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IRS to Plan Sponsors: You Must Retain Documentation for Loans and Hardship Withdrawals

Most sponsors of defined contribution plans rely on a third-party administrator (a “TPA”) to handle participant loans and hardship withdrawals—typically through the TPA’s website. However, in guidance issued last week, the IRS cautions that the sponsor—not the TPA or the participant—is responsible for maintaining documents proving that those transactions comply with the law.

Plan Loans

According to the IRS, the plan sponsor’s files should include all of the following documents, in paper or electronic format, for each plan loan:

  • The participant’s loan application, along with records of its review and approval;
  • An executed promissory note;
  • For home loans, proof that the loan proceeds were used to purchase or construct a primary residence;
  • Proof of all loan repayments;
  • In the event of a default, proof of collection activities; and
  • In the event of a deemed distribution of loan proceeds, the related Form 1099-R.

A repayment period of more than five years is permissible only if the purpose the plan loan is to purchase or construct a primary residence. The guidance stresses that self-certification of this requirement is not permitted. In fact, if a participant requests a repayment period of more than five years, the plan sponsor’s file must include documentation of the home purchase before the loan is approved.

Hardship Withdrawals

The guidance also reminds plan sponsors that they must keep records of all hardship withdrawals. In fact, the IRS pointedly notes that failure to have these records for prior hardship withdrawals on file for examination is itself a qualification failure that should be corrected using the Service’s Employee Plans Compliance Resolution System (“EPCRS”).

The sponsor’s files should contain the following documents for each hardship withdrawal, in paper or electronic format:

  • The participant’s application for a hardship withdrawal, and records demonstrating its proper review and approval;
  • Financial information and documentation that substantiates the participant’s “immediate and heavy financial need” (as that phrase is defined in the Treasury Regulations);
  • Proof that the hardship withdrawal was made in accordance with the applicable plan provisions and the Tax Code; and
  • Records of the actual distribution and the related Form 1099-R reporting it to the IRS.

Some TPAs and sponsors allow participants to electronically self-certify that they qualify for a hardship distribution. But as the guidance stresses, self-certification is never sufficient to demonstrate the nature of the participant’s hardship.

To qualify for a hardship withdrawal, a participant must prove two things: that the withdrawal is “necessary” to meet an “immediate and heavy” financial need. While self-certification is permitted to show that a distribution was necessary, it is not permitted to show that the need is immediate and heavy. Thus, the guidance reminds sponsors that they must obtain documentation showing the nature of the hardship.

What Does This Mean for Plan Sponsors?

There is nothing new in the substance of this guidance; i.e., none of the rules have changed. Two things about the guidance are notable, however. The first is the IRS’s emphasis on impermissible self-certification (for both loans and hardship withdrawals). Taken together with the guidance’s pointed reference to audits, the clear message is that the IRS is on the lookout for precisely this issue as it expands its audit program.

The second notable point is the IRS’s statement that each loan or hardship withdrawal for which a plan sponsor does not have the documents listed above in its files constitutes a qualification failure that should be corrected under EPCRS. Plan sponsors should therefore review their loan and hardship files against these lists to ensure that the documents they contain satisfy the applicable regulations. Any sponsor choosing to rely on a TPA to retain these documents will want to make sure that the Services Agreement with the TPA clearly imposes that obligation on the TPA, with meaningful remedies for any breach.

Where loans or hardship distributions were made properly, but the files are incomplete, sponsors should simply obtain the necessary documents. Where loans or hardship withdrawals have been made improperly, sponsors should consider correcting the resulting qualification failures under EPCRS. Spencer Fane’s Employee Benefits Group has decades of experience with EPCRS and would be pleased to assist in any necessary corrections.