Prohibited transactions with retirement plans.

Who Is Liable and For How Much?

Both the Department of Labor (DOL) and the IRS are charged with enforcing laws that prevent conflicts of interest in dealings between certain individuals and/or organizations and retirement plans. While the focus of the legislation enforced by both has a common goal of preventing abuse in dealings between retirement plans and related parties, the terminology used to define the abusive actions and relationships differs. The Employee Retirement Income Security Act of 1974 (ERISA) seeks to prevent certain transactions between "parties-in-interest" and "employee benefit plans;"(1) the Code prohibits similar transactions between "disqualified persons" and "qualified plans."(2) In addition, both agencies impose different sanctions for violations of the laws they are called on to enforce. This dual treatment has led to considerable confusion on the part of tax practitioners and plan administrators.(3)

This article will look beyond the differences in terminology and answer the following questions. 1. What are "prohibited transactions?" 2. Who is disqualified from participating in prohibited transactions? 3. What exemptions apply and to whom do they apply? 4. What penalties are imposed on those who violate the rules?

Prohibited Transactions

Both ERISA and the Code forbid "disqualified persons"(4) and retirement plans from engaging in - the sale, exchange or leasing of any property; - the lending of money or other extension of credit; and - the furnishing of goods, services or facilities.

In addition, both forbid such persons from engaging in any transaction involving retirement plan assets or income for personal benefit.

Under both ERISA and the Code, there are two additional prohibitions applicable to "parties-interest" and "disqualified persons" who are also acting as fiduciaries of a retirement plan. A fiduciary cannot deal with the income or assets of a plan in his own interest or for his own account. A fiduciary cannot receive any consideration from any party dealing with the retirement plan with respect to a transaction involving the income or assets of the retirement plan.(5)

ERISA contains additional prohibitions limiting the percentage (not to exceed 10% of the fair market value (FMV) of the assets) of the plan assets that can be invested in the employer's securities. An employer security is any security issued by the sponsoring employer on an affiliate. It also contains a similar prohibition against investing in the employer's real property. Real property consists of any real property (including related personal property) leased from the plan to the sponsoring employer or an affiliate.(6)

Note: The Supreme Court recently decided that the transfer of real property in satisfaction of a contribution to a plan is a prohibited transaction. It does not matter whether the property is encumbered or unencumbered.(7)

Disqualified Persons

There are nine categories of disqualified persons. (Except as noted, the Code's definition of a disqualified person is identical to ERISA's definition of a party-in-interest.) A disqualified person is any person who is: 1. A fiduciary. 2. A person providing services to the plan. 3. An employer any of whose employees are covered by the plan. 4. An employee organization any of whose members are covered by the plan. 5. An owner, direct or indirect, of 50% or more of the voting stock or value of a corporation, the capital or profits of a partnership, or the beneficial interest of a trust, which is an employer under category 3 or an employee organization under category 4. 6. A member of the family of a person defined in categories 1, 2, 3 or 5. 7. A corporation, partnership, trust or estate of which (or in which) 50% or more of voting stock or total value, capital or profits, or beneficial interest is owned directly or indirectly by persons described in categories 1, 2, 3, 4 or 5. 8. An employee,(8) officer, director, 10%-or-more shareholder or a highly compensated employee of a person described in categories 3, 4, 5 or 7. 9. A 10%-or-more (in capital or profits) partner or joint venturer of a person described in categories 4, 5 or 7.

A fiduciary, as listed in category 1, is broadly defined and includes those persons designated as fiduciaries under ERISA Section 405. A fiduciary includes anyone who exercises any discretion or authority with respect to the management or administration of the retirement plan or its assets, or anyone who provides investment advice for a fee or other compensation.(9)

Family members (as listed in category 6) include a spouse, ancestor, lineal descendant and any spouse of a lineal descendant. While this list of relatives is very broad, it is not as broad as that in other Code sections. The list does not include brothers and sisters.

