The IRS recently published an Issue Snapshot meant to guide examiners who encounter third party loans among the investments of plans they are auditing. Third party loans occur when a qualified plan trustee elects to loan plan funds to someone other than a plan participant, at a designated rate of return, in exchange for a promissory note, deed of trust, or other form of security. Below I summarize some of the key points in the IRS Snapshot and add some insights gleaned from third party loan issues I have encountered in my practice. Note: this post is not intended as a “how to” for these risky investments, but as a roadmap for plan sponsors who may have entered into such transactions in the past and could find themselves in an audit setting.
- Don’t Assume Your Trust Agreement Permits Third Party Loans. The Issue Snapshot notes that a plan document may limit the ability of a plan trustee or plan participant to invest in third party loans, and this is absolutely the case. It is necessary to check plan trust language before making any such investment. In my examination of plan trust agreements, I have seen language expressly permitting third party loans (e.g., allowing investments in “notes or other property of any kind, real or personal,” and I have seen language that cannot, even in broad “general powers” provisions, be construed to permit third party loans. A loan made in the absence of plan language permitting the investment is a fiduciary breach.
- Avoid Prohibited Transactions. The third party loan will be a prohibited transaction if the loan is either made directly to a “disqualified person” or indirectly benefits a disqualified person, for instance through rerouting the loan proceeds to them. A disqualified person includes the employer, fiduciaries, persons providing services to the plan (the IRS gives the example of accountants and attorneys), and persons and corporations who own a 50% or more interest in the employer. I sometimes see this issue arise in family-owned businesses, where the borrower is a family member who owns more than half of the plan sponsor entity. The Issue Snapshot encourages auditors to be on the lookout for plan loan terms that disadvantage the plan, such as little or no interest rate or unsecured loans, as indicators that the loan may have been made for the benefit of a disqualified person. I would add to that list, failure of the plan to enforce timely loan repayment, or frequent re-amortization of the loans on terms that are favorable to the borrower. Prohibited transactions are subject to excise taxes under Code § 4975(a) and (b).
- Avoid Self-Dealing. Self-dealing by a fiduciary violates the exclusive benefit rule articulated in both the Code and ERISA. With regard to the Code, the Issue Snapshot notes that others may benefit from a transaction with a plan as long as the “primary purpose” of the investment is to benefit employees or their beneficiaries. (Citing Shedco Inc. v. Commissioner, T.C. Memo. 1998-295.) An IRS examiner who concludes that a third party loan fails the primary purpose test must refer the matter to the Department of Labor. On the Department of Labor side, ERISA Section 406(b) prohibits a plan fiduciary from dealing with the assets of a plan “in their own interest of for their own account.” In my experience, self-dealing types of third party loans arise more often than direct loans to disqualified persons. It is not uncommon for there to be a pre-existing relationship between the plan sponsor or trustee, on the one hand, and the borrower, on the other hand, whether that of a business partner, friend, or family member, such that the loan benefits the fiduciary by assisting someone of importance to them. If identified in an IRS audit and referred to the Department of Labor, or identified in a DOL audit, a loan of this type may result in civil penalties.
- Value Your Asset. The Issue Snapshot cites Revenue Ruling 80-155 as requiring annual valuation of defined contribution plan assets and states that this rule applies to third party loans just like any other plan investment. It also notes that plan documentation may also expressly mandate annual asset valuations, making failure to obtain them a breach of the plan’s written terms. The Issue Snapshot does not specify that a professional valuation must be obtained but suggests that a fresh value must be assigned to the loan each year based on a number of factors including the discount/interest rate and the probability of collection. One thing not to do is to report a static value for the loan across multiple years’ Form 5500 Return/Reports as this will indicate to the Service “that payments under the loan contract are not being made and/or that the true fair market value of the loan is not being appraised or reported.”
- Documentation Is Key. This is not explicitly addressed in the Issue Snapshot but is something I observed in practice. In one matter I was involved with, the Department of Labor audited a 401(k) plan and observed a portfolio of about a dozen third party loans. All charged substantial rates of interest, resulting in returns that exceeded those realized by the Plan’s more conventional investments. All were secured by deeds of trust on real property held by the borrowers. Third party valuations of the real property parcels had been obtained at the time of the loan, and periodically updated. Amortization and repayment schedules were up to date on all loans. The borrowers had no relationship with the business that sponsored the plan or with the fiduciaries themselves. The Department of Labor scrutinized the loan files and were unable to find any ERISA violations in the loans as an asset class or individually. The plan sponsor had discontinued the practice of extending new third party loans even in advance of the audit, but by essentially operating with the procedural rigor of a commercial lender, it had maintained third party loans as successful plan investments for a number of years.
The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2022 Christine P. Roberts, all rights reserved.
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