Plan Sponsors and Fiduciaries: Beware the High Costs of Prohibited Transactions

August 28, 2017

When a plan fiduciary permits certain statutorily forbidden transactions, participants in the transactions may be heavily taxed and penalized for the transaction, even years later. The Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), both aim to prevent certain financial transactions (“Prohibited Transactions”) between a qualified retirement plan and specified people with control or influence over the plan, such as plan fiduciaries. The IRC refers to these people as Disqualified Persons, while ERISA refers to them as Parties in Interest. For simplicity, we will refer to them here as Disqualified Persons. 

The goal of the Prohibited Transaction provisions is to avoid use of plan assets to enrich Disqualified Persons. Such enrichment includes both self-dealing by a Disqualified Person and the plan lending or otherwise transferring plan assets to the Disqualified Person. The provisions generally apply to those transactions which carry a risk of Disqualified Persons receiving better treatment than disinterested parties would in the same situation. While penalties differ under IRC and ERISA, both sets of penalties apply to Prohibited Transactions. The Internal Revenue Service (IRS) may assess a 15 percent tax per year and a 100 percent tax if the Prohibited Transaction is not corrected prior to IRS discovery. Under ERISA, the Department of Labor (DOL) may issue penalties of between five percent and 100 percent of the amount involved. Additionally, ERISA requires the plan fiduciary to restore the plan for the benefit of the plan participants. Numerous statutory Prohibited Transaction Exemptions exist to prevent these rules from limiting otherwise legitimate transactions, and when applicable Prohibited Transaction Exemptions allow the underlying transaction without penalty to the Disqualified Person.

Disqualified Persons
Prohibited Transactions require participation by a Disqualified Person in a listed transaction; Disqualified Persons typically have a close relationship to the plan or to the employer sponsoring the plan, and they may include: 
• Fiduciaries;  
• Those providing services to the plan; 
• Plan sponsors and those owning significant interests in plan sponsors; and 
• Relatives of any of the previously mentioned people. 

Prohibited Transactions
Most direct and indirect transactions between Disqualified Persons and the plan are Prohibited Transactions, and it is the plan fiduciary’s obligation to avoid them. Prohibited Transactions include the sale, lease, or transfer of any property between the Disqualified Person and the plan. Neither party can lend money or extend credit to the other. One party cannot provide goods, services, or facilities to the other. Most importantly, the plan cannot transfer plan assets for use by or on behalf of a Disqualified Person.

Certain Prohibited Transactions occur only when the plan fiduciary is dealing with the plan. The fiduciary cannot deal with plan assets for the fiduciary’s own interest. Additionally, the fiduciary cannot act on behalf of any party whose interests diverge from those of the plan. Finally, the fiduciary cannot receive any compensation from parties managing plan assets. 

Prohibited Transaction Exemptions
As written, the Prohibited Transactions statutes are overly broad, and they stifle legitimate transactions occurring between Disqualified Persons and the plan. For example, the plan fiduciary is often a plan participant. Because the plan fiduciary is a Disqualified Person, the Prohibited Transaction rules prevent the plan from transferring any plan assets to the fiduciary, thus preventing the plan from paying retirement or health benefits to a legitimate plan participant. Prohibited Transaction Exemptions (PTEs) cover situations like this by allowing transactions that would otherwise be classified as Prohibited Transactions. The statutes contain over a dozen specific PTEs addressing a wide variety of specific situations. For example, one PTE allows Disqualified Persons to provide services required for plan operation, such as legal and accounting services, provided that no more than reasonable compensation is paid. Another PTE allows plan loans to be made to Disqualified Persons, provided that the loan is made according to the plan document and on terms available to other plan participants. 

The DOL also allows for non-statutory exemptions known as administrative exemptions and class exemptions. Administrative exemptions are individual exemptions approved by the DOL. Administrative exemptions apply only to the person who requested the exemption, while class exemptions apply to any person who meets the class exemption requirements. 

Penalties Associated with Prohibited Transactions
The IRC and ERISA each have their own set of penalties and excise taxes associated with Prohibited Transactions. The IRS has authority to enforce IRC penalties, and the DOL enforces ERISA penalties. Despite individually assessed penalties, the DOL and IRS are known to communicate with one another upon discovering Prohibited Transaction issues. 

The IRS can assess a tax equal to 15 percent of the amount involved in the Prohibited Transaction for each year or part of a year until the Prohibited Transaction is corrected or draws certain action from the IRS. If the IRS discovers an uncorrected Prohibited Transaction, an additional 100 percent tax applies, making uncorrected Prohibited Transactions a costly liability. 

Penalties assessed by the DOL are similarly harsh. The DOL may assess a five percent penalty for each year or part of a year in which a Prohibited Transaction continues to occur. Disqualified Persons have 90 days to correct a Prohibited Transaction after notice from the DOL. Failure to do so subjects the Disqualified Person to an additional penalty of up to 100 percent of the amount involved in the transaction. In addition to these penalties, ERISA permits recovery by the plan or plan participants of losses resulting from a breach of fiduciary liability, including all Prohibited Transactions. It is critical that Disqualified Persons and plan fiduciaries avoid the costly penalties, taxes, and liabilities related to Prohibited Transactions.

If your plan has uncorrected Prohibited Transactions or wishes to proactively avoid Prohibited Transactions, Hall Benefits Law encourages you to seek counsel from experienced ERISA attorneys. 

UPDATE: In prior HR Alerts, we addressed the implementation of the DOL’s Fiduciary Rule. Previously, many parts of the Fiduciary Rule came into effect on June 9, 2017, but the DOL stated that it would not fully enforce the Rule until January 1, 2018. The DOL has indicated a proposed additional delay until July 1, 2019. The delay is not yet effective and must be approved by the Office of Management and Budget prior to changing the Fiduciary Rule implementation timeline.