Note: The definition carries over to other categories of disqualified persons. When using attribution rules to determine direct and indirect ownership of stock, partnership interests, and interests in trusts and estates, brothers and sisters are excluded from the definition of family members.

Practically speaking, persons performing any function for a retirement plan, having any position of authority with the employer, or owning more than an insignificant percent of the employer, most probably are disqualified persons. This means they cannot engage in a prohibited transaction unless a specific exemption applies.

Exemptions

It is evident that disqualified persons would be entirely prohibited from dealing with most retirement plans unless exemptions existed. Sec. 4975(d) lists 15 exceptions to transactions that are normally prohibited. The most common exemptions relate to leasing office space, compensation for services, loans and payment of benefits normally available to plan participants.

* Services and compensation

Both ERISA and IRS regulations allow payments by a plan to a disqualified person, including a fiduciary, for office space or for any service or combination of services - necessary for the establishment or operation of the plan; - furnished under a contract or arrangement that is reasonable; and - for which no more than reasonable compensation is paid.(10)

A service is necessary for the establishment or operation of a plan if a service is "appropriate and helpful to the plan ... in carrying out the purposes for which the plan is established or maintained."(11) Therefore, a plan administrator may share office space with the plan.

Reasonable compensation depends on all the facts and circumstances. If an expense is considered to be unreasonable under Regs. Sec. 1.162-7 relating to ordinary and necessary business expenses, it is also unreasonable for purposes of this exemption.(12) Warning: The fact that compensation is reasonable as an ordinary and necessary business expense does not automatically mean that it is reasonable for purposes of the exemption. No contract is reasonable unless it permits termination by the plan on reasonably short notice without penalty. This prevents the plan from being locked into a financial arrangement that later becomes disadvantageous.(13)

Example 1: The D retirement plan leases space from a major shareholder in D Corp. at a rent considered to be reasonable. The lease agreement is for three years and cannot be canceled or assigned. The lease agreement is a prohibited transaction.

A contract may compensate the disqualified person for losses incurred on the early termination of the contract.

Example 2: Assume the same facts as in Example 1. The plan may cancel the lease at any time by giving the lessor 60 days' notice and payment of no more than one month's rent to cover the cost of re-leasing the space. Since the lease does not bind the plan to a long-term arrangement that may prove to be disadvantageous, the lease will not be treated as a prohibited transaction.

Wning: Any arrangement that provides for payment in excess of losses incurred or fails to provide for mitigation of losses is a prohibited transaction.(14)

The exemptions relating to compensation and for office space or services do not apply to fiduciaries dealing with the income or assets of the plan in their own interests or for their own account. Nor do they apply to fiduciaries receiving compensation for their own account with respect to the income or assets of the plan from any party dealing with a plan. Fiduciaries must have undivided loyalty to the plan.(15) Special restrictions are imposed on fiduciaries to deter them from exercising their authority in such a way as to create a conflict of interest with the plan on whose behalf they are engaged. Therefore, fiduciaries may not do anything that keeps them from acting in the best interests of the plan.

However, fiduciaries can receive normal benefits from a plan as one of the plan's participants. Fiduciaries can also receive reasonable compensation for services as well as reimbursement for expenses that have been properly incurred. However, fiduciaries cannot receive payment or reimbursement for service already included in their normal fee.

Example 3: H is a plan administrator for A Corp. He receives an annual fee for his services, which include the preparation of regular tax forms. He cannot bill the corporation separately for this service.

A fiduciary may provide services to a plan without compensation other than reimbursement for direct expenses that have been actually and properly incurred.(16) There is no prohibited transaction if the fiduciary does not use his authority in his capacity as a fiduciary to cause a plan to pay additional fees for a service furnished in which the fiduciary has an interest.(17)

Example 4: E's employees are covered by a pension plan. E also acts as the plan administrator and is, therefore, treated as a fiduciary. In his fiduciary capacity, E retains I to provide investment advice. I receives a fee for this service and is also treated as a fiduciary. I proposes to perform additional services for additional compensation on behalf of the plan. E must approve the additional fee. The additional fee paid to I is not prohibited so long as I and E are not related, because I did not use her fiduciary authority to obtain the additional fee and E has not ultimately benefited from I's additional fee.(18)

