United States: Computing the Excise Tax on Plan Loans That Are Prohibited Transactions

In July, the Internal Revenue Service ("IRS") issued Revenue Ruling 2002-43, which explained how to calculate the excise tax under Internal Revenue Code ("Code") section 4975 where a plan loan constitutes a prohibited transaction during successive taxable years.

Plan loans are generally excluded from Code section 4975’s rules prohibiting loans from a plan to a participant, as long as such loans satisfy the special plan loan rules in Code section 72(p) (e.g., adequate security). Where a plan loan fails to satisfy those special rules, the loan is a prohibited transaction subject to Code section 4975’s two-tier excise tax. Computing the excise tax for plan loans that are prohibited transactions raises two questions: how many prohibited transactions actually occurred; and how to calculate the excise tax for each prohibited transaction.

The first prohibited transaction occurs on the date of the plan loan. An additional prohibited transaction is deemed to occur on the first day of each taxable year after the year in which the loan was made.

To calculate the excise tax, you must know three things: the "amount involved," the "taxable periods" of the plan loan, and the applicable excise tax rate for each taxable period.

The "amount involved" in a prohibited transaction is the greater of the amount of money and the fair market value of the other property given, or the amount of money and the fair market value of the other property received, in the transaction. Fair market value is determined as of the date on which the prohibited transaction occurs.

A "taxable period" is the period beginning on the date the prohibited transaction (plan loan) occurs and ending on the earliest of (a) the date of the mailing of a notice of deficiency, (b) the date on which the first-tier excise tax is assessed, or (c) the date on which correction occurs.

From 1974 until recently, the first tier of the excise tax was 5% of the amount involved. However, the Small Business Job Protection Act of 1996 raised the first-tier excise tax to 10% of the amount involved for each year in the taxable period after August 20, 1996. The Taxpayer Relief Act of 1997 further increased the first-tier excise tax to 15% of the amount involved for each year in the taxable period after August 5, 1997.

Rev. Rul. 2002-43 provides a good example of the excise tax calculation. In the example, a plan loan in the amount of $10,000 was made on April 1, 1997. The interest rate on the loan was 11%, compounded annually. The loan was secured solely by the participant’s account balance of $12,000, and therefore was not adequately secured (because the loan was secured by more than 50% of the present value of the participant’s accrued benefit). In addition, because the participant did not make any of the required quarterly payments until December 31, 1999, when the participant repaid the loan in full, the loan failed to satisfy the level installment payments requirement of Code section 72(p)(2)(C). As a result, the plan loan is a prohibited transaction.

As noted above, an additional prohibited transaction is deemed to occur on the first day of each taxable year after the year in which the loan was made. Thus, this loan actually resulted in three prohibited transactions. The first occurred when the loan was made (April 1, 1997), the second occurred on the first day of the next taxable year (January 1, 1998), and the third occurred on January 1, 1999. The taxable period for each prohibited transaction ended on the date the transactions were corrected (December 31, 1999 for all three prohibited transactions).

The first-tier excise tax liability for each prohibited transaction is the sum of the amounts calculated by multiplying the "amount involved" by the excise tax rate in effect at the beginning of the taxable period. In this example, the "amount involved" for each prohibited transaction is the amount of interest for the first taxable year in the prohibited transaction’s taxable period.

First, the interest amount is computed as shown in Table A. Then, the first-tier excise tax is computed as shown in Table B.