If an account holder misses even one scheduled payment and then doesn’t make it up during a relatively-short “cure” period, the entire loan is considered a taxable distribution in which immediate income tax, and typically a 10 percent early withdrawal penalty, will be due. A recent taxpayer, who missed payments while on maternity leave, faced such a situation in which the IRS demanded payment and the Tax Court could not provide relief.

Crossed signals. The taxpayer took out a qualifying loan from her employer’s Section 401(k) plan immediately before she went on maternity leave. While out on leave without pay, she failed to make the first bi-weekly scheduled payment, having assumed that she only had to make payments through a payroll deduction. For the same incorrect assumption, she failed to make the payment within the so-called “cure period”. The taxpayer argued that while she was on leave, the substantially level amortization requirement under Reg. §1.72(p)-1 did not apply. The IRS argued that a taxable distribution occurred, accelerating the entire principal as well as triggering an early distribution penalty.

Court’s holding. The court held for the IRS. The court’s hands were tied by the terms of the loan. While the taxpayer’s circumstances and general confusion over the default and attempt to cure could not also excuse assessment of an early distribution penalty, however, the court did lift the accuracy-related penalty for failing to initially report the income – the only relief that was available under the circumstances.

Comment. The lesson to be learned here is that a plan participant should not rely on an employer/plan sponsor to protect against an unintentional “default” on a plan loan through missing a payment and cure period payment on the loan. Here, the employee had assumed that a payroll deduction covered the loan but she was deemed responsible by the court to monitor both the agreement and her pay stubs, despite any inattention during maternity leave.

Frias, TC Memo. 2017-139