plan may permit a longer repayment period in the case of a loan used to acquire the participant’s principal residence). If these rules are followed, the transaction will be treated as a bona fide loan for tax purposes, even though the participant has had the use of the loan proceeds and is, in effect, repaying the amount borrowed to himself or herself.

If a plan participant defaults on his or her loan repayment obligation, however, a taxable distribution is deemed to occur. Usually, a plan loan defaults occurs when a participant with an outstanding plan loan terminates employment with the employer sponsoring the plan and the participant is either not able to or not inclined to repay the balance of the loan. The entire principal balance of the loan - including interest accrued to the deemed distribution date - is includable in the participant’s income and is reportable as such on Form 1099-R, and there is no exception to the additional 10% tax on premature distributions in this situation. There would be no withholding, however, unless some other cash distribution is made at the same time.

A potential problem facing employers and plan participants is that a plan loan will not be treated as a debt under the bankruptcy laws in the case of a borrowing participant’s bankruptcy. This is an instance in which bankruptcy laws do not mesh very well with tax laws.

In many cases, an individual who seeks the protection of the federal bankruptcy laws files a petition for relief under Chapter 13 of the Bankruptcy Code. The goal of the debtor in a Chapter 13 case is to settle his or her debts to creditors pursuant to a court-approved payment plan. In general, all of the debtor’s disposable income to be received within the three-year period beginning on the date that the first payment is due under the Chapter 13 plan must be applied to make payments under the plan. For this purpose, “disposable income” means income received by the debtor that is not reasonably necessary for the maintenance or support of the debtor or a dependent of the debtor.

In the case of an individual who has an outstanding plan loan, most courts have held that a plan loan is not dischargeable in bankruptcy and that the debtor may not continue to make plan loan repayments under a Chapter 13 plan. It can be expected, in most cases, that the debtor will not be able to carve out his or her plan loan repayment obligations from his disposable income. Courts have not accepted the argument that plan repayments are necessary for the debtor’s maintenance or support, notwithstanding the potentially harsh tax consequences suffered where there is a deemed distribution of taxable income.

An employer that receives notice that a plan participant must cease making loan repayments, whether by payroll deduction or otherwise, will be forced to treat the loan as in default and report the principle balance and accrued interest as a taxable “deemed distribution.” More likely than not, however, the participant will remain an active employee and plan participant and there can be no discharge or offset of the loan for plan administration purposes until some event occurs that triggers the participant’s right to receive a distribution from the plan. In a 401(k) plan, for example, if any portion of the loan proceeds were attributable to the employee’s elective contributions, a distributable event may not occur until termination of employment (or the employee’s attainment of age 59-1/2, at the earliest).

Even though the employer may have been forced to report a taxable distribution equal to the unpaid principle balance of the loan plus accrued interest at the time of the default, the Internal Revenue Service’s proposed regulations would require the employer to continue to treat the loan as outstanding, for purposes of plan administration, until there is a distributable event with respect to the participant. Consequently:

• there may be a requirement for payroll deductions to resume once they are no longer prohibited by the Chapter 13 plan;

• interest continues to accrue on the defaulted loan, so that the periodic loan repayments will be substantially greater after the suspension is lifted; and

• all repayments must be accounted for as after-tax amounts, even if the plan does not otherwise permit after-tax contributions.

Moreover, the outstanding balance of a loan, including accrued interest, will be a factor in determining whether the participant is eligible to take another loan (assuming the plan permits multiple loans). For example, if the participant has a vested account balance of $40,000 (not including the loan) and an outstanding loan (plus accrued interest) of $24,000, the maximum new loan would be $8,000 [(50% x $64,000) - $24,000], rather than $20,000 [50% x $40,000].

In conclusion, absent some relief in the form of new legislation or Internal Revenue Service regulations, a plan participant’s bankruptcy can present both the participant and his or her employer with unanticipated headaches if the participant has an outstanding plan loan at the time of the bankruptcy. The participant will be burdened with a potentially large tax liability as a result of a deemed distribution from the plan, for which there has been no withholding. Needless to say, this will result in further stress on the participant’s finances. Meanwhile, the employer must attend to special plan recordkeeping requirements when loan repayments resume.