The IRS has significantly expanded the categories of "qualified individuals" who can receive distributions and loans with favorable tax treatment to include individuals who have suffered a pay cut and those whose spouses and household members have suffered an economic impact due to COVID-19. It also confirmed how to treat loans when qualified individuals have deferred payments during 2020 and explained how plans and individuals should report distributions for tax purposes.

Our previous advisory summarizing key provisions in the CARES Act applying to employee benefit plans can be found here. The IRS notice can be found here.

CARES Act Background

The CARES Act made numerous changes to retirement and welfare plans, but the most prominent were optional provisions for withdrawals and loans up to $100,000 from retirement plans for participants affected by COVID-19 and the economic dislocation it has caused. During 2020, a plan may allow a participant to take a distribution, without the standard 10 percent early distribution penalty tax, of up to $100,000.

Taxation of the distribution can be spread over three years. Until September 23, 2020, instead of the normal plan loan limit of the lesser of $50,000 or half of the participant's vested accounts, the plan can offer loans up to the lesser of $100,000 or the full vested balance. Many plans quickly made these new benefits available to "qualified individuals."

As written, the law allowed a participant who experienced adverse financial consequences as a result of a quarantine, furlough, layoff, reduction in hours, or inability to work due to lack of childcare due to COVID-19 to take this early distribution. The owner of a business can also qualify if the business has had to close or reduce hours.

The CARES Act did not on its face cover the common situation where a participant was still working but the household income was reduced by a spouse's furlough or reduction in hours. The law provides that the plan can rely on the participant's certification that he or she meets these conditions, but employers were uncertain whether they should question a dubious certification.

The CARES also allowed qualified individuals to extend loan installments due from enactment until December 31, 2020, by one year. The loan was to continue to accrue interest, but it was unclear exactly how the loan would be paid off when installment payments resumed in January 2021.

Expansion of Categories of Qualified Individuals

The IRS issued a short set of FAQs regarding these CARES Act provisions on May 4, 2020, but they did little more than parrot the statute and provide some clues as to future guidance. Responding to numerous requests from representatives of plan sponsors and financial institutions administering IRAs, the IRS in Notice 2020-50 expressly used its authority under the Act to expand the definition of qualified individuals in two important ways:

• A participant whose spouse or a member of the household is quarantined, furloughed or laid off, or has work hours reduced due to COVID-19, is unable to work due to lack of childcare due to COVID-19, has a reduction in pay (or self-employment income) due to COVID-19, has a job offer rescinded or start date for a job delayed due to COVID-19, or must close or reduce the hours of a business they operate. "Member of the household" means someone who shares the participant's principal residence.
• The individual has a reduction in pay (or self-employment income) due to COVID-19 or has a job offer rescinded or start date for a job delayed due to COVID-19. This covers two circumstances that were not listed in the law but which had the same impact as a reduction in hours or layoff.

A new model form of certification is provided in the Notice which includes the expanded categories of qualified individuals. Employers may rely on the certification unless they have actual knowledge to the contrary. The Notice clarifies that "actual knowledge" does not mean that the administrator has an obligation to inquire into whether an individual has satisfied the conditions; it only applies if the employer is already in possession of facts that disqualify the individual.

Given that an individual can now qualify based on the situation of a spouse or household member, which the employer will rarely know about, employers should easily be able to disclaim "actual knowledge" to the contrary. This should particularly be true when the certification simply states that the individual meets at least one of several possible criteria, as the model does.

The Notice clarifies that the amount withdrawn does not need to correspond to the need associated with COVID-19. Thus, a plan may permit up to $100,000 to be withdrawn by a "qualified individual," even if such individual has not terminated employment, become disabled or reached age 59½, and even if the qualified individual does not require the full $100,000 to satisfy the adverse financial consequences related to COVID-19.

Loan Repayments

Most plans that have implemented the provision to allow extension of loan repayments have left it up to the participant to request that installments be deferred. Therefore, a particular qualified individual might have from one to as many as 10 installments deferred. Installments must recommence in January 2021, but exactly how to reamortize the loan was unclear.

