Lender Beware:  IRS Issue Snapshot on Third Party Loans

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.

  1. 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.
  2. 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).
  3. 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.
  4. 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.”
  5. 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.

Photo credit: Evgeniya Litovchenko, Unsplash

    Five Good Reasons to Correct Retirement Plan Errors

    If your business sponsors a Section 401(k) or other retirement plan, it is governed by a lengthy plan document, often a separate trust agreement or custodial account agreement, and multiple other documents (salary deferral agreements, loan policy statement, investment policy statement, etc.)  Not surprisingly, most plan sponsors get something wrong somewhere along the way, whether with respect to the plan document, or operation of the plan.  Below are five reasons why taking prompt action to correct plan errors is in the best interests of your business, and your employees.   

    1. To preserve the tax-qualified status of your plan.

    Contributions to your plan are deductible to your business and excluded from your employees’ taxable compensation (i.e., are “tax-qualified”) because the plan document, and operation of the plan, conform to certain requirements under the Internal Revenue Code.  Under the Employee Plans Compliance Resolution System or EPCRS, the Internal Revenue Service permits plan sponsors to voluntarily correct a wide range of errors that, if left uncorrected, could result in a loss of the plan’s tax-qualified status and subject plan assets to taxation.   There are costs associated with participating in the EPCRS, including amounts that may be owed to the plan, attorneys’ fees, and program fees, but they are usually only a fraction of the potential expense of plan disqualification. 

    1. To correct prohibited transactions.

    While the IRS monitors the tax-advantaged status of benefit plans, the Department of Labor policies the actions of plan fiduciaries, both with respect to plan assets, and in fulfilling reporting and disclosure duties.  When salary deferrals and loan repayments are withheld from employees’ pay and not promptly deposited in the plan’s trust account, the Department of Labor essentially views this as an interest free loan, by the employer, of employee money.  Technically speaking, it is a “prohibited transaction” that requires correction under the DOL’s Voluntary Fiduciary Correction Program.  Uncorrected prohibited transactions, if discovered on audit, can result in civil monetary penalties to the fiduciaries, and also triggers excise taxes payable to the Internal Revenue Service.  Prohibited transactions also must be disclosed on the annual Form 5500 Return/Report, potentially alerting the Department of Labor to initiate further inquiry or audit.  Timely participation in VFCP eliminates the fiduciary penalties and offers alternatives to payment of the excise taxes in some circumstances (e.g., if the same amount is paid to the plan). 

    1. To minimize penalties in the event of a plan audit.

    The IRS, on audit, may assess penalties for uncorrected errors in plan documentation and operation, that can reach many thousands of dollars, on top of the amounts owed to the plan in order to correct operational errors.  And, as mentioned, prohibited transactions trigger potential civil monetary penalties.  Participation in IRS and DOL voluntary correction programs protects plan sponsors from these potential large assessments.  Whatever the cost of taking part in the voluntary program, whether it be costs of corrective contributions and earnings, attorneys fees, and the program fee, it is a quantifiable cost and one that is much smaller than the cost of correcting under the supervision of the IRS or DOL.

    1. To ensure the saleability of your business.

    Plan sponsors sometimes think that their uncorrected plan errors are only at risk of discovery if they are audited, and point to low levels of IRS and DOL audit activity as proof that they can safely play “audit roulette.”  However they are forgetting that, if they want to sell their business – particularly stock sales – or merge with another business, the due diligence process preceding the transaction will likely require them to identify any errors in plan documentation or operation within a 3 year or longer period.  An unresolved plan error could derail the transaction, or at best require correction under terms and conditions that are not as favorable, to the plan sponsor, as self-correction would have been.  If you envision your business as a purchase target or merger partner in the future you owe it to yourself to make sure that plan errors are corrected promptly and in advance of any due diligence inquiries. 

    1. Because it’s the right thing to do.

    Your retirement plan document is a contract you have entered into for the benefit of plan participants and beneficiaries and you should take it as seriously as any contract you enter into with a third party.  It spells out the right way to do things, for the most part, and the IRS and DOL self-correction programs are there to minimize the downside when plan documentation or operation falls short of perfection.  Whether your goal is to sell your business without a hitch, or glide through an IRS or DOL audit with a minimum of fuss, fixing plan errors promptly is the right choice every time.

    The above information is a brief summary of legal issues 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. © 2021 Christine P. Roberts, all rights reserved.

    Photo credit:  Sasun Bughdaryan, Unsplash

    Summertime Blues for Your 401(k) Plan, Pt 3

    The third in our series of posts on common plan errors that are discovered when plan audits are underway each summer, is the failure to timely deposit plan assets consisting of employee elective deferrals and loan repayments. Unlike the operational errors we discussed in the prior two posts, which are corrected under the IRS Employee Plans Compliance Resolution System or EPCRS, this particular error of late deposits is corrected under a Department of Labor program called the Voluntary Fiduciary Correction Program or VFCP. There is an IRS piece that must be attended to, however, discussed below.

    First – to identify the problem. Money taken out of employee pay in the form of elective deferrals, whether pre-tax or Roth, and loan repayments, becomes ERISA plan assets as of a certain point in time. Once they become plan assets, they must be invested in the Plan “trust” – meaning they must be documented as having been deposited with the plan recordkeeper. If they have not been deposited by the magic “plan asset” hour, then the Employee Benefits Security Administration of DOL (EBSA) views the situation as an illegal, interest-free loan of plan assets, by the plan sponsor. In formal terms, this is a “prohibited transaction” or misuse of plan assets by a fiduciary, and it has adverse consequences with DOL. It also triggers excise taxes with IRS, described below.

