Nonqualifying Assets in 401(k)

[Guest metallic]

We have a prospect (fewer than 100 participants) with a 401(k) plan. The owner and 1 other participant have purchased shares of a non-publically traded franchise using some of their plan assets that were in mutual funds. All participants were given that option at the time but only 2 chose to invest. These funds currently account for about one third of the plan assets. My understanding is that they need to be properly bonded to avoid an annual audit. Appraisal of those funds is not needed annually (I assume an appraisal would be needed if either one of the participants wants to liquidate the shares). They will need to find a buyer when that time comes. We would need to account for these assets to be reported on the 5500 and a more detailed SAR would be in order.

Any other thoughts to be concerned about?

[QDROphile]

Do the account owners or their family members have any other interest in the franchise, such as personal share ownership, or do they participate in or have any other relationship with the the franchise's business? The combination of retirement plan and investement in a nonpublic franchise is highly suspect.

[Guest metallic]

Do the account owners or their family members have any other interest in the franchise, such as personal share ownership, or do they participate in or have any other relationship with the the franchise's business? The combination of retirement plan and investement in a nonpublic franchise is highly suspect.

I do not know the answer to those questions. What are the implications if they do? Thanks.

[QDROphile]

Prohibited transactions.

[ESOP Guy]

And while there isn’t an explicit requirement to get the assets appraised by an INDEPENDENT appraiser in this case it isn’t true that the assets don’t have to be valued. Only ESOPs are required to have the INDEPENDENT appraiser, all plans are required to know the value of their assets.

Knowing the value of the assets is the job of the trustee and fiduciaries. I will grant if there are no distributions/loans etc going on there might not be an meaningful impact on the plan. Some of the Fiduciary experts (like Peter Gulia) might be able to give us better insight in how serious of a Fiduciary violation this is. Come on Peter you like giving quizzes can you help answer this quiz?

But if they want a loan how do you know what 50% of the account value is without a recent appraisal? You will need to know the value to compute a correct RMD also.

This sounds a lot like a ROBS, link below talks about them. The IRS has just announced recently that they are giving ROBS even more attention.

Also, without the independent appraiser you have to answer the question on the 5500 admitting that you did not get the independent appraiser. Every client I have, very small number, who we put answer that way gets a letter from the IRS asking about it. And they ask a ton of questions on how the value is being set. They will not like the answer we are not valuing it.

I strongly recommend they come up with a rational way to set this investments value every year and change it to reflect those fluctuations.

link about ROBS

http://www.irs.gov/retirement/article/0,,id=231594,00.html

Edit:

I believe all document would require the trustee to know the value of the assets in the plan so gains/losses can be allocated properly. So failing to value assets could be a failure to operate per the terms of the document.

[Peter Gulia]

This sounds like a "ROBS"-like situation, with some potential for a prohibited transaction or other fiduciary breach. (It's also possible that it could be a legitimate, but perhaps incorrectly managed, directed investment.)

How serious it is, as a practical matter (rather than under relevant law) might turn on whether these investments affect only two directing participants (as the OP seems to suggest), or relate to assets invested commonly for all participants.

metallic, you might prefer to thoroughly evaluate this prospective client before you decide to accept any engagement. If you find that each of the two participants received his or her expert lawyer's opinion or advice and is knowingly and intelligently choosing some risks, you might feel better about that situation than you would about someone who just did it without any professional help (not counting those who have a stake in selling these things). And think about what these investments suggest about whether the plan fiduciary is inclined to listen to you, and whether you'll have a comfortable working relationship.

If you do accept anything, write in your agreement that responding to EBSA, IRS, SEC, and other government examiners isn't included in any fixed fee, and instead is on your highest time-billing rates. You want those protections and more, even if you wouldn't be representing anyone, because the agencies have powers to summon third persons and they'll try to scour your records to find what others didn't reveal.