Participant Loan or Prohibited Transaction?

[John A]

A participant has a life insurance policy in the plan. The participant takes a loan of the cash value from the policy directly from the life insurance company without going through the plan, despite the policy being an asset of the plan.

Is this loan a prohibited transaction due to not being made in accordance with specific provisions that are set forth in the plan, or could this be an allowable participant loan as long as the plan does have a written loan program? What additional info. do I need to determine whether or not this is a PT?

[R. Butler]

Wouldn't it just be an operational failure due to not following the terms of the plan? Unless it was made to a sole-proprieter or a >5% of an S-corp. (or possibly a "party-in-interest" trying to circumvent the terms of the plan), I can't see why it would be a prohibited transaction.

[Steve72]

But the participant (if still an employee) is a party-in-interest. Unless the insurer followed the terms of the plan in providing this loan (including making such loans "reasonably available" to other participants), I would think the there is a prohibited transaction here.

[R. Butler]

I should have used the term fiduciary and not party-in-interest. I don't disagree that the employee is a party-in-interest under ERISA, but does that make this a prohibited transaction? I thought that a prohibited occurred when a fiduciary causes the plan to engage in a transaction that the ficuaciary knows or should know constitutes...blah,blah,blah.

From the initial question I assume that there is a loan program that makes loans reasonably available to all participants. Unless the employee is a fiduciary, I don't see why this is a prohibited transaction.

[John A]

Would it be a PT due to the interest rate on the policy loan being less than 6%?

[Bob R]

Under ERISA, there is a PT if there is a transaction between the plan and a "party in interest" unless an exemption applies. It's possible the loan could be exempt. Many times loans are made from a policy to strip it of cash value before making a distribution.

The exemption for loans applies if all of the rules are satisfied - adequate security, reasonable rate of interest (I'm not sure where the 6% comes from), reasonable available, follows terms of loan program, etc.

I think you'd need to go through each of these to determine where the loan complies. For example, the loan program probably requires payroll deduction (at least most do). If the person went directly to the insurance company, it's possible payroll deductions aren't being made. That could be a problem.

And you have the 72(p) issues to deal with (can't exceed 5 years, etc.).

If you find that it is a PT, then there is potential disqualification of the plan. Under IRC 401(a)(13), you can't pledge your interest in a plan as collateral unless it's a participant loan exempt from the PT rules.