Timing of a deemed distribution from loan default is upheld

The Tax Court held that a taxpayer failed to include in taxable income for the tax year in which it occurred a deemed distribution from his Sec. 401(k) plan account arising from a loan default and was liable for the 10% additional tax on early distributions. The court also sustained an accuracy-related penalty.

Facts: The taxpayer, Gregory Gowen, a CPA, borrowed $50,000 from his Sec. 401(k) retirement plan account in March 2012. The loan required semimonthly payments through March 2017. After he lost his job, Gowen was unable to make the payments, beginning with the payment due on Aug. 30, 2012. The plan administrator notified him in October 2012 of the past-due payment and possible consequences of a default, including that the remaining unpaid balance and accrued interest on the loan would be reclassified as a taxable distribution in the year of default and could also be subject to the additional tax. The cure, or grace, period for making the payment to prevent default would expire at the end of the calendar quarter following the calendar quarter in which the payment was missed, the notice said.

The administrator sent Gowen two additional warning notices in 2012 and a statement dated Jan. 7, 2013, reporting the deemed distribution of $46,703. In addition, the administrator reported the distribution amount on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for tax year 2012. Although Gowen acknowledged receiving the Jan. 7, 2013, statement, he denied ever receiving a copy of the Form 1099-R.

On his income tax return for 2012, Gowen reported wages, unemployment compensation, and two other, nonloan distributions from his Sec. 401(k) account in income, but he did not report a liability for or pay the 10% additional tax under Sec. 72(t)(1) on those distributions, although he was age 51 at the end of 2012. He did not report the deemed distribution from the loan default or report or pay any liability for additional tax on it as an early distribution.

The IRS determined a tax deficiency from the unreported deemed distribution and additional tax liability under Sec. 72(t) for it and the other two distributions, and assessed an accuracy-related penalty under Sec. 6662.

Issues: Loans from qualified plans, including those under Sec. 401(k), are excepted under Sec. 72(p)(2) from being treated as distributions in the year received if (1) the outstanding loan balance does not exceed a statutory maximum; (2) the loan is required to be repaid within five years (unless used to acquire a home); and (3) repayment occurs by substantially level amortized payments made at least quarterly. Under regulations and case law, the latter requirement is no longer satisfied when the debtor fails to make a loan payment when due or within the allowed cure period, which may not extend beyond the last day of the calendar quarter following the calendar quarter in which the required payment was due. At that point, a deemed distribution occurs in an amount equal to the outstanding loan balance and accrued interest at the time of the failure (Regs. Sec. 1.72(p)-1, Q&A-10(b)).

The taxpayer did not dispute that the default resulted in a deemed distribution but argued that it occurred in 2013, not 2012, noting that the first and only notice of default or distribution he received was in 2013. Alternatively, he argued that the calendar quarter in which he first missed payments was August through October 2012, making Jan. 31, 2013, the end of the following quarter and thus the end of the cure period.

Holding: The Tax Court rejected the taxpayer’s arguments, noting that Regs. Sec. 1.71(p)-1, Q&A-10(c), provides an example similar to his circumstances. In the example, a taxpayer fails to make payments beginning in August of a tax year. The example notes that the administrator could have allowed a cure period through the end of the next calendar quarter after the quarter in which the debtor failed to make required payments, which the example says would result in a deemed distribution on Dec. 31 of that year. Accordingly, the court agreed with the IRS that Gowen received a deemed distribution on Dec. 31, 2012. The Jan. 7, 2013, plan administrator’s statement was not controlling and did not say when the distribution occurred, the court stated.

With respect to the Sec. 72(t)(1) 10% additional tax, the taxpayer argued that Regs. Sec. 1.401(k)-1(d)(3)(i) permits a distribution made on account of an employee’s hardship, i.e., one necessary to satisfy the employee’s “immediate and heavy financial need,” which he suffered. The court noted that while this provision authorizes distributions from a plan on account of an employee’s hardship (if the financial need and the amount necessary to meet it are determined in accordance with nondiscriminatory and objective standards set forth in the plan), it does not provide an exception to the additional tax under Sec. 72(t)(1) for the distribution.

• Gowen, T.C. Summ. 2017-57

—By Paul Bonner, a JofA senior editor.