Prohibited Transaction?

An owner, who sponsors, participates in, and is a trustee for a plan that covers NHCEs, wants to form an LLC with a friend in which they will each own 50% of the LLC.  The LLC will totally consist of an interest in an existing, unrelated business.  The owner would like to use plan assets to acquire his 50% share of the LLC.  I am guessing that this would be a PT unless he were to own no more than 10% of the LLC - is this accurate?   

No, actually if it is a new start up LLC and they invest capital for the 50% at the time that the LLC is established, it is not a PT. You can reference Swanson v. Commissioner (106 T.C. 76 (1996)). The U.S. Tax Court rules that "a corporation with shareholders does not fit within the definition of a disqualified person". This is the case that people use to have single member LLC (checkbook IRAs) held directly within their Retirement Accounts. The one thing that I would caution is that the LLC would become a plan asset because 50% of ownership is compromised of retirement funds.

Swanson case could (depending on facts; JOH's conclusion seems reasonable, but of course the description of facts given is greatly summarized in the OP) could get you out of a 4975(c)(1)(A) sale or exchange PT, but would need to fully investigate a lot more facts to make sure not a 4975(c)(1)(E) self-dealing transaction. Is this going to be a self-directed account or pooled investment? Have they considered prudence, UBTI? Does the form of the investment limit the trust's liability if there is a lawsuit?

Also, under Swanson the initial purchase from an entity being formed may not be a 4975(c)(1)(A) PT, but exiting the same investment may be a PT if the percentage at that time is 50% or more.

Thank you both for your input. The plan has a pooled arrangement, so it would seem that 4975(c)(1)(E) may not apply - sorry for not mentioning that. 

The UBTI issue was discussed and the owner believes going forward with the LLC will still be worth her while.  As for prudence, well, she keeps telling me the sky is not blue.  

Since the official statement issued by the court in the Swanson case specifies 'corporation', I imagine the LLC would have to be set up, e.g., as a sub-S instead of as a partnership.  Notwithstanding that, it would appear the owner would have an argument to proceed, pending the extent of the trust's liability in the event of a lawsuit.  We would also be assuming that a court would come to a similar conclusion were it a qualified plan that was involved in the case as opposed to an IRA.

2 hours ago, Lucky32 said:

The plan has a pooled arrangement, so it would seem that 4975(c)(1)(E) may not apply

No. Would potentially apply if the plan fiduciary has ANY ulterior motive for the investment. She's investing OPM (other people's money). If has no ulterior motive, and is simply doing it because she thinks it will make the most money for her and the other participants at reasonable risk, then maybe no PT, but is the investment prudent? Anyway, the fact that this is a 50/50 investment with a friend suggests that there may in fact be an ulterior motive/judgement clouding interest that would result in a PT under 4975(c)(1)(E) and parallel ERISA provision.

Lucky- one thing that you mention is about changing the organizational structure from an LLC to a S-Corp. If the organization has retirement funds, it shouldn't be set up as a S-Corp. S-Corps don't allow retirement funds to be used for ownership. The investment should can be organized as a LLC.

Lucky32, another thing I should have pointed out is that since > 25% of the investment in the LLC will be from a retirement plan, you may have "plan assets" at the LLC level, which would create another area of concern for PTs.

Good points.  JOH, the structure would still be an LLC - instead of saying it would be set up as a sub-S I should have said they will elect to have the LLC taxed as a sub-S as opposed to being taxed as a partnership.  Perhaps I'm focusing too much on how the Swanson case refers to a 'corporation '.

1 hour ago, Lucky32 said:

Good points.  JOH, the structure would still be an LLC - instead of saying it would be set up as a sub-S I should have said they will elect to have the LLC taxed as a sub-S as opposed to being taxed as a partnership.  Perhaps I'm focusing too much on how the Swanson case refers to a 'corporation '.

You are, because an LLC electing to be taxed as a sub-S is a sub-S.