401(k) Plan with 20 participants wants to purchase Private Investment

We administer a self-trusteed 401(k) plan that offers self-directed investment accounts to all participants. I believe each can purchase mutual funds through their American Funds account. The plan does not restrict each of these participant to just mutual funds but also allows for private investments.

One of the participants wants to purchase a small Almond Ranch. He would like to personally invest $400,000 and invest $600,000 from his plan account. There would be strict accounting splitting the income and expenses each year for both the individual portion (40%) and the plan portion (60%). If this is followed we do not think there would be a prohibited transaction.

We know somebody needs to run the Almond Growing entity. They could get 3 leased employees from a PEO. Correct me if I am wrong here (I very well could be). I believe that after this potential transaction, they would need to cover these leased employees in their plan if the leased employees are substantially full time. I believe substantially full time is 1,500 hours or more per year. What if they had 3 Leased employees who would be restricted to only 1,200 hours per year? I would think the leased employees would ever become eligible for the plan.

Another Issue might be UBTI. Does anyone think UBTI would apply in this case?

Thanks!

Why is the individual involving the plan in the purchase rather than buying the ranch entirely with personal (non-plan) funds? In these types of propositions I am concerned that the individual is using plan funds to serve personal (non-plan) interests, such as enabling the purchase when the participant does not have enough money outside the plan to cover the purchase price. That fits my understanding of a prohibited transaction.  I also think it is a set-up for future PTs and other problems as the ranch is operated. Is the plan capable of covering its share of potentially unlimited demands for more capital? Qualified plans are not meant to operate businesses.

Thought experiment:

For a retirement plan that allows a participant to direct investment beyond designated investment alternatives and brokerage windows, consider whether the plan might require, uniformly, that the directing participant at her personal expense deliver to the plan’s administrator the US Labor department’s prohibited-transaction exemption or a written opinion, addressed to the administrator, of a law firm acceptable to the administrator, that a proposed investment involves no nonexempt prohibited transaction.

Reciting the idea reveals the risk about tax law’s nondiscrimination condition: The IRS or a court might perceive the uniform condition as favoring some highly-compensated employees, who might have or get money to spend on lawyering, when many nonhighly-compensated employees might lack that financial capability.

But if the would-be directing participant doesn’t bear the expense, who does?

Would getting advice that each proposed investment involves no nonexempt prohibited transaction be a loyal and prudent plan-administration expense for the plan’s exclusive purpose?

If it is a proper expense, how would the administrator allocate the expense among individuals’ accounts? Would it be fair that an individual who directs investment only in designated fund shares is charged a portion of expenses incurred because others seek question-raising investments?

Or, if the legal-advice expenses are charged only among individuals who requested question-raising investments, does that raise nondiscrimination issues (even if at a different layer)?

Despite a participant’s otherwise proper direction, a plan’s fiduciary must not invest if she knows or, using an experienced fiduciary’s “care, skill, prudence, and diligence”, would know that the investment involves a nonexempt prohibited transaction.

So, someone has to pay for the needed lawyering—whether that’s serving as an applicant’s representative in a submission to the Labor department, or researching law and analyzing facts to write a lawyer’s opinion.

If a plan’s administrator, trustee, or other fiduciary doesn’t get some legal comfort, how would she show she acted prudently?

Everyone has made excellent points. 

Even if allowed(very doubtful) - consider the additional expenses of a periodic independent appraisal for valuation to report correct as a plan asset, as well as the expense of an ERISA bond covering a non-qualifying asset. Is the plan or employer willing to pay those expenses?
 

This seems to run afoul of the rules that the plan asset cannot be used personally by the participant.  Consider that a participant can invest their account in works of art, but cannot hang the works of art over their mantle at home.  Similarly, a participant can invest their account in a antique car, but cannot drive it.

The whole scheme to hire leased employees from a PEO to run the entity seems to be at best window dressing, and more likely is (pick one: a facade, hocus-pocus, deception, dissimulation, funny business, pretense, an illusion...)

I certainly would not want to be in a co-fiduciary role in any capacity that is associated with this arrangement.

Not sure how this isn't a PT.... Under ERISA §3(13) states a party in interest as to an ERISA plan includes (C) an employer any of whose employees are covered by the plan... [and] (H) an employee ... of a person described in subparagraph (C)...  Since this person is a participant in the plan, presumably he is an employee of an employer maintaining the plan. ERISA §406(a) prohibits various types of transactions between a plan and parties in interest including a direct or indirect ... transfer to, or use by or for the benefit of a party in interest, of any assets of the plan.  Even if you use the one bite of the apple principle that might allow the initial purchase to be exempt, the ongoing business aspect of this investment seems fraught with risk.

To simplify an illustration, I deliberately left out expenses for initial and periodic valuations.

About those expenses, the ERISA fiduciary questions and tax law nondiscrimination issues are similar. Would expenses for valuing the almond-ranch business be paid personally by, or charged against only the plan account of, the individual who directs that investment? If so, might such a condition for a directed investment disfavor nonhighly-compensated employees? Or if an expense is not borne by the directing individual alone, is it fair for others to be burdened with extra expense?

And each year’s incremental expense for ERISA fidelity-bond insurance might be nontrivial in the small-plan context Dougsbpc describes. An insurer might require a bigger premium because the coverage limit is higher, or because the investment in the almond-farm business might involve ways of handling insured plan assets that lack some controls used regarding fund shares processed by a trust company or a registered investment company.