Loans from qualified plans to owner-employees can be prohibited transactions.

Qualified employee benefit plans, including Sec. 401(k), pension and profit-sharing plans, are prohibited by the Employee Retirement Income Security Act of 1974 (ERISA) (Sections 406-407) and the Code (Sec. 4975) from engaging in certain transactions; engaging in such transactions can result in significant penalties. Among other things, the rules either prohibit or place limitations on the lending of money or extension of credit between a qualified plan and a related party.

Statutory exemptions allow certain types of plan-participant transactions that would otherwise be prohibited. Specifically, an exemption is available for certain participant-loan programs under ERISA Section 408(b)(1) and Sec. 4975(d)(1), provided the loan program meets certain conditions (e.g., the loan program is made available on the same basis to all participants, the loans bear a reasonable rate of interest, the loans are adequately secured, etc.). Unfortunately, due to an exception under ERISA Section 408(d) and Sec. 4975(d), this exemption does not extend to plan participants classified as "owner-employees." As a result, plan loans to owner-employees are prohibited transactions regardless of the borrowing terms, unless an individual exemption is obtained from the Department of Labor (DOL). For this purpose, an owner-employee includes self-employed individuals, more-than-10% partners in a partnership, more-than-5% S shareholders and participants or beneficiaries of an individual retirement arrangement (IRA), including an employer or group of employers that establishes IRAs for their employees.

In determining who is a more-than-5% S shareholder, certain family attribution rules apply.

Example: A is employed by an S corporation and is a participant in the corporation's Sec. 401(k) plan. A's parents own 4% of the S corporation and A owns 2% of the S corporation. Through attribution, A is considered to own 6% of the stock. Therefore, A is deemed a more-than-5% shareholder and cannot borrow from the plan, even if loans are made on the same basis to all participants and otherwise comply with ERISA Section 408(b)(1).

To encourage compliance, both ERISA and the Code prescribe civil penalties that may apply to prohibited transactions. Sec. 4975 imposes a 5% penalty on the amount of any prohibited transactions that involve qualified pension and savings plans. In the case of a loan, the amount involved is the greater of the fair market value or the actual amount of interest charges applicable to the prohibited loan or extension of credit. This penalty is imposed on the related party, not the plan. This self-assessed penalty applies annually until the transaction is fully corrected. If the transaction is not fully corrected by the time a deficiency notice is mailed, a 100% penalty may be assessed against the related party.

ERISA Section 502(1) enables the DOL to assess a minimum 20% civil penalty against any plan fiduciary or any other person involved in a fiduciary breach. By definition, a prohibited transaction is considered a fiduciary breach if the plan's fiduciary knew or should have known that such transaction was prohibited. This penalty is reduced to the extent of any penalty assessed under Sec. 4975. Furthermore, the penalty may be waived if it can be shown that the fiduciary acted reasonably and in good faith, or it is reasonable to expect that the person would not be able to restore all losses to the plan without extreme financial hardship. From a practical standpoint, this is an extremely difficult standard to meet.