Is It Permissible for a Plan to Pay IRS Penalties?

IRS issued Notice CP1348 assessing penalties regarding a profit sharing plan due to distributions being made to terminated participants without federal tax withholding payments being submitted nor the Form 945 being filed.  The Notice was addressed to the plan and stated that the plan's TIN should be written on the penalty payment.  The employer paid the penalties, which were over $10,000, from the plan - AI says this is a prohibited transaction - do  you agree?  The plan has a pooled arrangement, so if the penalties are a valid plan expense, each participant would be dinged an average of about $300, which could become as issue.     

In my view (which is not advice to anyone), a fiduciary ought not to direct paying or reimbursing from plan assets such a penalty if a fiduciary, a service provider, or an employer is responsible for the act or failure to act that results in the penalty.

That’s so even if a penalty was administratively addressed to the plan.

If an employer paid a penalty but another person was at fault, the employer might get its lawyer’s advice about rights and remedies regarding the other person.

Peter is being very non-alarmist (even though he is of course correct!).  I would like to be much more alarming.  Fix this immediately, it is super-duper bad.  The Plan Administrator made a mistake; that's the plan administrator's fault and they need to pay the expense.  At best you can take the position that this is a prohibited loan from the plan to the plan administrator, corrected with interest (etc).  Get an attorney involved.  This is very very problematic. probably eligible for self-correction under the new DOL Program, but absolutely needs to be corrected.

The Labor department’s Voluntary Fiduciary Correction Program, at its § 7.6(b), suggests, indirectly, an opportunity to correct a fiduciary’s breach in paying, or allowing to be paid, from plan assets an expense that was not a proper plan-administration expense.

While there are some further conditions and details, the correction is mostly about restoration or disgorgement, whichever is the greater recovery for the plan.

https://www.govinfo.gov/content/pkg/FR-2025-01-15/pdf/2025-00327.pdf

A VFCP no-action letter affords some relief from some ERISA title I civil investigation and civil penalties.

I don’t know what might obtain tax law relief.

This is not advice to anyone.

Usually, I would not add anything to the responses of the wise folks on this thread but I have to commend the OP for questioning the response they received from "AI".  While AI may give one a starting point, AI responses can be flat out wrong so, in my view, AI responses should always be viewed extremely critically.

I fully agree with @Peter Gulia and @austin3515.  I would like to add a couple of thoughts. OP notes that their initial query is in response to IRS Notice CP1348.  The IRS's purview does not cover the entire universe of whether plan amounts can be used to pay penalties.  So what occurs in an IRS Notice regarding prohibited transactions may not be the end of the story.  Their purview only covers whether there is a prohibited transaction under 4975 and the consequences under the tax code.  @austin3515 and, ultimately, @Peter Gulia look at the entire universe in bringing up the views of the DOL under ERISA.  Also note that the concept of "plan assets" is an ERISA concept monitored by the DOL.  In my experience, under ERISA, civil penalties assessed against fiduciaries, plan sponsors, or other parties for some sort of legal violations or prohibited transaction cannot be paid using plan assets.  Plan assets must be used exclusively to provide benefits to participants and beneficiaries and to defray "reasonable administrative expenses."  I have not researched this recently but my understanding is the DOL maintains that paying penalties from plan assets is not a reasonable expense and is strictly prohibited.

DOL has stated that penalties under ERISA 502(i) must be paid by the party in interest involved in the transaction not the plan, and using plan assets to pay penalties is likely a breach of fiduciary duty.

Also, regarding restoration or disgorgement as @Peter Gulia brings up, I have colleagues who distinguish between restoration/disgorgement, which are remedial in nature, as opposed to penalties, which are punitive in nature.  They seem to imply that plan assets could be used for restoration or disgorgement but I must be thick-headed because I don't see it.  How can you use plan assets to restore something to the plan? disgorge from plan?  There may be circumstances that I am just not thinking of but it  seems like a zero sum game.

The person that ought to have been responsible to pay, or reimburse payment of, a penalty—whether an ERISA title I penalty, or a tax law penalty—restores to the plan the money the plan was not responsible to pay, with interest or another measure of the time or investment value of the money.

And, if the person that ought to have been responsible obtained a gain by having the use of what in conscience was the plan’s money, the person disgorges not only the money had but also its gain and pays it over to the plan.

The “interest” portion of the plan’s recovery is the greater of the time or investment value of the money or the other person’s gain by having the use of what in conscience was the plan’s money.

Equitable remedies run to the plan that was deprived of what in conscience was the plan’s money, other property, and rights.

Restoration or disgorgement does not come from the plan. These remedies come from the person that had the money that ought to have been in the plan, and go to the plan to be made whole.

This is not advice to anyone.