Interest Rate For Participant Loans

The following article, reproduced from the most recent edition of the IRS publication, Retirement News for Employers, discusses the determination of a reasonable interest rate for a participant loan.  The article includes several examples taken from the DOL regulations that describe the process that should be followed in determining a reasonable rate.  The examples clearly demonstrate that the interest rate used should be based on the current commercial lending rates for loans to individuals of similar creditworthiness.

Participant Loans - What is a Reasonable Interest Rate?

[Tax Information for Sponsors of Retirement Plans - IRS Tax Exempt and Government Entities]

When a retirement plan allows participant loans, that loan is an investment of plan assets and must bear a reasonable rate of interest.  According to the Department of Labor, a plan's loan interest rate is reasonable if it is equal to commercial lending interest rates under similar circumstances (DOL Regulations section 2550.408b-1(e)).

To determine if a participant loan interest rate is "reasonable," ask these questions:

*          What current rates are local banks charging for similar loans (amount and duration) to individuals with similar creditworthiness and collateral?

*          Is the plan rate consistent with the local rates?

Examples

The DOL Regulations give several examples of how to determine a reasonable rate of interest for a plan loan.

Example 1: Plan P makes a participant loan to A at the fixed interest rate of 8% for 5 years. The trustees, prior to making the loan, contacted two local banks to determine under what terms the banks would make a similar loan taking into account A's creditworthiness and the collateral offered. One bank would charge a variable rate of 10% adjusted monthly for a similar loan. The other bank would charge a fixed rate of 12% under similar circumstances. Under these facts, the loan to A would not bear a reasonable rate of interest because the loan did not provide P with a return commensurate with interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances. As a result, the loan would fail to meet the requirements of section 408(b)(1)(D) and would not be covered by the relief provided by section 408(b)(1) of ERISA.

Example 2: Pursuant to the provisions of plan P's participant loan program, T, the trustee of P, approves a loan to M, a participant and party in interest with respect to P. At the time of execution, the loan meets all of the requirements of section 408(b) (1) of ERISA. The loan agreement provides that at the end of two years M must pay the remaining balance in full or the parties may renew for an additional two year period. At the end of the initial two year period, the parties agree to renew the loan for an additional two years. At the time of renewal, however, A fails to adjust the interest rate charged on the loan in order to reflect current economic conditions.  As a result, the interest rate on the renewal fails to provide a "reasonable rate of interest" as required by section 408(b)(1)(D) of ERISA. Under such circumstances, the loan would not be exempt under section 408(b)(1) of ERISA from the time of renewal.

Example 3: The documents governing plan P's participant loan program provide that loans must bear an interest rate no higher than the maximum interest rate permitted under State X's usury law. Pursuant to the loan program, P makes a participant loan to A, a plan participant, at a time when the interest rates charged by financial institutions in the community (not subject to the usury limit) for similar loans are higher than the usury limit. Under these circumstances, the loan would not bear a reasonable rate of interest because the loan does not provide P with a return commensurate with the interest rates charged by persons in the business of lending money under similar circumstances. In addition, participant loans that are artificially limited to the maximum usury ceiling then prevailing call into question the status of such loans under sections 403(c) and 404(a) where higher yielding comparable investment opportunities are available to the plan.

What are the consequences of not using a reasonable loan interest rate?

Unless a reasonable rate of interest is assessed, participant loans may result in a prohibited transaction (see DOL Regulation section 2550.408b-1(a) and Internal Revenue Code section 4975(c)(1)(B)).  As a result, the loans would not:

*          meet the requirements of ERISA section 408(b)(1)(D);

*          be covered by the relief provided by ERISA section 408(b)(1); and

*          meet the prohibited transaction exemption for participant loans in IRC section 4975(d)(1).

Group Health Insurance Coverage Cost Reporting to Employees

The following article is the third in a four part series discussing the group health insurance coverage cost reporting to employees guidance contained in IRS Notice 2011-28 with the addition of IRS Notice 2012-9's clarifications, modifications and additional guidance.  The combined IRS notices contain 38 questions and answers (Q&A) in total.

Part I found in our January 2012 newsletter, covered the Background of the IRS Notices; the General Requirements; the Employers Subject to Reporting Requirements; and the Method of Reporting on the Form W-2.  Part II found in our February 2012 newsletter covers the Aggregate Cost of Applicable Employer-Sponsored Coverage and the Cost of Coverage Required to be Included in the Aggregate Reportable cost.