Example 5: Assume the same facts as in Example 4, except that I is E's daughter. As a result of this relationship, the fee that E must approve for I is treated as a fee that he receives himself. Since he is using his fiduciary capacity to obtain the fee, E has engaged in a prohibited transaction.(19)

Warning: Even if the fiduciaries are unrelated, care must still be taken. Fiduciaries must act independently and in the plan's best interest. Mere approval of a transaction by a second fiduciary is not sufficient to show that the first fiduciary has not used his fiduciary authority for his own benefit.(20) It is important to be particularly aware of the quid pro quo acts of fiduciaries.

Example 6: F is the trustee of a plan and has discretion over the management and disposition of plan assets. F hires C to provide administrative services, which makes C a fiduciary. At the time that C is hired, it is clear that the plan will require additional management services. C hires F to perform such services for an additional fee. Regardless of intent, F hired C and thereby engaged in a prohibited act because she exercised her authority, which ultimately caused the plan to pay her additional fees. C, whose continued employment depends on F, has also engaged in a prohibited act because he has a personal interest in the appointment.(21)

* Loans

Exemptions for loans made between a retirement plan and a disqualified person who is also beneficiary or participant in the plan apply, if the loans - are available to all participants and beneficiaries on a reasonable equivalent basis; - are not made available to highly compensated employees (as defined in Sec. 414(q)) for amounts greater than those made to other individuals; - are made made according to specific provisions in the plan; - bear a reasonable rate of interests; and - are adequately secured.(22)

This exemption should not be confused with Sec. 72(p), which provides only that the loan will not trigger constructive receipt of income. Sec. 4975 must also be satisfied to keep the loan from being treated as a prohibited transaction. Accordingly, if a loan is made to a disqualified person, its terms must satisfy Sec. 72(p) to avoid income tax problems; it must also satisfy Sec. 4975(d)(1) to avoid treatment as a prohibited transaction.

Warning: If a loan is made to a plan participant at an unreasonable rate of interest, the loan may also constitute a prohibited assignment of plan benefits in violation of Sec. 401(a).

* Other exemptions

An exemption also exists that entitles any disqualified person to receive any benefit that he may be entitled to as a participant or beneficiary of the plan. However, the receipt of any benefit must be consistent with the terms of the plan in question.(23)

A disqualified person who is not covered by a statutory exemption may be entitled to a specific exemption. A specific exemption is granted if the transaction is - administratively feasible; - in the interests of the participants; and - protective of the rights of participants and beneficiaries.(24)

Planning problem: Special exemptions must be applied for before the commencement of the transactions that would otherwise be treated as a prohibited transaction. The process has been streamlined somewhat, but it is still time-consuming. As a practical matter, the investment opportunity is usually lost before the exemption is granted.

Any current or prosperative fiduciary may ask for a special exemption. The fiduciary may represent the retirement plan or be a party to the transaction for which the exemption is requested. The DOL will not consider requests that are incomplete, unorganized or undocumented.(25)

Who Is Entitled to the Statutory Exemptions?

All disqualified persons are entitled to the statutory exemption allowing receipt of any plan benefit to which the disqualified person is entitled under the terms of the plan in question.(26) However, the other statutory exemptions are not available to all disqualified persons. Exemptions for loans, compensation for services and property acquisitions are denied anyone classified as an owner-employee or a shareholder-employee. While this seems to eliminate a large category and effectively defeat the exemptions, the terms "owner-employee" and "shareholder-employee" are narrowly defined in Sec. 401(c)(3). An owner-employee is an employee who owns an entire interest in an unincorporated trade or business (i.e., as sole proprietor), or a partner who owns more than 10% of either the capital interest or the profits interest of a partnership.

