Publication: Journal of Pension Benefits
Date/Volume/Issue: Summer 2020, Vol. 27, No. 4
NOTE: This article was written before the IRS issued Notice 2020-50, which clarified and expanded much of what is discussed below. Please see Ferenczy FlashPoint dated June 19, 2020 (“The IRS Cares! (Who’d Have Thunk?) Expanded List of Qualified Individuals and More Info!)” for updated information. (click here: FlashPoint: The IRS CARES! (Who’d Have Thunk?) Expanded List of Qualified Individuals and More Info!)
Loans and Distributions Under the CARES Act: Legislation in the Time of Cholera
(With Apologies to Gabriel Gárcia Marquez)
Ilene H. Ferenczy, Esq.
Several sections of the Coronavirus Aid, Relief, and Economic Security (CARES) Act relate to retirement
plans, specifically those relating to distributions and loans to qualified individuals, which provide relatively
ready access to money for those suffering financially from the pandemic and the related quarantine.
In what was likely historic legislation, Congress and the President acted in late March to provide substantial relief to an American population affected by the coronavirus. The legislation, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, contained several sections related to retirement plans. Two of these sections, those relating to distributions and loans to qualified individuals, provide relatively ready access to money for those suffering financially from the pandemic and the related quarantine.
This article reviews these provisions of the CARES Act, as well as the questions and concerns that have arisen in its wake. As things are changing legislatively and regulatorily at a rapid pace, we encourage you to augment this article with anything that has happened since it was prepared for publication.
Who Does CARES Benefit?
The retirement-based CARES provisions generally apply to “Qualified Individuals” or “QIs.” The law defines a QI to include:
- A retirement plan participant who has been diagnosed with the virus (as confirmed by a CDC- approved test);
- A participant whose spouse or dependent has been diagnosed with the virus; or
- A participant who has suffered financially from the pandemic because:
- S/he was laid off, furloughed, quarantined, or had hours reduced;
- S/he cannot work due to the unavailability of childcare because of the pandemic; or
- His or her own business has had to close or reduce hours.
CARES permits the Secretary of the Treasury to broaden the category of individuals who are QIs, although no such action has yet been taken.
Probably the most obvious omission is a participant whose spouse meets the requirements of the third category, that is, not working or had hours reduced due to the pandemic. At a time when two-income households are almost omnipresent, and where it is likely that the economics of those households are dependent on both incomes, it is not hard to imagine that this gap has denied CARES relief to many who need it .
If both spouses are not covered by retirement plans, or if the contributions to the retirement plans (i.e., the ready cash for the CARES benefits) are heavily weighted to one spouse’s plan, it is possible that the couple severely needs to access the retirement funds of the non-QI spouse.
Example: Sam and Harriett, both employed, have two children . Because the daycare center that they normally patronize is closed due to the quarantine, Harriett has had to stay home from work to care for the children. Unfortunately, Harriett has no retirement plan where she works. Although the household income has been severely reduced because of Harriett’s new avocation, no CARES retirement plan provisions apply, as Sam is not a QI.
The second type of situation that has been roundly criticized as not qualifying someone to be a QI is a participant who is working as hard as ever, but who has had significantly reduced compensation because of the pandemic. This would include, for example, those whose jobs are sales and commission-based, who are still pounding the pavement, but whose sales success is affected by the inability to meet with potential clients. Similarly, many professionals, such as lawyers and accountants, have seen their compensations cut but their hours remain the same.
The CARES Act provides that an employer may rely on the employee’s certification that s/he is a QI. The Internal Revenue Service (IRS) modified this in a series of Frequently Asked Questions [Q11, available at https://www .irs .gov/newsroom/coronavirus-related-relief-for-retirement-plans-and-iras-questions-and-answers (FAQs)], indicating that the reliance on the employee’s self-certification was appropriate only if the employer had no knowledge to the contrary. This raised a lot of discussion among practitioners as to whether this changed the level of the employer’s duty to obtain proof as to the employee’s QI status.
It appears, however, that the IRS was confirming that an employer cannot rely on a certification that the employer knows to be untrue. For example, a company that is maintaining full-time employment for its workers likely cannot accept a claim that someone is a QI because s/he has been furloughed. Similarly, an HR director whose employee hands in a self-certification, saying, “This is total malarkey, but I want my money,” might reasonably be considered to have knowledge that the employee is not a QI.