This part (Part III) will cover the Methods of Calculating Cost of Coverage and Other Issues Relating to Calculating the Cost of Coverage.

Part IV will cover the Additional Guidance added to IRS Notice 2012-9.

Part III

Methods of Calculating Cost of Coverage (Q&A #s 24-28)

Employers may use one of three methods to calculate employee-sponsored coverage cost (1) the COBRA applicable premium method or (2) an employer that is determining the cost of coverage for an employee covered by the employer's insured plan may calculate the reportable cost using the premium charged method and (3) an employer that subsidizes the cost of coverage or that determines the cost of coverage for a year by applying the cost of coverage in a prior year may calculate the reportable cost using the modified COBRA premium method which is the reportable cost for an employee receiving coverage under the plan is the sum of the reportable costs for each period (such as a month) during the year as determined under the method used.  An employer is not required to use the same method for every plan, but must use the same method with respect to a plan for every employee receiving coverage under that plan. (Q&A 24)

COBRA applicable premium method - the reportable cost for a period equals the COBRA applicable premium for that coverage for that period. (Q&A 25)

Premium charged method - can only be used if the employee is covered by an employer's insured group health plan. If this is the case then the premium charged by the insurer for that employee's coverage for each period is the reportable cost for that period. (Q&A 26)

Modified COBRA premium method - this can be used if the employer subsidizes the cost of COBRA (so the premium charged to COBRA qualified beneficiaries is less than the COBRA applicable premium) or where the actual premium charged by the employer to COBRA qualified beneficiaries for each period in the current year is equal to the COBRA applicable premium for each period in a prior year.  If the employee subsidizes the cost of COBRA, the employer may determine the reportable cost for a period based upon a reasonable good faith estimate of the COBRA applicable premium for that period, if such reasonable good faith estimate is used as the basis for determining the subsidized COBRA premium.  If the actual premium charged by the employer to COBRA qualified beneficiaries for each period in the current year is equal to the COBRA applicable premium for each period in a prior year, the employer may use the COBRA applicable premium for each period in the prior year as the reportable cost for each period in the current year. (Q&A 27 with examples)

Other Issues Relating to Calculating the Cost of Coverage (Q&A #s 28-31)

Employers Who Charge Composite Rates

An employer is considered to charge employees a composite rate if (1) there is a single coverage class under the plan, that is, if an employee elects coverage, all individuals eligible for coverage under the plan because of their relationship to the employee are included in the elections and no greater amount is charged to the employee regardless of whether the coverage will include only the employee or the employee plus other such individuals, or (2) there are different types of coverage under a plan (for example, self-only coverage and family coverage, or self-plus-one coverage and family coverage) and employees are charged the same premium for each type of coverage.  In such a case, the employer using a composite rate may calculate and use the same reportable cost for a period for (1) the single class of coverage under the plan, or (2) all the different types of coverage under the plan for which the same premium is charged to employees, provided this method is applied to all types of coverage provided under the plan.

For example, if a plan charges one premium for either self-only coverage, or self-and-spouse coverage (the first coverage group), and also charges one premium for family coverage regardless of the number of family members covered (the second coverage group), an employer may calculate and report the same reportable cost for all of the coverage provided in the first coverage group, and the same reportable cost for all of the coverage provided in the second coverage group.  In such a case, the reportable costs under the plan must be determined under one of the three methods described above. (Q&A 28)

Cost Changes During the Year

If the cost for a period changes during the year (for example, under the COBRA applicable premium method because the 12-month period for determining the COBRA applicable premium is not the calendar year), the reportable cost under the plan for an employee for the year must reflect the increase or decrease for the periods to which the increase or decrease applies. (Q&A 29, see Q&A 30 for example)

Employees Who Change Coverage During the Year

If an employee changes coverage during the year, because, for example he/she was employed less than a year, terminated, got married, or has a family, the reportable cost under the plan for the employee for the year must take into account the change in coverage by reflecting the different reportable costs for the coverage elected by the employee for the periods for which such coverage is elected.  If the change occurs mid-month, costs are determined on a monthly basis.  Employers may use any reasonable method to determine the reportable cost for such period, such as using the reportable cost at either the beginning or end of the month or averaging or prorating the reportable costs, provided that the same method is used for all employees with coverage under that plan. (Q&A 30 with example)

Reporting on a Calendar Year Basis

The reportable cost under a plan must be determined on a calendar year basis.  For rules on translating the COBRA applicable premium to a calendar year amount see Q&A 29 and 30. (Q&A 31)