Warning: The term also applies to family members of an owner-employee as well as to other persons related to or controlled by an owner-employee. In this situation, brothers and sisters are counted as family members.(27)

A shareholder-employee is an employee or officer of an S corporation, as defined in Sec. 1379 in effect on the day before the enactment of the Subchapter S Revision Act of 1982.

In short, shareholders, employees and officers of C corporations are allowed exemptions that are denied if S status is elected. Furthermore, a 100% owner of a C corporation may, under certain circumstances, borrow money from his plan. However, a sole proprietor or a partner owning more than 10% of the capital or profits of a partnership may not secure the same loan either directly or indirectly.(28)

Example 7: K is a 15% partner in the KB partnership. He borrows money from his retirement plan at a reasonable rate of interest and provides adequate security. The plan permits loans to all participants. While K is entitled to any benefits as a participant of a plan under Sec. 4975(d)(9), he is not qualified for the exemption that allows him to borrow money under Sec. 4975(d)(1). Accordingly, K has engaged in a prohibited transaction.

Penalties for Prohibited Transactions

If a disqualified person is involved in a prohibited transaction and is not covered by an exemption, he is first subject to a 5% tax on the amount involved for each year (or part of a year) in a taxable period.(29) The "amount involved" is the greater of the amount of money and the FMV of other property given or the amount of money and the FMV of other property received. However, if the prohibited transaction involves services, the "amount involved" is limited to excess compensation.(30) The "taxable period" begins on the date of the prohibited transaction act ends on the earlier of - the date of mailing a notice of deficiency with respect to the tax imposed by Sec. 6212(a); - the date on which the tax imposed is assessed; or - the date on which correction of the prohibited transaction is completed.(31)

If more than one disqualified person is involved in a prohibited transaction, all disqualified persons are jointly and severally liable for the tax.(32)

Note: The penalty tax is levied regardless of the intent of the disqualified person and irrespective of any benefit that the transaction may have had on the plan.(33) In fact, prohibited transactions must be reported to the IRS and the DOL on the plan's annual Form 5500, Annual Return/Report of Employee Benefit Plan (With 100 or more participants), reporting series. Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, which provides the information necessary for computing the amount of the prohibited transaction and the amount of tax due, must also be filed. The IRS will notify the DOL before imposing the 5% penalty. The DOL will notify the IRS when the penalty tax is justified.

The 5% penalty is merely the initial penalty involved for prohibited transactions. If the prohibited transaction is not corrected, the disqualified person is subject to an additional tax of 100% of the amount of the transaction.(34) To avoid the 100% tax, the prohibited transaction must be corrected within the taxable period.(35)

Note: According to the IRS, if a distribution to an owner-employee is a prohibited transaction and the fiduciary is only responding to written instructions in making the distribution, the fiduciary is not participating in the prohibited transaction and is not liable for the penalty tax.(36)

Reminder: Neither of the penalty taxes is deductile.(37)

Payment of the penalty tax imposed by the IRS does not relieve the disqualified person from any liability to the plan. If the disqualified person violates a fiduciary duty owed to the plan, he is personally liable to the plan for any losses and must also restore any profits made through the use of plan assets. The disqualified person may also be removed from any fiduciary position held with respect to the plan.(38)

Warning: Many courts have ruled that nonfiduciaries are also liable for monetary damages for knowingly participating in a breach of a fiduciary duty.(39)

The use of exculpatory agreements will not relieve any fiduciary from his duties with respect to the plan. However, fiduciaries may purchase insurance to cover themselves for any liability for a breach of duty.(40)

Note: Fiduciaries are not liable for any acts that occurred before becoming fiduciaries. Similarly, liability stops after the fiduciary responsibility ends.(41)

Conclusion

The prohibited transaction rules represent a mine field for practitioners and plan administrators. If a disqualified person engages in any transaction without benefit of an exemption, penalty tax will be owed. If the transaction is not corrected, an additional 100% penalty is imposed. Joint and several liability exist for the payment of the penalty taxes imposed. Defenses such as intent, reasonableness and ultimate benefit to the plan will not relieve the disqualified person from the penalty tax.