The IRS has made it clear in FAQ 11, however, that employees can fool their employers some of the time, but they are permitted to fool the federal government none of the time. “Although an administrator may rely on an individual’s certification in making and reporting a distribution, the individual is entitled to treat the distribution as a coronavirus-related distribution for purposes of the individual’s federal income tax return only if the individual actually meets the eligibility requirements.”
One other issue remains relating to the self-certification rules for QIs. The actual statutory language provides that, “The administrator of an eligible retirement plan may rely on an employee’s certification.” [CARES Act §2202(a)(4)(B), emphasis added] Terminated employees, beneficiaries, and alternate payees under a qualified domestic relations order may all be QIs. Does this language reflect a statutory intention that self-certification should be available only to employees, and that the others need to provide substantiation of their status? In addition, the certification language is found in the section of the law that relates only to coronavirus-related distributions (discussed below). Does that mean that self-certification is unavailable for the other CARES purposes?
On the one hand, the language of the statute controls. On the other hand, the gravamen of relief legislation and regulation is to provide assistance with less attention to the details that might prevent or delay needed assistance. For example, a Notice issued jointly by the IRS and the Employee Benefit Security Administration stated,
Recognizing the numerous challenges participants and beneficiaries already face as a result of the National Emergency, it is important that the Employee Benefits Security Administration, Department of Labor, Internal Revenue Service, and the Department of the Treasury (the Agencies) take steps to minimize the possibility of individuals losing benefits because of a failure to comply with certain pre-established timeframes. [85 FR 26351]
And, finally, FAQ 11 refers to an administrator’s reliance on “an individual’s certification,” rather than an employee’s certification. On the other hand, the FAQ discusses self-certification only in the context of distributions, and not in relation to the other CARES provisions.
Clarification as to the use of self-certification is required . However, it appears to be a widespread practice for administrators to permit self-certification of QI status for all CARES purposes.
CARES permits “coronavirus-related distributions” (CRDs) of up to $100,000 to a QI. CRDs receive the following positive tax treatments:
1 . The CRD is not subject to the additional 10-percent premature distribution tax under Internal Revenue Code (Code) Section 72(t).
2 . While the distribution is exempt from the 10-percent penalty tax, it is still subject to ordinary income tax. However, QIs may spread the income taxes ratably over a three-year period . Example: Mathilda, a QI, receives a $30,000 distribution from her employer’s retirement plan. Under the three-year spread of the taxable income, she claims $10,000 as taxable income in 2020, $10,000 in 2021, and $10,000 in 2022.
3 . Recipients of CRDs may repay all or part of the distribution to the affected plan or any plan that can accept rollovers within the three-year period and avoid taxation. Such repayment is treated as a tax-free rollover of the funds to the plan and is not adjusted for earnings.
Although no guidance has been issued yet about how exactly this will be handled on a practical basis, procedures were developed for similar distributions and repayments in relation to similar relief for victims of major hurricanes. In those situations, participants who repay distributions can file an amended return to recover tax paid on income reported in earlier years. [See, IRS Notice 2005-92, relating to the relief provided to victims of Hurricane Katrina in the Katrina Emergency Tax Relief Act of 2005 (KETRA), §4E]
A distribution to a QI constitutes a CRD if it is distributed from an “eligible retirement plan” anytime during 2020. Therefore, someone who was a QI anytime during the year—even before CARES was enacted—who received a distribution after s/he became a QI is subject to the favorable taxation.
An “eligible retirement plan” for this purpose includes qualified plans, IRAs, 403(b) plans and governmental 457(b) plans. The law further permits employers to amend their 401(k), 403(b), and governmental 457(b) plans to provide for a special CRD distribution event. Profit-sharing plans, permitted by Treasury Regulations to allow distributions upon a stated event, may also be amended to provide for a special CRD distribution event.
However, pension plans and tax-exempt 457(b) plans are not permitted to make distributions for this purpose, unless the participant qualifies for a distribution for other permissible reasons, such as termination of employment or attainment of age 59½.
Who Says It’s a CRD? Do We Have to Permit a CRD?
This leads to an interesting conundrum caused by the language of CARES, which has also been of issue in other similar legislation, such as Katrina Emergency Tax Relief Act of 2005 (KETRA). Clearly, if the plan sponsor amends a profit-sharing, 401(k), 403(b), or governmental 457(b) plan to permit a special distribution event for a QI and that is the provision used by the participant to receive the distribution, the distribution is acknowledged by all to be a CRD.
