Restoration of plan investment losses is not a contribution.

In Letter Ruling 9507030, the IRS recently ruled that a payment to a qualified plan to restore investment losses resulting from a breach of a fiduciary duty will not be a contribution for Sec. 401(a)(4) purposes and does not give rise to an annual addition under Sec. 415. The Service also ruled that such payments may be deductible under Sec. 162.

P corporation sponsors several qualified defined contribution plans on behalf of its employees and its subsidiaries. P's division D performs all investment management duties related to the plans. D is managed by a P corporate officer, who is responsible for managing the assets of the investment funds of the plans; the investment officer has authority to delegate this responsibility to outside investment advisers or to manage the trusts himself.

One of the investment funds in which plan participants may elect to have their account balances invested (the Fund) has stated objectives that include security of principal, liquidity and rates of return in excess of the rate for 90-day Treasury bills. During 1993 and 1994, D directed the Fund to invest several million dollars in debt instruments - principal risk securities - commonly known as derivatives. In 1994, P's management determined that the Fund may not have met the investment expectations of plan participants, and D determined that it would be prudent to sell the investments, which resulted in a principal loss of several million dollars.

The Department of Labor investigated the loss and stated in a 1994 letter that P and D had breached their fiduciary duties in violation of the Employee Retirement Income Security Act of 1974 (ERISA). Separately, a group of plan participants filed a class action suit in Federal district court, alleging violations by P of ERISA and Federal and state securities laws, as well as various common law causes of action, with respect to the investments.

To resolve these actual and potential fiduciary claims, P proposed to restore the principal loss by making a restoration payment to the Fund, equal to the amount of the principal loss but reduced by amounts disclaimed by participants who were senior P officers, plus interest at the actual rate the Fund earned from the date of the principal loss until the date of the restoration payment. No restored participant account would exceed the amount that would have been in the account but for the loss.

In Letter Ruling 9507030, the IRS ruled that the proposed restoration payment by the investment manager would not constitute a contribution for purposes of Secs. 401(a)(4), 404 and 415; would not be treated as giving rise to an annual addition under Sec. 415; and would not result in taxable income, when made, to the plan participants or beneficiaries.

P also requested that the Service rule that the payment made to resolve the actual or potential claims for breach of a fiduciary duty would be deductible by P under Sec. 162. The IRS reasoned that, in general, payments in settlement of lawsuits or potential lawsuits can be deducted if the acts giving rise to the litigation were performed in the ordinary course of the taxpayer's business; see Kornhauser, 276 US 145 (1928); Rev. Ruls. 78-210 and 69-491. Citing Gilmore, 372 US 39 (1963), and Anchor Coupling Co., 427 F2d 429 (7th Cir. 1970), cert. denied, the Service stated that one must look to the nature and origin of the claim asserted to determine the nature of the acts giving rise to the litigation, rather than to the claim's potential effect on the taxpayer's business operations. In addition, the origin of the claim test may require allocation of a portion of the settlement payment to claims that are only threatened, as well as to claims litigated; see De Mink, 448 F2d 867 (9th Cir. 1971), and Rev. Rul. 80-119.

The IRS found no case law involving a similar payment by an employer to a pension plan, but noted that authority exists supporting the deduction of payments in settlement of a breach of fiduciary duty in other contexts. The Service emphasized that the restoration payment was being made in response to actual and potential claims for breach of fiduciary duty. Therefore, P's payment in settlement of actual or potential claims of breach of fiduciary duty could be deducted in full under Sec. 162.