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Keystone raises red flags for pensions and foundations.

The Supreme Court, in an 8-to-1 decision, held in Keystone Consolidated Industries, Inc., 5/24/93, rev'g 951 F2d 76 (5th Cir. 1992), aff'g TC Memo 1990-628, that a contribution of unencumbered property by an employer to a defined benefit pension plan in satisfaction of the employer's minimum funding obligation constituted a prohibited sale or exchange under Sec. 4975(c)(1)(A). Although Keystone resolved a controversy over prohibited transactions under pension law, the decision clearly has ramifications for similar excise taxes imposed on self-dealing transactions by private foundations. In light of this decision, practitioners may want to advise their pension and private foundation clients, including certain charitable trusts, to proceed with the remedial steps necessary in order to prevent the application of the additional 100% (pensions) Sec. 4975(b) and 200% (private foundations) Sec. 4941(b) taxes.

The facts

Keystone Consolidated Industries, Inc. maintained several qualified defined-benefit pension plans, funding them with contributions to the Trust. In 1983, the company contributed five truck terminals (with a total fair market value (FMV) of approximately $9.7 million), and in 1984 real property (located in Key West, with an FMV of approximately $5.3 million). None of the contributed properties were encumbered by any type of mortgage or lien at the time of transfer, and the properties' FMVs were never in dispute. Keystone reported the transactions on its income tax returns for 1983 and 1984, taking a deduction under Sec. 412 for the FMV of the properties contributed and recognizing a capital gain for the difference between their bases and their FMVs.

The IRS determined that Keystone's transfer of the properties was tantamount to a sale between a disqualified person and a plan and, therefore, was a prohibited transaction under Sec. 4975(c)(1)(A). The Service issued a deficiency notice to Keystone for approximately $12.8 million, which Keystone contested.

The applicable law

Sec. 4975 was enacted by the Employee Retirement Income Security Act of 1974 (ERISA) in order to provide a disincentive for engaging in certain prohibited transactions without causing a tax-qualified retirement plan to lose its tax-qualified status. An initial first-tier excise tax of 5% of the amount of the prohibited transaction is imposed on the disqualified person involved; the failure to correct the prohibited transaction within the tax period results in the application of a 100% second-tier tax. This two-tier excise tax was meant to operate in the same manner as the Sec. 4941 tax on self-dealing transactions with respect to private foundations.

Under Sec. 4975(c)(1)(A), prohibited transactions for purposes of the application of the excise tax include "any direct or indirect . . . sale or exchange, or leasing, of any property between a plan and a disqualified person . . . ." A plan is generally defined as either a Sec. 401(a), or Sec. 408(a) or (b) tax-qualified retirement plan (Sec. 49 75 (e) (1)); disqualified persons are designated to include employers Sec. 4975(e)(2)(C)). Sec. 4975(f)(3) defines a sale or exchange:

A transfer of real or personal property by a disqualified person to a plan shall be treated as a sale or exchange if the property is subject to a mortgage or similar lien which the plan assumes or if it is subject to a mortgage or similar lien which a disqualified person placed on the property within the 10-year period ending on the date of the transfer.

The issue

The sole issue was whether the transfers of the unencumbered properties were sales or exchanges within the meaning of Sec. 4975(c)(1)(A), thereby making them prohibited transactions. This issue turned on the question of whether congressional enactment of Sec. 4975(f)(3), within the context of Sec. 4975(c)(1)(A), was intended to expand or limit the definition of sales and exchanges.

The IRS reasoned that it is a well-established principle of tax law that the transfer of property in settlement of an obligation is analogous to a sale and generally is treated as such. When Congress enacted Sec. 4975 along with other comprehensive ERISA provisions, it was presumptively aware that the transfer of property was indistinguishable from a sale or exchange. Therefore, by enacting Sec. 4975(f)(3), Congress implicitly meant to expand, not limit, the scope of the prohibited transactions' provisions to account for contributions of encumbered property that do not satisfy funding obligations. Furthermore, the Service contended that Sec. 4975 was not a penalty provision and, therefore, was entitled to be construed broadly enough to encompass the common-law definition of a sale that has been developed for income tax purposes.

On the other hand, Keystone reasoned that the issue of whether a transfer to a pension plan is a prohibited sale is inherently different from the common law on sales for income tax recognition. Since Sec. 4941, on which Sec. 4975 was modeled, was a penalty provision, Sec. 4975 must also be a penalty provision. Penalty provisions of the Code are to be strictly construed; therefore, Sec. 4975 required narrow construction. Keystone further reasoned that Congress was presumptively aware of this fundamental principle and, therefore, intended to limit, not expand, the definition of a sale or exchange in the promulgation of Sec. 4975(f)(3).

