May 401k plan create LLC with Plan Sponsor

[Dalai Pookah]

X is sponsor of 401k plan (solo; H&W).  X wants to invest both personal and plan money in a managed account with a major broker.  The account requires a minimum investment of $500,000.  X would like to form an LLC with 40% owned by 401k and 60% individually to own and make this investment.

My understanding is that it would not be a prohibited transaction for a plan and a party-in-interest to form a new entity and have that new entity make investments, which would naturally split according to membership interests.

I haven't been able to find any support or prohibition thus far.  Opinions? Citations?

Thank you.

[PensionPro]

My understanding is that it does not in itself create a prohibited transaction but creates the potential for prohibited transactions so would not recommend such a course of action to my clients but ymmv.

[Dalai Pookah]

31 minutes ago, PensionPro said:

but creates the potential for prohibited transactions

Please elaborate on this.

[Kevin C]

I read it differently.  The minimum investment is $500,000.  If the plan assets enable X to meet the minimum investment requirement, I don't see how this could be anything other than the use of plan assets for the benefit of X, a disqualified person and a PT under 4975(c)(1)(D). 

You really need to be discussing this with an attorney who is well versed in the prohibited transaction rules.

[Dalai Pookah]

It's more the other way around, the plan doesn't have 500k, but sponsor wants both to invest.  Rather than sponsor doesn't have 500k and needs the plan to help.

At any rate, I am an attorney (see under my name)  who knows something about PT rules; I just can't find anything specific to this issue.  Hoping someone in the peanut gallery would know.

 

[jpod]

Quote

 

I see no inherent pt by this "co-investing," although as you noted there may the potential for a self-dealing pt  based on actual facts.  I do see some complications:  (a) LLC needs to file an annual 1065 with k-1s; and (b) How are the LLC start-up expenses and on-going expenses going to be paid (e.g., legal fees in connection with formation and ongoing accounting fees and other expenses).  Perhaps there are more complications which don't occur to me right now.

[John Feldt ERPA CPC QPA]

Have you considered the retirement-exit strategy? Would that cause PTs? Would the tax situation be worse or better if it had been invested without using any plan funds? Capital gains vs. regular income tax?

[Kal]

the DOL approved such a design in their PTE 2000-10A to Hugh Janow in 2000-cf DOL PTE 2000-10A

The clients (with hindsight)  probably wished they hadn't

The Partnership's assets were to be invested by Bernard L. Madoff Investment Securities-an unrelated Investment Advisor-

that made them Plaintiffs

[Dalai Pookah]

Thanks, Kal.  But that is Advisory Opinion 2000-10A, not PTE

[Elizabeth G]

You might find this analysis helpful....

https://www.truckerhuss.com/2006/03/dol-provides-new-guidance-regarding-ira-investments-and-the-prohibited-transaction-rules-erisa-opinion-letter-2006-01a/

[Luke Bailey]

Having worked in the area extensively, and as the previous astute (but opposing) comments demonstrate, the issue is not subject to resolution with the typical degree of certainty that we expect for most federal income tax issues dealing with retirement savings.

This is a plan for only a husband and wife, so likely not subject to ERISA, making Elizabeth G's link to an article regarding IRA investment highly relevant. If there is a problem, it will be in IRC sec. 4975 or the UBIT rules of IRC secs. 511 et seq.

Mere coninvestment, in and of itself, is not a transaction between the plan trustee/participant, as an individual, and the plan, and does not appear to transfer assets of the plan to the trustee/participant as an individual, so, depending on facts and circumstances, you may be able to check off, as inapplicable, IRC secs. 4975(c)(1)(A) through (D). (Note, however, that the potential for future transactions such as recapitalizations, capital calls, etc., or decisions relating to tax issues of the investment, may mean that down the road there will be indirect transactions between the plan and the trustee/participant as an individual, resulting in an unavoidable prohibited transaction at that time.)

But what about IRC sec. 4975(c)(1)(E)? The rules tell us that even though not subject to DOL fiduciary rules, the individual in control of the investment (whether of a one participant plan or an IRA) is to be treated as a fiduciary for purpose of the prohibited transaction rules of IRC sec. 4975. See IRC sec. 4975(e)(3). How far do we take that and how do we apply it where the issue is conflict of interest (IRC sec. 4975(c)(1)(E))? Do we say, "Well, IF this were a plan subject to ERISA and IF the person controlling the investment decision was a real fiduciary and the plan contained other people's money (OPM), he or she certainly wouldn't be able to coinvest personally with the plan that he or she is a fiduciary of, because this would present a conflict of interest with respect to the OPM. Thus, the coninvestment is a prohibited transaction." Or, alternatively, do we say, "What are you talking about? It's this person's own money. As long as he or she honestly believes the purpose of the transaction is to benefit the plan or IRA at least as much as him- or herself individually, it's OK." To the best of my knowledge, this issue has not been settled by IRS, DOL, or the courts, other than in dicta in a footnote in the Ellis case.

