Prohibited transactions: IRS expands self-dealing rules.

Under the Internal Revenue Code and the Employee Retirement Income Security Act of 1974 (ERISA), excise taxes may be imposed on a qualified pension or profit-sharing plan that engages in "prohibited transactions," i.e, certain financial transactions between the plan and a "disqualified person." Disqualified persons include (among others) fiduciaries, persons providing services to the plan, the employer of persons covered by the plan, owners of the business sponsoring the plan and family members of such owners (Sec. 4975(e)(2)). Prohibited transactions include, in part, certain sales and exchanges of money or property, the lending of money or extension of credit, and the furnishing of goods, services or facilities to the plan.

Most prohibited transactions may be easily avoided, since the law and regulations set forth reasonably objective standards. On two recent occasions, however, the IRS adopted a surprisingly expansive view of prohibited transactions, in each case by applying lesser-utilized self-dealing restrictions of the Code. These provisions, Sec. 4975(c)(1)(D) and (E), generally prohibit any transaction involving plan assets that provides a direct or indirect benefit to a fiduciary or other disqualified person.

In IRS Letter Ruling 9119002, a corporation's defined benefit plan loaned money to a partnership in which one of the trustees was a 39% partner. The Service concluded that the individual, as a co-trustee of the plan, was a fiduciary with respect to the plan and, as a partner in the partnership, indirectly received a benefit from plan assets through the partnership's use of the borrowed funds. Accordingly, the plan loans to the partnership were prohibited transactions under Sec. 4975(c)(1)(E). Interestingly enough, the IRS did not consider the adequacy of interest, nor did it address the fact that the promissory note signed by the partnership was timely repaid to the plan.

In IRS Letter Ruling (TAM) 9118001, the partners of a law firm, who were also trustees of the firm's money purchase pension plan, used the plan to provide loans to the firm's clients pending final disposition of their cases. The loans were repaid, with adequate interest, either from the proceeds of a financial settlement or, if the lawsuit was lost, from the client's personal assets.

The law firm argued that the loans were made solely for the benefit of the plan participants. The IRS disagreed, and ruled instead that the law firm, a disqualified person (i.e., as employer of employees covered by the plan), benefited indirectly by having plan assets advanced to its clients. The indirect benefit resulted from the law firm's partners having their personal business objectives satisfied through the use of plan assets. In addition, since the partners of the law firm were fiduciaries under Sec. 4975(c)(3)(A), loans to the clients also constituted prohibited transactions. The Service found it irrelevant, in determining that a benefit was derived by a disqualified person through the use of plan assets, that the clients could have received comparable loans elsewhere and that the loans were otherwise "good investments."

These two rulings illustrate the IRS's continuing effort to strictly enforce the prohibited transaction rules applicable to qualified pension and profit-sharing plans. These broad interpretations of the prohibited transaction rules may be viewed as a warning to fiduciaries considering investing plan assets in other than traditional institutional investments; as in the rulings, the Service need not evaluate the overall propriety of an investment, with respect to either interest or collateral, in determining whether a prohibited transaction has taken place or whether excise taxes will be imposed.