In Notice 2020-50, the IRS decided that the loan could be reamortized over its remaining term plus a period of up to one year. In other words, even if the participant only skipped four installments, the remaining term of the loan could be extended by up to 12 installments. This method is described as a safe harbor, so presumably a plan could reamortize the loan over a shorter period—even over the original remaining term.

The Notice includes the following example of the safe harbor:

On April 1, 2020, a participant with a nonforfeitable account balance of $40,000 borrowed $20,000 to be repaid in level monthly installments of $368.33 each over 5 years, with the repayments to be made by payroll withholding. The participant makes payments for 3 months through June 30, 2020. The participant is a qualified individual (as described in section 1.B of this notice). The participant's employer takes action to suspend payroll withholding repayments, for the period from July 1, 2020, through December 31, 2020, for loans to qualified individuals that are outstanding on or after March 27, 2020. Because the participant is a qualified individual, no further repayments are made on the participant's loan until January 1, 2021 (when the balance is $19,477). At that time, repayments on the loan resume, with the amount of each monthly installment reamortized to be $343.27 in order for the loan to be repaid by March 31, 2026 (which is the date the loan originally would have been fully repaid, plus 1 year).

Additional Guidance on Tax Treatment of Distributions

For purposes of calculating the $100,000 distribution to qualified individuals, distributions from all qualified plans of the controlled group are aggregated. The distributions are not subject to the 20 percent income tax withholding, nor are the distributions subject to 10 percent penalty tax under section 72(t). However, the distributions are subject to the voluntary withholding rules.

Under the voluntary withholding rules, withholding will be made at the rate of 10 percent unless the participant opts out of withholding. Because the plan has an obligation to notify the participant of the ability to opt out of withholding, the distribution forms should include a provision that allows the participant to elect out of withholding, and state that income tax will be withheld at the rate of 10 percent if no election is made.

The retirement plan reports the COVID-19 distribution on IRS Form 1099-R. The plan may code the distribution as either:

• Code 2 (early distribution, exception applies); or
• Code 1 (early distribution, no known exception).

The reporting is required even if the distribution is recontributed to the plan in the same tax year. The qualified individual is required to report the distribution on his or her federal income tax return and on IRS Form 8915 E (which will be available by the end of the year). The qualified individual can elect to either report the entire distribution in the year received or elect to report the income ratable over three years. This election cannot be changed after the due date of the individual's tax return, including extensions, for the year of distribution.

Even if the plan does not adopt the CARES Act distribution provision, if the plan otherwise permits an in-service or other distribution, the participant may treat the distribution as a COVID-19-related distribution if the individual is otherwise a "qualified individual." The participant can obtain the favorable tax treatment by reporting it as described above.

A qualified individual can recontribute all or any portion of the distribution within a three-year period that begins on the date of the distribution. The qualified individual reports the recontributed amount on IRS Form 8915-E.

If an amount is recontributed before the due date of the return, including extensions, for the year in which the distribution is to be reported on the individual's tax return, it will not be reported as income in the year of recontribution. If the amount has already been reported as taxable income, the individual must file an amended tax return.

• Example 1: Taxpayer receives a $100,000 distribution on March 30, 2020. Taxpayer elects to treat the entire amount on his or her 2020 tax return. On December 31, 2022, the taxpayer recontributes the $100,000 to the plan. The taxpayer reports the recontribution on IRS Form 8915-E and files an amended tax return for 2020.
• Example 2: A qualified individual receives a $100,000 distribution on March 30, 2020, and elects to treat the amount as ratable over three years. On March 31, 2021, taxpayer recontributes $33,334 and reports such amount on IRS Form 8915-E. No portion of the distribution is included in income for the 2020 tax year.

If the amount of the recontribution is more than the amount that is required to be reported in the tax year, it may be carried back or forward to reduce the income tax consequences of any coronavirus distribution, at the option of the taxpayer. If the individual dies prior to the full amount being taxable, the remainder is included in income in the year of death.

Cancellation of Deferral Election Under Nonqualified Plan

The Notice also permits cancellation of deferral elections under a nonqualified plan due to an unforeseeable emergency or financial hardship related to COVID-19. The deferral election must be cancelled, not merely postponed or otherwise delayed.

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