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2017 Tax Cuts and Jobs Act Breathes New Life Into Old Trick For Dealing With Participant Loans in Corporate Transactions

One of the more difficult issues in corporate transactions that are structured as asset purchases is how to deal with outstanding participant loans.  In the typical asset purchase scenario – where the purchaser does not assume sponsorship of, or accept a transfer of assets from, the seller’s retirement plan – employees of the seller who become employed by the asset purchaser generally incur a termination of employment with the seller, and therefore a distributable event under the seller’s 401(k) plan.  If a participant has an outstanding loan at the time of the asset sale, then unless the distribution is paid in a direct rollover to another employer plan that is willing to accept a rollover of a participant loan, the participant must either (i) pay off the loan before taking the distribution, or (ii) incur a potentially taxable “plan-loan offset” (where the participant’s account balance is reduced, or offset, by the outstanding loan balance).

Prior to the 2017 Tax Cuts and Jobs Act (the “TCJA”), participants had only 60 days from the date of a plan loan offset to come up with the funds needed to “roll” the offset amount to an IRA or to another employer plan (to avoid the loan offset becoming a taxable event).  However, for loan offsets occurring after December 31, 2017, participants have until the due date (with extensions) of their tax return for the year of the offset to “roll” the offset amount to another plan or IRA.  This provides additional time for participants to make use of a previously seldom-used alternative to either rolling over the loan or treating the loan as a taxable distribution.  For purposes of this article, I will call this the “replacement loan” alternative.

The “replacement loan” alternative is best described by way of a specific example.  Let’s say that Participant A has an outstanding loan from Seller’s 401(k) plan.  Seller enters into an asset purchase agreement with an unrelated Buyer.  Under the agreement, Buyer agrees to purchase substantially all of the assets of Seller, and agrees to employ substantially all of Seller’s employees, including Participant A.  On the Closing Date, Participant A’s employment with Seller is terminated, and he becomes a participant in Buyer’s 401(k) plan.  However, Buyer does not agree to assume Seller’s plan, nor to accept any “plan-to-plan” transfer of assets from Seller’s plan.  Therefore, Participant A’s termination of employment with Seller is a distributable event under Seller’s 401(k) plan.  Under the terms of Seller’s plan, if a participant does not repay an outstanding loan balance before taking a distribution of his or her vested account balance, the participant’s account balance is offset, or reduced, by the outstanding balance of the loan.

Let’s assume for convenience that Participant A’s total account balance, including the loan, at the time of his termination is $100,000, and that the outstanding balance of his participant loan is $20,000.  Unless he can come up with $20,000 (to pay off the loan) before he takes a distribution, his account balance will be offset/reduced by the $20,000 outstanding loan balance, and his “distribution” from the plan will be only $80,000.  Participant A would then have the option to roll this $80,000 to an IRA or to another plan, including Buyer’s plan (if it accepts rollover contributions).  However, because the $20,000 “loan offset amount” is also eligible for rollover, Participant A actually has the right to roll over the entire $100,000 (assuming he can come up with the $20,000 that was previously held by Seller’s plan in the form of a promissory note).

Prior to the TCJA, even if Participant A had elected a direct rollover of the $80,000 distribution, he would have had only 60 days to come up with the additional $20,000 “loan offset amount” if he wished to roll the entire $100,000 and thereby avoid a taxable distribution.  Had he been clever enough to do so (and had he acted fast enough), Participant A could conceivably have taken the $80,000 distribution from Seller’s plan, rolled it directly to Buyer’s plan, immediately applied for a loan from Buyers’ plan (of at least $20,000), and then used the $20,000 loan proceeds to make a “second” rollover of $20,000 to Buyer’s plan.  At the end of this process, he would have rolled his entire $100,000 account balance from Seller’s plan into Buyer’s plan, and would now have a $20,000 (or more) loan from Buyer’s plan (rather than a loan with a $20,000 balance from Seller’s plan).  The new loan could then be amortized over a period of up to 5 years (regardless of the remaining amortization period of the loan under Seller’s plan).  In addition, the maximum loan amount under Buyer’s plan would not be affected by the “highest outstanding loan balance over the last 12 months” of the loan under Seller’s plan, because Seller and Buyer were unrelated employers.

