Property contributions to pension plans are prohibited, but what about profit-sharing plans?

The Supreme Court ruled on May 24, 1993 that a contribution of unencumbered real property to a company-sponsored pension plan in satisfaction of its funding obligations is a prohibited transaction (Keystone Consolidated Industries, Inc., Sup. Ct., rev'g 951 F2d 72 (5th Cir. 1992), aff'g TC Memo 1990-628). While not without doubt, it appears that the prohibition will not be extended to profit-sharing, Sec. 401(k), employee stock ownership plans (ESOPs) and other types of plans that are not subject to statutorily created funding obligations. Furthermore, it appears that the IRS will soon issue guidance that may provide limited relief from excise taxes with respect to property contributions that took place before the Keystone decision.

Background

Sec. 4975(c)(1)(A) lists those transactions between a retirement plan and a disqualified person that are deemed prohibited. One of the listed transactions is any direct or indirect sale or exchange of property. if such a transaction takes place, a two-tier excise tax is imposed. The first tier is a 5% penalty on the amount involved; the second tier is a 100% penalty, imposed if the prohibited transaction is not corrected within a prescribed time frame.

In January 1992, the Fifth Circuit affirmed the Tax Court holding that contributions of real property by Keystone to one of its company-sponsored defined benefit plans were not a sale or exchange. Two weeks later, the Fourth Circuit reversed the Tax Court in Wood, 955 F2d 908 (4th Cir. 1992), rev'g 95 TC 364 (1990), by holding that the contribution of a third-party promissory note to its defined benefit plan in satisfaction of its funding obligation was a sale or exchange, and therefore prohibited. The U.S. Supreme Court granted certiorari as a result of this conflict.

The argument for limiting the meaning of the phrase "sale or exchange" is based on Sec. 4975(f)(3). That subsection provides that if encumbered property (real or personal) is transferred to a plan by a disqualified party (which includes the sponsoring employer), the transaction will be treated as a sale or exchange, and therefore prohibited. It was argued by the taxpayer in Keystone that by including this provision in the Tax Code Congress indicated its intent to limit the meaning of "sale or exchange" to those situations involving the contribution of encumbered property. Absent an encumbrance, a contribution of property would not be prohibited.

The Keystone decision

The majority of the Supreme Court concluded that the phrase "sale or exchange" should be interpreted consistently throughout the Tax Code. They concluded that the income tax rule that the transfer of property in satisfaction of a monetary obligation is a sale or exchange is equally applicable in determining whether a plan contribution is prohibited. A property contribution to a pension plan in satisfaction of a funding obligation is essentially a property transfer in satisfaction of a monetary obligation and, therefore, a prohibited sale or exchange. The Court stated that the language of Sec. 4975(f)(3) on transfers of encumbered property is not a limitation on the meaning of the phrase "sale or exchange," but rather an expansion. A transfer is a sale or exchange if it is either in satisfaction of a funding obligation or if the property transferred is encumbered.

It appears that the Court's conclusion is based in large part on the policy objective that led to the enactment of the prohibited transaction rules - to categorically bar a transaction likely to injure the pension plan. it was the Court's view that a property transfer posed numerous potential problems for the plan, including a shortage of funds to pay promised benefits, assumption by the plan of the obligation to pay an encumbrance, overvaluation of the property, lack of liquidity and the employer's substitution of its judgment as to investment policy.

Based on that policy objective, the Court has seemingly made a distinction between property contributions made to satisfy funding obligations and other property contributions. The Court reasoned that property contributions satisfying a funding obligation have the potential to burden the plan, while other property transfers present far less potential for causing loss to the plan. In footnote two, the Court cited an example in which a property contribution is prohibited if in satisfaction of an outstanding funding obligation or if encumbered, but permissible if there is no outstanding funding obligation and the property is unencumbered. This seems to indicate that contributions of unencumbered property to profit-sharing plans, stock bonus plans and other defined contribution plans not subject to the Sec. 412 minimum funding requirements are not prohibited. From informal conversations with IRS personnel about the decision, it appears that the Service has no current intent to attempt to extend the logic of Keystone to situations involving plans not subject to the Sec. 412 funding requirements. However, the meaning of the phrase "funding obligation" could be interpreted more broadly in the future so as to include any obligation to make retirmement plan contributions. This could include statutory obligations such as top-heavy minimum contributions, and contractual obligations such as promises made to lenders to a leveraged ESOP.

The dissent by justice Stevens highlights an apparent inconsistency in the majority's distinction between contributions that satisfy a funding obligation and those that do not. Justice Stevens argues that if "sale or exchange" should throughout the Code be interpreted to mean a transfer in satisfaction of a monetary obligation, the Court should not be making a distinction between transfers satisfying a funding obligation under Sec. 412 and other transfers. Whether the transfer is in satisfaction of a funding obligation or not, it is correctly treated as a sale or exchange for income tax purposes and, therefore, to be consistent, should be for prohibited transaction purposes as well. Justice Stevens took a contrary view and concluded that the phrase "sale or exchange" should not be given the same meaning for all purposes, and accordingly, a transfer of unencumbered property should not be prohibited. It is apparently his view that, following the language of Sec. 4975(f)(3), transfers of encumbered property are the sole type of property contribution that should be prohibited.

The aftermath

The Service has indicated that it will soon issue guidance with respect to the correction of pre-Keystone property contributions that are now clearly prohibited. IRS personnel have informally indicated that the guidance will provide that if such transactions are corrected within a prescribed time frame, the Service will be willing to waive the 5% first-tier excise tax. However, there will be no waiver of interest on waived excise taxes. The guidance to be issued is likely to be limited to corrective measures only, and will not extend to other issues raised by Keystone.

The Department of Labor (DOL) has the authority to grant exemptions for transactions that would otherwise be prohibited in situations in which the transaction is administratively feasible, in the interest of plan participants and protective of their rights (Sec. 4975(c)(2)). Informal discussions with DOL personnel indicate that the Department does not anticipate that it will grant a special exemption for property contributions made to satisfy a funding obligation, but that special exemptions may be granted for property contributions not applied to satisy funding obligations. While consistent with Keystone, this position suggests the DOL's unwillingness to exempt transactions that are in fact advantageous to a plan and its participants, but are otherwise prohibited by Keystone.

While not necessarily the death knell for defined benefit plans that some commentators have suggested, Keystone certainly is another limitation on their operation. In deciding Keystone, the Supreme Court took action that it believed to be for the benefit of plan participants. Ultimately, the impact may be just the opposite. Keystone may cause some defined benefit plan terminations. Others may be converted to defined contribution plans structured such that there are no mandated contributions, and where the risk of investment loss is on plan participants, not the sponsoring employer.

The potential adverse impact on defined benefit plans of Keystone may be offset, at least in part, by other recent developments. The tax rate increases make some plans inherently more valuable. The Service's setback in the battle over the reasonableness of small plan actuarial assumptions certainly enhances the viability of defined benefit plans. Under some circumstances, the reduction in the amount of compensation that can be considered for retirement plan purposes (from $235,840 to $150,000) will make defined benefit plans more attractive than in prior years.