What happens if your payroll system, for some mysterious reason, doesn’t take participant loan payments from an employee’s pay? How do you fix it? First thing to do is to figure out that mysterious reason and correct your payroll system. Then make sure it doesn’t happen again. Also verify whether the error impacted other participants’ loan repayments. And while you would think that the employee would notice that the payments weren’t coming out of their paycheck, and alert the employer, it is up to the employer to fix the problem where the mistake is caused by the employer, not the participant.
So, what to do about those missed payments? Will the correction be self-corrected or submitted to the IRS under its Voluntary Correction Program (VCP)? The scope of the failure—how long were loan payments missed and how many participants were affected—will dictate the required correction
How Long Were Payments Missed?
Once a loan payment is due, it must be paid no later than the end of the cure period for loan payments. Under the rules of Code Section 72(p), the maximum cure period is the last day of the quarter following the quarter in which the payment was due, although a plan could provide for a shorter cure period, or no cure period. So, if a payment was missed in August (during the third calendar quarter), then the maximum cure period would end December 31st (the end of the fourth calendar quarter). If the payment is not paid by that date, the loan goes into default and becomes taxable to the participant, as reported in a Form 1099-R.
In addition, if the maximum permitted loan term (generally 5 years from the date of the loan, longer if for the purchase of a primary residence) has expired, then the loan failure is not eligible for self-correction and a VCP submission would be needed.
How Many Participants are Affected?
If loan payments are missed for one participant, it is a good idea to review and make sure that this has not happened for other participants. If several participants are affected, then this failure becomes more significant, and VCP may be the best, or only, option for correction.
What Are the Options for the Employee To Make Up the Missed Payments?
When making up for the missed payments, there are various options and the employer can decide which ones to offer, as long as the same options are available to all participants:
- Catch-up Payment. The participant makes up all the missed payments now and the original payment schedule continues for the remaining payments with the same loan term. This can be done through payroll deduction if the participant has sufficient pay and agrees to this, or the participant can make the catch-up payment from their own funds by check. Having to pay a significant amount all in one payment may present an unexpected financial hardship for the employee.
- Reamortize Remaining Loan Payments. Another way to recoup the missed payments is to reamortize the loan to include the missed payments. This can be done over the remaining term of the loan or, if longer, the maximum permitted loan term. This tends to be the most popular choice, as it spreads the correction over several future payments. fo
- Combination. The participant can also do a combination of these options: make a partial lump sum repayment of the missed payments and reamortize the balance.
Example: Harry takes out a participant loan with a 3 year term in July 2022. His payments are $100 each month through payroll deduction. In January 2023, his employer, Acme, Inc., discovers that payroll deductions for the payments were never activated, and 6 payments were missed. This means that the missed loan payments were not caught and corrected before the grace period for payments ended (the last day of the quarter following the quarter when the first payment was missed), the loan is now in default. Because the error was due to Acme’s failure to withdraw loan payments from Harry’s pay, Acme wishes to self-correct the failure and put Harry in the same position he would have been in had the failure not occurred. Acme immediately starts payroll deductions for Harry’s loan payments. For the missed payments. Acme offers Harry the following options:
- Pay $600 in missed payments now
- Reamortize the remaining loan payments to include the missed payments. Because Harry’s original loan term was 3 years, not the maximum 5 years, the re-amortization can be calculated using the same repayment date in June 2025, or can the loan term can be extended up to June 2027, the maximum loan term.
- Use a combination of these options.
Harry decides to pay $300 by check, and then reamortize his loan to include the additional $300.
Note that all repayments must be adjusted for interest. Under IRS guidelines, the employer is generally responsible for paying the interest. If self-corrected, then the employer does not need to issue a Form 1099-R as would be required for a defaulted participant loan.
The correction steps will be different if the loan payments were taken from the participant’s paycheck but not transmitted to the participant’s plan account by the employer, or if some other violation of the requirements of Code Section 72(p) is involved.
Best Practices
Having tight procedures to keep an eye on the payroll process is important in so many ways. Where feasible, it is always a good idea to have a procedure to do a check on a regular basis to verify that loan payments are being withheld from paychecks and transmitted to the plan in a timely manner. The added administrative effort will pay off, compared with the costs and aggravation of assessing and correcting a plan qualification failure. For the IRS’ discussion of plan loan corrections, see their Fix-It Guide on this topic.