The problem, prior to the TCJA, was that Participant A would have had only 60 days from the date of the loan offset to get the distribution processed and rolled over to Buyer’s plan, obtain a loan from Buyer’s plan, and then use those loan proceeds to make the second rollover contribution.  That’s a lot to accomplish in only 60 days.  Now, pursuant to the TCJA, Participant A would have until the due date (with extensions) of his tax return for the taxable year in which the loan offset occurred in which to make the “second” rollover of the $20,000.  And during this period, he would have no outstanding loan on which to make payments.  If the corporate transaction occurred in the first half of the year, he would have more than 12 months to either (i) come up with the money to “fund” the second rollover, or (ii) take a loan from Buyer’s plan to fund the second rollover.

There are, of course, some conditions that must be met in order for this “replacement loan” option to work.

First, the seller’s plan must treat a loan balance at the time of the transaction as a “loan offset” and not a “deemed distribution.”
Second, the buyer’s plan must allow rollovers into the plan (even though it need not accept rollover contributions of participant loans).
Third, the buyer’s plan must allow employees to make rollover contributions immediately (even if there is a waiting period to become a “participant” for other purposes), and it must allow employees to borrow from those “rollover” contributions.
Fourth, the amount rolled over (i.e., the net account balance under the seller’s plan after the loan offset) must generally be at least twice the outstanding loan amount. This is because the maximum amount that a participant may borrow under the buyer’s plan is 50% of the amount rolled into that plan.

In the scenario described above, the $80,000 direct rollover should be sufficient to allow Participant A to borrow $20,000 from Buyer’s plan.   However, if a participant with a $50,000 account balance owed $22,000 on a participant loan, the “net” proceeds rolled over to a buyer’s plan ($28,000) would not be sufficient to allow that participant to take a new loan for $22,000.  Such a participant could borrow only $14,000, and would have to come up with the remaining $8,000 from other funds in order to roll the entire $50,000.

It is the author’s view that this “replacement loan” approach is superior to making a direct rollover of the participant loan, for several reasons.

First, the seller’s plan may not permit distributions “in kind.” The direct rollover of a promissory note is an “in-kind” distribution. Thus, many plans will not allow the distribution of a participant loan, and/or the plan sponsor may not be willing to amend the plan to allow for such distributions.
Second, and perhaps more importantly, many plans will not accept a rollover contribution that includes a participant loan. Many trustees, custodians, and recordkeepers do not want to administer promissory notes that were originally issued by another trustee or custodian. So, even if a seller’s plan is willing to distribute the participant loan, a buyer’s plan may not be willing to accept it.
Finally, allowing the original promissory note to be offset, and then taking a new “replacement” loan from a buyer’s plan, allows a participant a period of time with no loan payments, and also allows the new loan to be amortized over up to 5 additional years (rather than simply the remaining term of the old loan).

In summary, the TCJA’s extended time period for rolling over “plan-loan offset” amounts not only allows a participant with an outstanding loan at the time of termination of employment (or termination of the plan) additional time to come up with the funds needed to roll some or all of the offset amount to an IRA or another employer plan (to avoid having the loan offset treated as a taxable distribution), but it also breathes new life into the old “replacement loan” trick.  And hopefully, that old trick will now allow more participants to avoid taxable loan offsets when they terminate employment with one employer and become employed by a new employer in an asset purchase transaction.

If you have any questions about the treatment of plan loans in corporate transactions (or simply when a participant terminates employment with one employer and becomes employed by an unrelated employer), please do not hesitate to contact any of the attorneys in Spencer Fane’s Employee Benefits Practice Group.

This post was drafted by Rob Browning, an attorney in the Kansas City, MO office of Spencer Fane LLP. For more information, visit spencerfane.com.