The disqualified person may also be liable to the plan for any losses caused by the transaction and must restore any profits made in the transaction.

(1) ERISA Sections 4(a) and 3(14). (2) Sec. 4975(e)(1) and (2). (3) The scope of this article is limited to a discussion of retirement plans and does not include material on rules and regulations with respect to private foundations. (4) For purposes of this article, "disqualified persons" also include "parties-in-interest" unless otherwise specified. (5) Sec. 4975(c)(1) and ERISA Section 406(b). (6) ERISA Section 407(a); Anton Lambos, 88 TC 1440 (1987); IRS Letter Ruling (TAM) 8744004 (7/13/87). (7) See Keystone Consolidated Industries, Inc., TC Memo 1990-628, aff'd, 951 F2d 76 (5th Cir. 1992)(69 AFTR2d 92-517, 92-1 USTC [paragraph] 50,045) rev'd, 113 Sup. Ct. 2006 (1993)(71 AFTR2d 93-1812, 93-1 USTC [paragraph] 50,298); Dallas C. Wood, 95 TC 364 (1990), rev'd, 955 F2d 908 (4th Cir. 1992)(69 AFTR2d 92-649, 92-1 USTC [paragraph] 50,073), cert. granted. (8) The term "employee" appears only in ERISA's definition. (9) Sec. 4975(e)(3). See also IRS Letter Ruling (TAM) 9208001 (10/4/91). (10) Regs. Sec. 54.4975-6(a)(1); ERISA Section 408(b). (11) Regs. Sec. 54.4975-6(a)(2). (12) Regs. Sec. 54.4975-6(e)(6). (13) Regs. Sec. 54.4975-6(a)(3). (14) Regs. Sec. 54.4975-6(a)(3). (15) Regs. Sec. 54.4975-6(a)(5)(i) (16) Regs. Sec. 54.4975-6(a)(5)(iii). (17) Regs. Sec. 54.4975-6(a)(5)(ii). (18) Regs. Sec. 54.4975-6(a)(6), Example 1. (19) Regs. Sec. 54.4975-6(a)(6). (20) Regs. Sec. 54.4975-6(a)(5)(ii). (21) Regs. Sec. 54.4975-6(a)(6), Example (5). (22) Sec. 4975(d)(1). (23) Sec. 4975(d)(9). (24) ERISA Regs. Section 2570.30-52. This replaces Rev. Proc. 75-26, 1975-1 CB 722, and applies to transactions on or after Sept. 10, 1990. (25) For additional information, contact Office of Exemption Determinations, Division of Exemptions, Pension and Welfare Benefits Administration, U.S. Department of Labor, 200 Constitution Avenue, N.W., Washington, D.C. 20210. (26) Sec. 4975(d)(9) and (12). (27) Secs. 4975(d) and 267(c)(4). (28) IRS Letter Ruling (TAM) 9238001 (8/8/91). (29) Sec. 4975(a). (30) Sec. 4975(f)(4). (31) Sec. 4975(f)(2). (32) Sec. 4975(f)(1). (33) Cutaiar v. Marshall, 590 F2d 523 (3d Cir. 1979). (34) Sec. 4975(b). (35) Sec. 4975(b) and (f)(2). See Anton Zabolotny, 8th Cir., 1993 (72 AFTR2d 93-5340, 93-2 USTC [paragraph] 50,567). (36) IRS Letter Ruling 7813089 (12/30/77). (37) Sec. 275(a)(6). (38) ERISA Section 409(a); Leigh v. Engle, 727 F2d 113 (7th Cir. 1984). (39) See Brock v. Hendershott, 840 F2d 339 (6th Cr. 1988). However, the Ninth and Eleventh Circuits hold that a nonfiduciary cannot be sued for monetary damages. Nieto v. Ecker and Frommer, 845 F2d 868 (9th Cir. 1988); Useden v. Acker, 947 F2d 1563 (11th Cir. 1991). (40) ERISA Section 410(b). (41) ERISA Section 409(b).