Example: Kenneth is diagnosed as having been infected with COVID-19. Kenneth’s employer sponsors a 401(k) plan and has expressed an intent to amend the plan to permit distributions to QIs of up to $100,000 (or, if less, their full accounts) during 2020. Kenneth applies for a distribution of his full account of $25,000, and that distribution is made. It is a CRD.
CARES provides that CRDs are not eligible roll-over distributions for purposes of tax withholding (although they may be rolled over, both as eligible rollover distributions and under the three-year repayment discussed above). [CARES §2202(a)(3)(B)] This means that the distribution is not subject to 20-percent mandatory withholding. Instead, the withholding rules for nonperiodic distributions that are not eligible rollover distributions provide for 10-percent withholding that is waivable by participants. [Code §3405(b) (1)] The plan making such a distribution should not provide the Special Tax Notice under Code Section 402(f), but must instead provide the participant with a notice that s/he may waive withholding. [Code §3405(e)(10)(B); Treas . Reg. 35. 3405-1T, Q&A d-18]
But, what about distributions that are CRDs under the law, but taken from a plan that is not amended to recognize CRDs? Consider the following:
Example: Matthew, age 35, is diagnosed as having been infected with COVID-19. He is a QI under CARES. He is a participant in a 401(k) plan that has not been (and will not be) amended to provide for a special CRD event. However, Matthew incurs significant uninsured medical expenses during his illness. He applies to the plan for a hardship distribution in an amount appropriate to pay those medical expenses and receives a $20,000 distribution. That distribution is a CRD, as it is a distribution from a qualified plan to someone who is a QI.
Here, the plan does not specifically acknowledge CRDs. The plan administrator may not even know that the distribution qualifies as a CRD. What are the withholding obligations under this circumstance?
Again, we have no current guidance, but must look to IRS rules issued in relation to similar past events. IRS rules relating to Katrina acknowledge that the QI’s treatment of a distribution may be different from the treatment of such distribution by the plan. [Notice 2005-92, §1C] If similar rules apply to CARES, the plan sponsor may choose whether to treat distributions from its plans as CRDs. If the distribution is treated by the employer as a regular distribution, it is likely subject to the normal withholding rules for an eligible rollover distribution, that is, the 20-percent mandatory withholding, the ability to elect a direct rollover to an eligible retirement plan, and the provision of the Special Tax Notice under Code Section 402(f). However, if a plan treats the distribution as a CRD, it must be consistent in such treatment for purposes of withholding rules. [Notice 2005-92, §2C]
Example: The company that sponsors the plan from which Matthew (from the prior example) received a distribution has elected not to recognize CRDs. Therefore, when Matthew receives his hardship distribution, it is treated the same as any other hardship distribution for withholding and tax reporting purposes. Matthew will reflect the receipt of a CRD when he does his 2020 taxes.
Plan Amendments for CRDs
If a plan needs an amendment to permit a CRD, it may be operated as intended during the crisis, and the amendment must be ultimately adopted by the end of the 2022 plan year. The amendment should be effective retroactively to when CRDs were permitted by the plan and should reflect the actual administrative practice.
CARES Participant Loan Provisions
Under normal circumstances, a plan may permit participants to borrow from the plan in an amount that does not exceed the lesser of 50 percent of their vested interest (reduced by any existing loan) or $50,000 (reduced by the highest outstanding balance of any loan in the prior 12-month period). Furthermore, the plan loans must be repaid within five years (unless they are to purchase a primary residence) on an amortized basis, with payments not less frequently than quarterly. [Code §72(p)(2)] Most plans require loans to be repaid on a payroll deduction basis. Loans in excess of the limitations or that are not repaid timely are deemed to be taxable to the participant. [Treas. Reg. §1 .72(p)-1, Q&A-4, -10] If the participant experiences an event that permits a distribution, the plan administrator may offset the loan, treating it as an actual distribution. [Treas. Reg. 1 .72(p)-1, Q&A-13]
Increased Loan Amount Available
CARES amends Section 72(p) to permit loans of up to 100 percent of a QI’s vested account or benefit, up to $100,000. This provision covers loans made between March 27, 2020, and September 23, 2020. These maximum amounts are reduced by existing loans in the same way as the normal loan limits, that is, the 100 percent of vested interest is reduced by existing loans, and the $100,000 limit is reduced by the highest outstanding balance in the prior 12-month period.