Because of the ERISA reorganization plan of 1978, the DOL, not the IRS, has all of the regulatory/guidance authority for IRC sec. 4975. But DOL does not have enforcement authority for IRC sec. 4975. Moreover, because all of the plans that are subject to ERISA (basically), and certainly all of the plans that the DOL is interested in, have OPM, the DOL has no interest in clearing up this issue of how closely to pus the "fiduciary" analogy in a case where OPM is not involved. The IRS, on the other hand has no regulatory authority for IRC sec. 4975, although they do occasionally make law as part of their enforcement jurisdiction by bringing cases such as Ellis.

So I think in the end there is not going to be a certain answer to your question, Dalai Pookah, even assuming no complicating facts and circumstances, so you need to proceed carefully and with appropriate disclosure to the decisionmaker.

[Belgarath]

This is probably a stupid question, but have they asked the broker if, for purposes of the $500,000 minimum that the broker requires, that the separate investments could be "aggregated" solely for purposes of satisfying that minimum requirement? I assume this has already been explored and the answer was "no" but I just thought I'd ask...

[Luke Bailey]

5 hours ago, Belgarath said:

This is probably a stupid question, but have they asked the broker if, for purposes of the $500,000 minimum that the broker requires, that the separate investments could be "aggregated" solely for purposes of satisfying that minimum requirement? I assume this has already been explored and the answer was "no" but I just thought I'd ask...

Note that to the extent the problem is IRC 4975(c)(1)(E) (i.e., acting for the "plan" under a conflict of interest), the problem would not go away just because of the plan and individual would not be investors in the same entity. However, separate but simultaneous investment could avoid some "down the road" PT issues, probably.

[jashendorf]

Using the the plan money to enable the personal money to meet the minimum investment is a (c)(1)(D) violation, and so a PT. (AO 2000-10A did not have that factor in it.)
If there were not a minimum investment requirement that the plan assets were needed to satisfy, and all other things being the same, then the investment itself wouldn't automatically be a PT, but could turn into one (or more), depending on future events (e.g., changes in ownership that involve sales/purchases among partners, etc.)

[ESOP Guy]

To bring in a side issue or a possible issue.  If a 401(k) plan invests in an S Corp they would owe UBIT on the pass through income.  Does that apply with an LLC that only invests in investments? 

To be clear I am asking not saying it does. 

I just had a client get blindsided by a UBIT situation when a PSP had S Corp stock put into it.  So to me it never hurts to ask about it and pass through entities. 

[Luke Bailey]

6 hours ago, jashendorf said:

Using the the plan money to enable the personal money to meet the minimum investment is a (c)(1)(D) violation, and so a PT. (AO 2000-10A did not have that factor in it.)
If there were not a minimum investment requirement that the plan assets were needed to satisfy, and all other things being the same, then the investment itself wouldn't automatically be a PT, but could turn into one (or more), depending on future events (e.g., changes in ownership that involve sales/purchases among partners, etc.)

jashendorf, why do you say (c)(1)(D) instead of (c)(1)(E)?

[Luke Bailey]

43 minutes ago, ESOP Guy said:

To bring in a side issue or a possible issue.  If a 401(k) plan invests in an S Corp they would owe UBIT on the pass through income.  Does that apply with an LLC that only invests in investments? 

To be clear I am asking not saying it does. 

I just had a client get blindsided by a UBIT situation when a PSP had S Corp stock put into it.  So to me it never hurts to ask about it and pass through entities. 

Any pass through entity has the same problem, partnership, S corp, LLC taxable as either of those. The basic holding is from a Rev. Rul. from the 70's. I can find it if you want.

[ESOP Guy]

13 hours ago, Luke Bailey said:

Any pass through entity has the same problem, partnership, S corp, LLC taxable as either of those. The basic holding is from a Rev. Rul. from the 70's. I can find it if you want.

I don't need to see it.  To me if this structure really causes the plan to owe UBIT than the whole PT issue is moot.  You don't want to do this because you are making a tax exempt plan into one that now pays taxes.  And the odd thing is the beneficiary of the trust will have to pay taxers again when they take a distribution as i don't believe UBIT creates a basis.  (Not a UBIT expert but the few times I have seen it in action I have not seen a basis created.) 

 

[jpod]

I was under the impression that the LLC would not be engaged in a trade or business (i.e., merely investments), so as long as there is no leveraging there would be no UBTI.  

[ESOP Guy]

28 minutes ago, jpod said:

I was under the impression that the LLC would not be engaged in a trade or business (i.e., merely investments), so as long as there is no leveraging there would be no UBTI.  

And maybe I wasn't clear in my question.  That was what was causing me to doubt or wonder if it might not be subject to UBIT.    I just thought it was worth asking. 

[Luke Bailey]

10 hours ago, ESOP Guy said:

And maybe I wasn't clear in my question.  That was what was causing me to doubt or wonder if it might not be subject to UBIT.    I just thought it was worth asking. 

These strings get so long that sometimes we get so far into the weeds on the legal and tax issues that we forget the detailed facts of original question. Unleveraged trading of publicly traded stocks and bonds is not going to produce UBIT.