John Bullis: Retirement plan loan is income in year of default

Mr. and Mrs. A.J. Scroggins discovered that the form 1099-R they received for year 2010 was correct. Mr. Scroggins got a loan of $29,700 from his employer’s 401(k) plan in 2007.

He made monthly payments to repay the loan until October 2010. He lost his job because of an undescribed disability and stopped making the monthly payments.

The balance owed on the loan in October 2010 was $17,459. The retirement plan administrator issued a Form 1099-R (Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc) as a taxable distribution to Mr. Scroggins in 2010.

Generally a loan from a qualified retirement plan is not a taxable distribution if the terms of the loan repayment satisfy certain conditions. If the borrower defaults (fails to pay as promised), it is a “deemed distribution” of the unpaid amount, in the year of the default. Since Mr. Scroggins failed to make the monthly payments in the last part of 2010, his loan from the retirement plan was in default.

It seems he borrowed the money to buy stock in the company where he was employed. He sold the stock in 2009 at a loss. It is common to suggest that investing in the stock of your employer is not a great idea in most cases. You already are heavily involved with the employer. Why not invest in other companies?

The tax result was he was taxable on the unpaid balance of the loan in 2010 when the default occurred. However, they did not report that income on the 2010 individual income tax return. So, IRS audited the return and sent Notice of Deficiency.

It is sort of difficult to understand why this even went to Tax Court to be resolved. The rule here is clear. Regulation 1.72 in Question and Answer 10 seems to give an example that is just like the facts in Scroggins case.

The entire matter hinged on when was the default, in 2010 or some other year. It is properly deemed a taxable distribution in 2010, the year the promised monthly payments were not made.

If you receive a Form 1099-R that you feel is a mistake or is issued in error, don’t just ignore it. Contact the firm that issued the form and try to get a full understanding of the facts and why the form was issued. If it is a mistake, ask for a corrected Form 1099-R for that year.

Did you hear? “I do my best not to live up to my name.” — Adrian Careless, a bank manager.

John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.