These larger loans are only available if the plan sponsor chooses to amend the plan or loan procedure to permit them. It is not mandatory that this additional loan be offered to participants . If the increased loans are made available, the amendment must be adopted by the end of the 2022 plan year and must reflect actual plan operations in the interim.
Participant loans have the potential of becoming prohibited transactions if the exemption provided by ERISA Section 408(b)(1) is not followed. Two of the mandates of that exemption are potentially violated by the CARES changes to Code Section 72(p). In particular, ERISA Section 408(b)(1) requires that not more than 50 percent of a participant’s vested interest act as security for loans, and that loans be made according to written procedures. The Department of Labor (DOL) has since announced that it will not consider loans that follow the CARES rules to be prohibited transactions. [EBSA Disaster Relief Notice 2020-01, Participant Loans under the CARES Act]
Extension of Loan Repayment Periods
CARES further assists QIs by extending their required repayment periods. Specifically, CARES modifies Code Section 72(p) to provide any loan payment due from a QI on any outstanding loan between the date of enactment and December 31, 2020, is delayed for one year, and that the due date for subsequent repayments “shall be appropriately adjusted to reflect the delay in the due date … and any interest accruing during such delay.” Finally, CARES provides that the five-year limit on the permissible repayment period for loans is also extended for one year. Interest accrues on the loan during the delay period.
Determining the Repayment Schedule Post-2020
Although a similar loan repayment extension also was a part of KETRA, the proper way to determine what gets repaid when is not clear. The confusion comes from the fact that loan repayments due in January 2021 and later are not extended. Therefore, while the post-CARES payments through the end of 2020 are ostensibly delayed for a year, repayments must nonetheless begin again in January.
If that is so, you may ask, what did Congress mean when they said that subsequent repayments “shall be appropriately adjusted”? Good question. Nonetheless, if we follow the KETRA-related guidance, the loan repayments will begin afresh in January 2021, with interest accruing on the unpaid amount between the loan suspension date and that payment. The loan is then reamortized on that date with repayments to continue to the date that is one year later than the original due date. [See, Notice 2005-29, Section 5B, particularly the example therein .]
(Forgive the author for a moment, as she breaks the fourth wall and turns to the audience à la House of Cards for a side comment: the KETRA-related repayment structure forged by the IRS makes absolutely no sense to me, and is not the resolution that I would have structured if I had the power to do so. So, if you are looking at the Journal in wonder at this point, I feel your pain. I’m hoping the IRS comes to a different way to recalculate the loan payments when it gets around to providing CARES guidance, but expect that they will likely follow the rules they already provided in 2005.)
What Happens if the Plan Administrator Does Not Want to Recognize the CARES Loan Extension Provisions?
As discussed above, if a participant does not repay the loan as documented, the plan administrator normally is required under Code Section 72(p) to recognize a taxable event, also known as a “deemed distribution.” Under CARES, however, there is no taxable event if the individual is a QI and the loan payment was due during the one-year delay period under the Act. Therefore, whether the employer modifies the plan or loan procedure, there is no taxable event for a QI who suspends his or her loan payments, and no Form 1099R should be issued to the participant.
A different result ensues, however, if the borrowing participant incurs a distributable event under the plan (generally, a termination of employment).
Most plan documents or loan procedures provide that the employer either must or may offset the loan, which creates an actual distribution of the loan to the participant; this is always a taxable event. [See, Treas. Reg. §1.72(p)-1, Q&A-13(b), which provides that a plan loan offset “is an actual distribution for purposes of the Internal Revenue Code, not a deemed distribution under Section 72(p).”] If the plan does not provide for an offset at termination of employment, it is likely that actions by the participant to take a distribution of the balance of his or her account after termination will result in a loan offset under the plan.
Sometimes, the plan is not so straightforward. It might provide that the loan “goes into default” when the participant terminates employment. Does this mean that the loan offset is required? It is not clear. The plan administrator is tasked under most plans with the responsibility of interpreting the plan document. Therefore, service providers should discuss this issue with the plan administrator and encourage the administrator to put its interpretation in a written memo or, even better, modify the plan or the loan pr cedure to clarify what that phrase means for this plan.