    Thus, there are several parts to this inquiry – first, what is the magic hour at which employee funds become plan assets, and second, what relief from adverse consequences with DOL and IRS is available under VFCP? Lastly there is how this issue is reported on the Form 5500 Return/Report series. We discuss each in turn below.  And – no surprise, there is a COVID-19 angle to consider, as well.

    When Do Employee Funds Become Plan Assets?

    The magic “plan assets” hour depends upon the size of the plan in question. If the plan has fewer than 100 participants as of the first day of the plan year, employee funds are timely deposited if they are deposited with the recordkeeper no later than the 7th business day following the day on which the amounts would otherwise have been payable in cash (i.e., the applicable pay date). Recordkeepers often refer to the deposit event as the “trade date.” If employee funds are not deposited by the end of that 7th business day, they are plan assets improperly held by the plan sponsor.

    If the plan has 100 or more participants as of the first day of the plan year, employee funds are timely deposited if they are deposited with the recordkeeper as of the earliest date on which such amounts can reasonably be segregated from the employer’s general assets. In some cases, EBSA has asserted that, if payroll taxes can be segregated from general assets, so can employee contributions, making pay date the earliest segregation date. More commonly, the earliest reasonable segregation date can be determined by looking at payroll processing history and identifying the shortest amount of time that generally elapses between a pay date, and the recordkeeper trade date. Very often nowadays this is a period of only one or two business days. If employee funds are not deposited by the end of that period, they are plan assets improperly held directly by the plan sponsor.

    Holidays may be taken into account in calculating the earliest reasonable segregation date, thus the deposit date would be the first business day after a holiday Monday, for example.  For unusual events that are out of the plan sponsor’s control, the “drop dead” deposit deadline is the 15th day of the month following the month containing the normal earliest reasonable segregation date.

    What about the impact of COVID-19?  In EBSA Disaster Relief Notice 2020-01, issued on April 29, 2020, relief is granted only if a timely deposit cannot be made “solely on the basis of a failure attributable to the COVID-19 outbreak.”  This is a very fact-specific inquiry; each situation will be different. At the early stages of the pandemic, such a failure might have included a staff furlough that included payroll personnel or personnel at a third party payroll provider.  Now that the pandemic is almost eighteen months along, even taking into account setbacks like the Delta variant, deposit delays that can be demonstrated to be exclusively due to the virus are unlikely to be common. That said, the Disaster Relief Notice 2020-01 remains in effect from March 1, 2020 through the 60th day following the announced end of the COVID-19 National Emergency.

    What Relief is Offered under VFCP?

    Through timely participation in the VFCP program, which includes preparation of a written submission with proof of payment of earnings on late deposited elective deferrals and loan repayments, a plan sponsor may avoid potential civil actions, penalties, and the assessment of civil penalties under Section 502(i) of ERISA.  Successful participants receive a “no action letter” from EBSA that is useful to demonstrate plan compliance in the event of a later plan audit or in a due diligence process related to a corporate merger or acquisition.

    Importantly, participation in VFCP must precede the point at which a plan is “under investigation” by EBSA meaning an EBSA audit of the plan in question.  Other circumstances can give rise to a plan being “under investigation” such that VFCP is unavailable.

    A prohibited transaction consisting of late deposited ERISA assets gives rise to a first-tier excise tax under Internal Revenue Code Section 4975 that is equal to 15% of the amount involved, with the amount involved equal to the time value of the money that was untimely deposited in a plan.  The excise tax is payable by the plan sponsor and reported on Form 5330.  The VFCP offers a limited relief from this excise tax.  VFCP can be used for multiple years (but a plan sponsor should ask itself why its timely deposit problems are persisting), but the excise tax relief can only be used once every three years. 

    Information on VFCP is found here – but keep an eye on that location as the program, which dates in its current form back to 2006, is under a rewrite and overhaul.  It is anticipated that the new version will streamline some of the correction methods currently described under VFCP (late deposits is only one of a number of other transactions that the program covers). 

    How Are Delinquencies Reported on Form 5500/5500 S-F?

    Form 5500 and Form 5500 S-F require a plan sponsor to disclose whether there was a failure to transmit any participant contributions to the plan during the plan year in question, and to disclose the aggregate amount that was not deposited timely.  Even if the late deposits were corrected under VFCP, you must report them.  If you report late deposits on Form 5500 without adding an attachment explaining that they were corrected under VFCP, you may get a letter from EBSA that politely “invites” you to participate in VFCP by a firm deadline.  You are recommended to submit your VFCP application by that date, or risk further action that may result in penalties.    

    One question that comes up around late deposited employee funds is whether it is necessary to participate in VFCP for delinquent deposits that are small in amount and/or short in duration.  The answer is that, until EBSA announces a self-correction version of VFCP, participation in VFCP is recommended in order to avoid adverse consequences when the uncorrected delinquencies must be reported on Form 5500 or 5500 S-F.  If you have questions about a possible need for correction under VFCP, contact your plan’s third party administrator or ERISA attorney.


    Photo credit: Inna Kapturevska, Unsplash

    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. © 2021 Christine P. Roberts, all rights reserved.