3984 / When is a plan loan exempted from the prohibited transaction rules?

Loans made to plan participants and beneficiaries generally are exempted from the prohibited transaction rules if the loans:

(1)  are made available to all participants and beneficiaries on a reasonably equivalent basis,

(2)  are not made available to highly compensated employees ( Q 3930) in an amount greater than the amount made available to other employees,

(3)  are made in accordance with specific provisions regarding such loans set forth in the plan,

(4)  bear reasonable rates of interest, and

(5)  are adequately secured.¹

A reasonable rate of interest is one that provides the plan with a return commensurate with the interest rates charged by persons in the business of lending money for loans made under similar circumstances.²

Security for participant loans is considered adequate if it may reasonably be anticipated that loss of principal or interest will not result if default occurs.³ The effect of this no loss requirement varies depending on the type of plan; a plan in which the investment experience of the plan’s assets is shared by all participants may require additional loan conditions, such as mandatory payroll deduction repayment on stated events or additional collateral.

No more than 50 percent of the present value of a participant’s vested accrued benefit under a plan generally may be considered as security for the outstanding balance of all plan loans made to the participant.⁴ Except in the case of directed investment loans, this loan exemption is not an exemption from the other fiduciary standards of ERISA. The prohibited transaction rules apply to a loan that does not meet the exemption requirements, even if it is treated and taxed as a distribution ( Q 3953).⁵

Loans from a qualified plan to S corporation shareholders, partners, and sole proprietors generally are exempt from the prohibited transaction rules ( Q 3953),⁶ although there are rules applying to certain S corporation ESOPs that the IRS views as abusive
( Q 3825).

The Tax Court determined that a loan between a plan and a corporation partially owned by a disqualified person did not constitute a prohibited transaction where the loan was approved by and made at the sole discretion of the plan’s independent bank trustee.⁷ A transfer of property to a plan in satisfaction of a participant loan was treated as a prohibited transaction where the borrower was a disqualified person.⁸