The Tax Court decision

The Tax Court held that the transfer of property by Keystone to the Trust was not a prohibited sale. The court reasoned that the issue of whether a transfer to a pension plan was a prohibited sale was separate and distinct from the issue of whether a transfer was a common-law sale for income tax purposes. Since Sec. 4975(f)(3) specifically described certain transfers of real or personal property to a plan by a disqualified person as a sale or exchange for purposes of Sec. 4975, the definitional concerns of a sale were preempted by that statute and removed from the general definitions found in other areas of the tax law.

The Fifth Circuit decision

The Fifth Circuit affirmed the Tax Court by holding that it was implicit within Sec. 4975(f)(3) that transferred property must be encumbered by debt to be treated as a sale. The court rejected the IRS's argument that Sec. 4975(f)(3) was meant to expand the definition of a prohibited sale. The court concluded t transfers of property to a pension plan were treated as Sec. 4975(c)(1)(A) sales, Sec. 4975(f)(3) would be superfluous.

The Supreme Court decision

The Supreme Court reversed the Fifth Circuit, holding that the transfers of the properties were sales or exchanges within the reach of Sec. 4975(c)(1)(A) and were, therefore, prohibited transactions to which the taxes under Sec. 4975(a) and (b) were applicable.

The Court reasoned that protection against potential abuses (such as overvaluation, burden of disposal and employer substitution of his judgment as to the plan's investment policy) was part of the intended general goal in enacting ERISA along with the specific protection against the plan's becoming primarily obligated to satisfy an encumbrance. The Supreme Court drew from this reasoning that in order to accomplish Congress's goal of categorically barring transactions that had the potential to jeopardize the plan's ability to pay promised benefits permitted a broad construction of Sec. 4975. The Court held that the statutory language of Sec. 4975(f)(3) was meant to extend Sec. 4975 to include contributions of encumbered property that did not satisfy minimum funding obligations. Therefore, the logic applied in previous interpretations of what constituted a sale or exchange for income tax purposes was equally applicable under Sec. 4975. The Court made reference to the fact that this has been the consistent position of both the Department of Labor and the IRS; however, it did not rule on the deference that should be applied to the rulings of these agencies.

Justice Stevens's dissent asserted that Congress implicitly understood the common-law term "sale or exchange" as it had been applied to other areas of the Code. The fact that the statutory language of Sec. 4975(f)(3) did not match that definition indicated congressional abandonment of the common-law standard for purposes of Sec. 4975(c)(1)(A).

Implications of Keystone for private foundations

In order to curb certain perceived abuses involving private foundations, Sec. 4941 was enacted by the Tax Reform Act of 1969. A first-tier tax of 5% on the amount involved is imposed on the self-dealing person and 2.5% on the foundation manager. Failure to correct the self-dealing act results in an additional second-tier 200% tax on the disqualified person and a 50% tax on the foundation manager.

As it applies to private foundations, self-dealing acts include the sale, exchange or leasing of property between a private foundation and a disqualified person. A transfer of property subject to debt by a disqualified person is treated as a sale or exchange under Sec. 4941(d)(2)(A). Private foundations are defined to include certain split-interest trusts, such as charitable annuity, lead and unitrusts, if such trusts are not exempt from taxation under Sec. 501(a); all of the unexpired interests are not devoted to specified charitable purposes; and they have amounts in trust for which a charitable deduction was (or will be) allowed.

The statutory language of the excise tax on prohibited transactions for tax-qualified plans was modeled directly on the private foundation provisions and was intended to operate in the same manner. As a general rule of statutory construction, identical words used in different parts of the same act are intended to have the same meaning. Therefore, it is quite reasonable to extend the Keystone decision to self-dealing in private foundations.


The Supreme Court's decision in Keystone resolves the question of whether the transfer of property, unencumbered by debt, to a plan is a prohibited transaction. In light of the legislative history of Sec. 4975, it is a logical extension to apply the Keystone decision to similar excise taxes placed on prohibited transactions by private foundations.
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Title Annotation:Keystone Consolidated Industries
Author:Sprohge, Hans
Publication:The Tax Adviser
Date:Sep 1, 1993
Previous Article:Structuring advertising expenditures to avoid reclassification as charitable contributions.
Next Article:Arnes defines an "on behalf of" redemption under sec. 1041.

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