Prohibited Transaction

[Belgarath]

Here's a strange one - at least seems strange to me.

Participants in a Defined Benefit plan have an insured death benefit. Plan sponsor decides to reduce plan formula, so the life insurance must be surrendered or purchased from the plan for its Fair Market Value. There has been NO distributable event under the plan, so no participants are eligible for any current distribution.

Pursuant to Prohibited Transaction Exemption 92-6, the plan may sell the policy to a participant for its Cash Surrender Value. Note that this may be less than the FMV, but isn't germane to this question.

Here's where the rot sets in. The plan assigns the ownership of the policies to the participants. However, the participants HAVE NOT paid the plan anything whatsoever. This apparently took place a few months ago. So, the participants have received an impermissible distribution from the plan in the amount of the FMV of the policies.

ERISA 406(a)(1)(D) prohibits a fiduciary from transferring plan assets to any party in interest. Party in interest is defined under ERISA 3(14)(H) to include an employee. However, each of these common law employees, while a "party in interest" under ERISA, is not a "disqualified person" under IRC 4975(e)(2).

So, it appears that there has been a Prohibited Transaction. But, what penalty is payable in this specific situation? It would appear that the IRC 4975(a) tax isn't payable, as it isn't imposed on a fiduciary who is acting only in that capacity? And if that's correct, what is paid, and to whom? Since the DOL gets the 5500 forms that will presumably show that a PT has taken place, do they send the information to the IRS under their "coordination" clause in ERISA 3003, and then the IRS imposes a penalty? Would the DOL have to bring an action under ERISA 502(a)(2) for a Fiduciary breach? Basically, we're looking at something on the order of a $3,000 distribution, so the recovery plus interest will be peanuts, but I'm trying to see if any other penalty is automatically imposed.

Thanks in advance for any insight!

[jpod]

Isn't the typical construct to first strip out all of the cash value or as much of it as possible? Maybe they did that, and as a result thought that the participants would have to pay $0.

I don't have off the cuff answers to your specific questions, but don't you have operational/qualification issues, including a 401(a)(2) exclusive benefit issue?

[Belgarath]

Yes, there are operational/qualification issues, but that's not where my question lies. And in answer, no, there were no loans taken on the policies prior to assignment.

So I'm back to the original question(s) re the PT and penalty. Thanks!

[Bird]

At the moment, they are simply impermissible distributions to participants. That is, I think, just a qualification issue. Is there any intent to have the participants complete the purchases? If so, then I think they could just finish the purchase now. I guess if there's a feeling too much time has elapsed, you could call them loans or other PTs that are corrected by the subsequent payment, and they could pay the small penalty. But if they don't intend to have the participants pay...that's not something that can be fixed as a PT w/penalty.

[Belgarath]

Right, but to perhaps get a bit more specific - I'm assuming that the Trustee/Administrator will get the amounts repaid to the plan. But what is the penalty, and how and to whom is it paid? The IRS form 5330 doesn't seem to have a category for this, since at least as I read it, the 4975(a) tax isn't applicable. This is where I'm getting stuck. Thoughts?

[Bird]

By "repaid" I assume you mean the participants complete the purchases by paying for the policies. Maybe I'm a cowboy but I'm not sure a problem exists any more. But if you really want to call it something, I'd call it a loan and pay the penalty on the interest.

If by "repaid" you meant return the policies, then I guess that would be a loan as well, same answer.

[Ron Snyder]

The problem you really have is that the transaction, if proper documents were executed, is a PT. And without documentation it is a disqualifying event.

The permissible way to do a sale of policies for FMV (assuming cash values) is to pay for the policy either immediately prior to or following the transfer. Failure to pay is an in-service distribution in violation of the plan's terms. Failure to pay timely is an extension of credit to the participant.

[Belgarath]

Thanks for the response. But it still doesn't get to my original question - since none of these people are a "disqualified person" under IRC 4975, then we have a PT under ERISA, but not the IRC. So I'm trying to determine exactly what the penalty is (if any), to whom it is paid, and how is it paid? And perhaps this is unanswerable, but I'm trying to see what I can find out. Thanks!

