There is nothing wrong with offering loans with your 401(k) plan. What will be wrong is if the program isn’t administered properly and you don’t have the backup to prove you administered it correctly.
One of the biggest targets of a 401(k) plan audit by the Internal Revenue Service (IRS) is the loan program. The IRS agent is going to want to see the loan documents, the loan repayments, and a Form 1099 if there has been a default. Anything missing on your end with loans is going to be a problem with the agent. Not only do you need the requested paperwork, but you also may discover that it wasn’t previously administered, such as a loan default occurring because payments weren’t made to a participant’s loan.
Regardless of what could go wrong, be on the alert that something bad has happened and make sure it’s corrected before the IRS agent on an audit finds first.