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IRS disqualifies plans when investment options offered only to prohibited group.

Many plans currently offer investment direction options to only specified participants - usually officers, shareholders or highly compensated participants. The rank-and-file employees' accounts are invested in a "safe" investment, such as U.S. Treasury notes or savings accounts, with a low rate of interest. The final regulations under Sec. 401(a)(4) specify that the opportunity to direct investment is an "other right or feature" of a plan that must be nondiscriminatory as to current and effective availability. Moreover, the IRS has issued a technical advice memorandum indicating that the same is true for plan years before the effective date of the Sec. 401(a)(4) final regulations - and that the result of noncompliance is plan disqualification (Letter Ruling (TAM) 9137001).

The facts

The plan sponsor was a corporation of eight doctors, each of whom was incorporated and whose professional corporations (PCs) were shareholders in the plan sponsor. The arrangement constituted an affiliated service group under Sec. 414(m). The plans, a profit-sharing and a money purchase pension plan, covered the doctors and six rank-and-file employees. Three of the doctors served as the plans' trustees.

The plans provided for directed investments by each "adopting employer" - that is, each participating PC. During the years at issue (pre-1989 plan years), each PC would direct the trustees - through an "investment committee" composed of some of the doctors - to invest its contribution in particular investments. These investments earned between 11% and 41% in the pension plan, and between 8% and 23% in the profit-sharing plan. For the same years, the investment committee directed the investment of contributions on behalf of the rank-and-file employees. Those investments showed only a 6% rate of return.

Law and rationale

Sec. 401(a)(4) provides that a plan is qualified only if the contributions or benefits provided under the plan do not discriminate in favor of highly compensated employees (officers, shareholders or highly compensated employees for plan years beginning before Jan. 1, 1989). Regs. Sec. 1.401-1(b)(3) provides that if the plan fails this test, either in the form of the plan or in its operation, the plan is not for the exclusive benefit of employees.

The Service relied on its ruling in Rev. Rul. 70-370, which disqualified a plan under which a self-employed individual could elect the percentage of contributions allocated to the plan's variable annuity fund, but under which the election was not available to any common-law employees. Rev. Rul. 70-370 held that, unless a plan provides that all participants are allowed to direct their investments, a provision allowing the prohibited group to direct investments was discriminatory on its face, since they would be allowed to select investments providing a higher rate of return.

In Letter Ruling 9137001, the plans operated to allow the doctors, but not the rank-and-file employees, to direct investment of plan assets. The return on investment for the prohibited group substantially exceeded that of the rank-and-file employees - but even if the doctors' self-direction had resulted in a lower return (or a loss), their opportunity to self-direct their investments still would have resulted in prohibited discrimination under Sec. 401(a)(4). Therefore, the plans were disqualified.
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Article Details
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Title Annotation:discriminatory control of investment fund
Author:Olson, Sallie
Publication:The Tax Adviser
Date:Jun 1, 1992
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