"ERISA 406(a)(1)(D) prohibits a fiduciary from transferring plan assets to any party in interest. Party in interest is defined under ERISA 3(14)(H) to include an employee. However, each of these common law employees, while a "party in interest" under ERISA, is not a "disqualified person" under IRC 4975(e)(2).

So, it appears that there has been a Prohibited Transaction. But, what penalty is payable in this specific situation? It would appear that the IRC 4975(a) tax isn't payable, as it isn't imposed on a fiduciary who is acting only in that capacity? And if that's correct, what is paid, and to whom? Since the DOL gets the 5500 forms that will presumably show that a PT has taken place, do they send the information to the IRS under their "coordination" clause in ERISA 3003, and then the IRS imposes a penalty? Would the DOL have to bring an action under ERISA 502(a)(2) for a Fiduciary breach? Basically, we're looking at something on the order of a $3,000 distribution, so the recovery plus interest will be peanuts, but I'm trying to see if any other penalty is automatically imposed."

[GBurns]

This is not my area of expertise but some thoughts have occurred to me.

The participants have receiived an impermissible distribution, hence a failure to in plan operation.

The participants have failed to pay, a violation of plan terms.

Aside from vebaguru's point about lack of documentation being a disqualifying event, aren't the above also disqualifying events ?

Then there is the issue of reporting the transfers as income/value received/paid to the participants.

I wonder why the cooncern is not about the IRS issues of plan disqualification, and underreporting/misreporting of income ? These will certainly be more than $3,000.

[Belgarath]

Thanks for responding - but I'm well aware of the other issues, and have no question about those. My question is specific to the PT. See my earlier comment. Thanks.

"Yes, there are operational/qualification issues, but that's not where my question lies. And in answer, no, there were no loans taken on the policies prior to assignment.

So I'm back to the original question(s) re the PT and penalty. Thanks!"

[Guest Sieve]

The penalty would fall under ERISA Section 502(i) - 5% of the amount involved. I don't know how the DOL would collect. Looks like the DOL has to ask for the penalty, though, because, as you indicate, it doesn't appear that the Form 5330 applies.

[Belgarath]

Hi Sieve - thanks for the response. I had looked at the 502(i) penalty earlier, but if I'm reading things correctly, the last sentence seems to say that it won't apply to a transaction with respect to a plan described in 4975(e)(1) of the Code. And 4975(e)(1) includes a trust under IRC 401(a).

Am I misunderstanding this section? Any further thoughts? Thanks again.

[Guest Sieve]

I read that too, and also saw it mentioned in the regs, but I also wondered just what it meant in your circumstance--I can't beleive there is no way to collect a PT tax for your transaction. I assume it means that the IRS collects the excise tax for a violation of IRC Section 4975 for a qualified plan, and the DOL will not double up and add an additional penalty. If that's true, then certainly somewhere--which neither you nor I can find--there must be authority for the IRS to collect a tax for a PT under ERISA Section 406 that is NOT an IRC Section 4975 PT. Otherwise, there's a big gap.

[Belgarath]

Thanks Sieve. If nothing else, this whole thing has at least made me feel a little better - apparently I'm not the only person who finds it challenging! I was originally certain there must be a simple answer in bold print right under my nose that I was somehow missing, but it appears maybe that's not the case. If I find out anything more, I'll be sure to post it.

[Guest Sieve]

Belgarath -- Look at the EBSA enforcement manual--

http://www.dol.gov/ebsa/oemanual/main.html

I know it has lengthy discussions on PT matters. Perhaps you can find something there.

[Belgarath]

Gracias. I didn't read it exhaustively, but on a skim I found nothing to answer the question. It did confirm that 502(i) wouldn't apply. At this point, I think they will just correct the PT, report it on 5500's, and wait to see if anyone imposes a penalty.