Failure to follow participant loan rules & violations of IRC 72 (p)
Top 10 retirement plan internal control pitfalls #8
Perhaps the most common compliance mistake is when the employer fails to properly set up payroll to collect loan payments. An employee requests a loan through a website run by the plan record-keeper. The loan is processed, the check comes out and the record-keeper generates an amortization schedule. The schedule is then sent to the plan sponsor. Yet, due to an internal controls issue, the schedule does not get set up properly in payroll. As a consequence, the plan participant can end up incurring a taxable distribution for failure to pay back the loan, and the plan sponsor has a plan qualification error.
There is a limited cure or grace period in which the sponsor can self-correct this situation; this occurs at the end of the quarter following the quarter in which the error occurred. If the correction does not occur within this time period, the sponsor will have to file a VCP request to inform the IRS what happened. The IRS could waive the taxable income for the participant or make another arrangement. Typically, the participant will be required to make a lump-sum payment or re-amortize to make the original due date of the loan.