Limitations on the Deductibility of Interest Attributable to Loans from Qualified Plans
Qualified retirement plans which authorize loans to participants provide employees access to funds prior to the time such funds would otherwise be available considering the general restrictions on plan distributions. The popularity of plan loans, however, may have been diminished by the promulgation of Department of Labor (DOL) Regulations in July 1989 which imposed significant new restrictions on their availability.
As a general rule, plan loans are prohibited transactions. Section 408(b)(1) of ERISA, however, provides an exception for loans to plan participants if the following requirements are met:
1. Loans are available to all participants
and beneficiaries on a reasonably
equivalent basis; 2. Loans are not made (or offered) to highly
compensated employees in amounts
greater than the amounts available to
other employees; 3. Loans are made in accordance with
specific provisions set forth in plan
documents; 4. Loans bear a reasonable rate of interest;
and 5. Loans are adequately secured.
These same requirements also apply for purposes of avoiding the prohibited transaction excise tax imposed by Section 4975(a) of the Internal Revenue Code (IRC) of 1986, as amended. Generally, IRC Section 4975(a) imposes a 5 percent excise tax on amounts involved in a prohibited transaction including loans made by a plan to a disqualified person as defined in IRC Section 4975(e)(2). It should be noted that all plan loans to owner-employees, as defined in IRC Section 401(c)(3), and shareholder-employees of S corporations, are considered prohibited transactions (i.e. meeting the requirements as outlined above will not exempt the loan from the excise tax). In general, an owner-employee means a sole proprietor who owns the entire interest in an unincorporated trade or …