Does disobeying the written plan tax-disqualify the plan?

[Peter Gulia]

An individual-account § 401(k) retirement plan provides participant-directed investment.

 

Following participants’ directions, the plan’s trustee engages in transactions with a party-in-interest.  No exemption applies, and there is no doubt these are prohibited transactions under ERISA § 406 and Internal Revenue Code § 4975.

 

Yet these transactions are not necessarily an IRC § 401(a)(2) exclusive-benefit violation.  Among other facts, each investment has an above-market return, and the plan’s counterparty has strong creditworthiness and liquidity.

 

The plan’s governing document includes this:  “The Trustee shall not engage in any prohibited transaction within the meaning of the Code and ERISA.”

 

Does something that might not have tax-disqualified a plan have that effect because the plan’s fiduciaries failed to administer the plan according to its governing document?

[C. B. Zeller]

I believe so. Rev. Proc. 2019-19 5.01(2)(B) defines Operational Failure as "a Qualification Failure (other than an Employer Eligibility Failure) that arises solely from the failure to follow plan provisions."

[CuseFan]

Agree w/CBZ and any facts about the investment - no matter how stellar - are irrelevant.

[Peter Gulia]

CBZ and CuseFan, thank you for confirming I wasn’t overlooking an exception or excuse.  CBZ, thank you for the helpful citation.

 

The situation described above shows how a plan sponsor might needlessly burden itself by using a preapproved document without getting advice about provisions a user might change or delete.

 

The plan-document sentence quoted above might be an “administrative provision” a user might delete without losing reliance on the IRS’s opinion letter.

 

Had it been deleted, the plan’s administrator might undo the prohibited transactions without also needing an IRS correction procedure for a qualification failure.

[Luke Bailey]

Peter, I am tempted to be a contrarian on this one. My guess is that in an audit, or at Appeals, you could successfully argue with the agent that since this is a self-directed plan, the Trustee did not actually "engage" in the PT, even if the Trustee's signature was required on the investment documents. I doubt there's anything precisely on point, e.g. a case or a PLR, but you could cite in support ERISA sec. 404(c)(1)(A)(ii) and 29 C.F.R. sec. 2550.404c-1(d)(2), and the "(other than a fiduciary acting only as such)" parenthetical in the second sentence of IRC sec. 4975(a). Not dispositive, but I think probably carry the day. Of course, why guess, so I completely agree with you that the plan provision is an unnecessary risk.

Does not have provisions whereby the participant making the investment indemnifies the Trustee and the plan's participants against any losses (including taxes from UBTI or disqualification) caused by the investment? These sorts of issues are often overlooked in "invest in the world" self-directed plans, but the need for them is obvious once you've seen them in action.

[Peter Gulia]

Luke Bailey, thank you for the further ideas.

 

[RatherBeGolfing]

@Luke Bailey, doesn't that raise the question of whether a plan fiduciary who approves an "invest in the world" self directed plan has met the requirements of 404(a)(1)(B)?

The plan fiduciaries still have to responsibilities to approve (at least in some sense), monitor, designate DIAs, and make disclosures related to the participant's investment direction.  

[Luke Bailey]

On ‎7‎/‎14‎/‎2019 at 11:40 AM, RatherBeGolfing said:

@Luke Bailey, doesn't that raise the question of whether a plan fiduciary who approves an "invest in the world" self directed plan has met the requirements of 404(a)(1)(B)?

The plan fiduciaries still have to responsibilities to approve (at least in some sense), monitor, designate DIAs, and make disclosures related to the participant's investment direction.  

I think this is correct, RatherBeGolfing. To the extent one participant's investment, even if it meets the requirements of 404(c), could possibly subject other participants' accounts to risk, it would seem to be a violation of 404(a)(1)(B). Usually the limited liability structure of the investment, e.g. for real estate, will protect the rest of the plan from tort or contract losses, but there could still be issues, e.g. UBIT. Obviously, the tax and commercial law generally treats the investment as being made by the plan, not the account. All 404(c) really fixes is the fiduciary liability problem.