To see how this works, consider the following example:
Example. The Ebenezer Scrooge 401(k) Plan is not amended to provide for the extended repayment period (or, for that matter, the higher loan limits). Bob Cratchit, a Scrooge employee, has an outstanding loan. Scrooge furloughs Bob without pay due to the pandemic, and Bob, in turn, stops making loan payments. Scrooge wants to consider the loan in default and taxable.
Bob is a QI, as he has been furloughed due to the pandemic. At the time that Bob stops making his loan payments, there is no taxable event. Section 72(p), as amended by CARES, provides Bob with an additional year to make a loan payment. As a result, there is no deemed distribution during the delay period. If Bob returns to work after the coronavirus crisis is over and begins making his loan payments under the extended rules of CARES, he never suffers a deemed distribution or taxable event. There is no taxable event, as the relevant Code section was amended due to CARES, and the plan is not permitted to consider the loan to be taxable to Bob.
On the other hand, if Scrooge fired Bob rather than furloughing him, and the plan so provides, Bob’s account is offset by the loan, creating an actual (taxable) distribution that is not forestalled by CARES.
If Bob were put on paid leave, rather than unpaid leave, nothing in CARES prevents the company from continuing to remove loan payments from Bob’s paycheck, notwithstanding the fact that CARES provides for the delay in repayment period for Code Section 72(p) purposes.
If all that were not enough, as a loan offset is an actual distribution, if the affected participant is a QI, the offset qualifies as a CRD. This means that the participant is entitled to the special tax rules for CRDs, including the ability to repay the funds to an IRA or a retirement plan within three years. For the offset to qualify as a CRD, the offset must take place before December 31, 2020.
Although it is not part of CARES, the IRS extended several tax-related deadlines until July 15, 2020. [IRS Notice 2020-23] This extension includes loan repayments that are due between April 1 and July 15, and is not limited to QIs. Therefore, a participant who is unable to make loan repayments in that period may delay doing so. In addition, if the loan procedure permits a participant a grace period for late loan payments, the participant may have even longer to make up a missed payment. Under Section 72(p), the maximum grace period that can be provided by a plan would permit the participant to bring the loan current by December 31, 2020, without being considered to have a deemed distribution.
What Is Better: A Loan or a Distribution?
A likely consideration for participants is: Should I borrow, or should I just take a distribution and be done? It depends…
If the Participant Can Repay the Loan During the Extended Repayment Period, Taking a Loan Is a Better Option
Assuming that the participant can and wants to repay the funds to the plan, and further assuming that he or she has the wherewithal to continue loan payments after the delay period, taking a loan is probably the better alternative.
The advantage to taking a loan is that the amount ultimately will be repaid and available when the par- ticipant retires, as originally intended. Furthermore, the participant will pay no taxes on the borrowed amount if the loan is ultimately repaid (and the tax presumption is that no taxes are due). Last but not least, the repayment period for a loan is five years, rather than the three-year period for repaying a distribution.
If the participant finds that he or she cannot afford to begin to repay the loan when the suspension period ends, s/he will recognize the loan balance as income in 2021, avoiding any taxation during 2020.
Alternatively, if the participant is terminated or otherwise experiences a distributable event during 2020 (such as becoming eligible for a CRD in a plan that so permits), the participant may convert the loan to a CRD if the plan administrator offsets the loan before year end.
If Repayment Is Not Expected to Be Possible, a Distribution Is the Way to Go
If the participant anticipates that s/he will not be able to repay the funds at all, taking them as a CRD instead of a loan permits the spreading of the taxes on the amount over a three-year period, possibly keeping the employee in a lower tax bracket. This treatment is not available after 2020, so will not be an option if a loan is defaulted in 2021. On the other hand, if a QI who took a distribution finds that s/he can put together the funds to repay the distribution within the three-year period, it can be paid back to the plan and any taxes will be recouped.
Remember the Market Decrease
An unfortunate biproduct of taking either a loan or distribution is that any value decrease suffered by a participant’s account (which is likely due to the market volatility since March) will be “locked in” when the assets are liquidated to make the payment. The impact on the participant’s ultimate retirement savings can be significant.
When all is said and done, people are in distress during these uncertain times, and if they need the money, CARES makes that reality less painful. Nonetheless, the distress that also will ensue due to some of the unanswered questions about these provisions hopefully will be relieved in the short term by the IRS issuing the guidance that everyone needs to properly assess their options and take proper action. ■
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