Mix and Match Personal Funds and Plan Benefits in an investment

[Oh so SIMPLE]

I have just become involved with helping a plan that has the following investments, and I am concerned that this is a prohibited transaction.

It is a defined contribution plan with individual accounts, over which the participants exercise control in directing the investments. Two of the participants directed that part of their benefits be loaned to an LLC that owned an undeveloped piece of property with a high development potential (before 9/2008). At the same time, the one of the two participants and his wife also loaned other, personal money to the LLC. A single note was issued to the plan and that participant/wife, secured by a 2nd mortgage on the property and personal guaranties from the LLC owners.

Then when the financial crisis began in 9/2008, the bank holding the 1st mortgage threatened to foreclose and sale off the property. To avoid that, the two participants directed more of their plan benefits be loaned to the LLC and the participant who had already loaned to the LLC other funds, loaned yet more other funds to the LLC. The new loans were not made in the same proportions as the initial loans. With the additional funds, the LLC paid off the 1st mortgage (at a discount).

The LLC and its owners are not themselves disqualified persons or parties in interest vis-a-vis the plan. It yet looks like there could be prohibited transactions due to:

1-Use of personal and plan benefits together to make one and the same investment, i.e. each of the two loans that resulted in the notes.

2-Use of personal and plan benefits in different proportions exacerbating the first note situation in an attempt to save the first note's value.

I'm wondering if anyone else has faced issues raised by this situation and what IRS rulings there might be addressing these issues. Thanks.

[Jim Chad]

FWIW This feels "not right". But I cannot see a particular rule being broken.

[Oh so SIMPLE]

Here's an update. Our attorney has sent us a letter on this, which basically amounts to this:

a-the participant giving the investment direction is a fiduciary-type disqualified person according to Flahertys Arden Bowl, Inc. v. Commissioner, 115 T.C. 269, 115 T.C. No. 19 (9/25/2000).

b-a deal between the plan and an arm's length third party can be prohibited transaction if if provides an advantage to a disqualified person, Rollins v. Commissioner, T.C. Memo 2005-260 (11/15/2004)

c-plan loans to companies in which a disqualified person has a minority but 'significant' interest might benefit the disqualified person because such a company does not then have to deal with other lenders, Rollins v. Commissioner, T.C. Memo 2005-260 (11/15/2004).

d-if challenged by the IRS, the disqualified person bears the burden of proving he did not get an advantage from the Plan's deal with the third party, Rollins v. Commissioner, T.C. Memo 2005-260 (11/15/2004).

e-H. Conf. Rept. 93-1280 (1974) at 308, 1974-3 C.B. 415, 469, "As in other situations, this prohibited transaction may occur even though there has not been a transfer of money or property between the plan and a party-in-interest. For example, securities purchases or sales by a plan to manipulate the price of the security to the advantage of a party-in-interest constitutes a use by or for the benefit of a party-in-interest of any assets of the plan."

The bottom line, according to the lawyer, is whether this participant could prove to a court that he got no personal advantage from the use of the plan assets.

My immediate problem is that their 5500 is due next week and no one wants to sign it saying there's no prohibited transaction, because they do not know whether this side-by-side investment would be considered by the IRS to be a prohibited transaction.

[K2retire]

Why are they worried about a prohibited transaction now, when they apparently thought it was OK at the time it was done?

[Oh so SIMPLE]

They changed accounting firms about 6 months ago, and the new accountants spotted the concern. The previous accounting firm had given them the okay on the first loan, but no advice was sought when they made the second one.

[Belgarath]

So didn't the attorney advise or recommend to them one way or the other as to whether a PT occurred or not?

FWIW, it seems to me unlikely that they could prove no personal benefit. Absent the potential PT, the bank apparently would have foreclosed, and sold off the property, probably at a substantial loss to the "outside" portion?

[Oh so SIMPLE]

The attorney's conclusion was that if the advantage to the disqualified person in Rollins v. Commissioner, T.C. Memo 2005-260 (11/15/2004) was enough to make the deal a prohibited transaction, the advantages to the participant making the side-by-side investment of personal funds and plan benefits would be too. The attorney noted that the outcome would depend on how minor the participant could prove his advantage from the deal to be. The attorney thought that the advantage in Rollins v. Commissioner, T.C. Memo 2005-260 (11/15/2004) was just that a company would not have to deal without commercial lenders and the disqualified person had a less than 10% interest in that company. If that attenuated of an advantage is enough for a prohibited transaction, then the advantages to the participant who makes a side-by-side investment of personal funds and plan benefits would be enough for a prohibited transaction as well. The attorney was more certain in his opinion that the later loan, to 'rescue' the value of the first, would found to be a prohibited transaction than perhaps the first loan.

The client is resisting or disbelieving that the attorney's conclusion is correct and asked what our firm thinks and whether we'd dealt with a situation like this before.

[Guest Sieve]

If you think the client really only wants a second opinion, then give it to him/her--or beg off because you are not a law firm (if that is, in fact, the case). If you disagree with the attorney, be prepared to recommend another law firm for them to use for their second opinion. If you think they are not agreeing because they don't want to hear it, then you have a client problem.

PTs are very fact intensive, and it ought to depend on the size of the individual loan compared to all loans. But, the 2nd loan does seem to result in plan assets being used for the benefit of a participant (to protect the individuals' loan). From a conservative perspective, the opinion already given seems sound.

[Ron Snyder]

I had a similar situation years ago. The auditor was unwilling to negotiate, labeling the transaction a "circuitous" PT. The IRS Appeals Officer split the baby in half. There are multiple ways of looking at a situation. At least one of those ways sees it as a PT and at least one way sees it otherwise. This are not great facts to go to court on. Exceeding the 10% threshold is pretty damning, because that is the level that determines whether they are "joint venturers" under ERISA and therefore whether the transaction is a PT.

ERISA specifically provides for administrative exemptions to the PT rules, which has led to Letter Rulings from the DoL. Do the attorneys believe that filing for such would be helpful? It may be better than ratting themselves out as participating in a PT or lying under oath when they sign the 5500 form with no PT disclosure.

[Oh so SIMPLE]

vebaguru, was your experience splitting the baby with IRS Appeals before 11/15/2004 or since?

I ask because the Rollins v. Commissioner, T.C. Memo 2005-260 (11/15/2004), seems to be fairly significant on this topic.

[Ron Snyder]

My experience was before 2004.

There is a Rollins v. Commissioner, T.C. Memo. 2004-260, but I could not find one with the reference you provided. Moreover, the Rollins v. Commissioner was a prohibited transaction case and was decided on grounds unrelated to whether or not the case had gone though the IRS appeals process (which it had). The joint venture rules have been in the Code since 1975.

Your point seems to be that IRS Appeals Officers will no longer "split the baby" because of the Rollins case. Generally, Memo cases are not much of a precedent. Court of Appeals and Supreme Court cases provide stare decisis, and District Court and Tax Court opinions provide value as precedents, but generally "Notes" and "Slip Opinions" are not cited because they are weak.