For any benefit plan manager who has filed an annual Form 5500, the term “prohibited transaction” will no doubt ring a bell. A prohibited transaction refers to a specific event that is forbidden between a plan and a disqualified person referenced by the Internal Revenue Service (IRS) or a party-in-interest referenced by the Employee Retirement Income Security Act (ERISA). These terms are defined slightly differently, although they both encompass many of the same actions.
Another term that seems to go hand-in-hand with prohibited transaction is fiduciary. Determining who is a fiduciary can be done by looking at which individuals have discretion over the plan. Administering and managing the plan, as well as controlling the plan’s assets, make that person a fiduciary. Typically the trustee, investment advisors and the administrative committee are fiduciaries. The determining factor is whether or not they are exercising discretion or control over the plan.
Prohibited Transaction Examples
A number of situations can create a prohibited transaction, although exemptions may apply under limited circumstances. Prohibited transactions may include:
• Use of plan assets by a disqualified person—the failure to deposit elective contributions and loan payments in a timely manner is a common plan sponsor error.
• A fiduciary action where plan assets are used for personal interest—a fiduciary, remember, includes any person who has the authority to manage plan assets.
• The sale, exchange or lease of property—This type of transfer typically occurs in the contribution of property (other than cash) by the employer to a plan.
• Direct or indirect loans or extending credit—Loans are not allowed unless they are participant loans under the plan provision and are available to all participants.
• Furnishing goods, services or facilities—The use of these items is prohibited in both directions, by the disqualified person or the plan.
• Acquisition of employer securities—Any employer security or property, on behalf of the plan, that violates ERISA is prohibited.
A party-in-interest includes a disqualified person and refers to an individual in a position to benefit personally when administering the plan. It includes:
• Employers whose employees are covered by the plan.
• Officers and directors.
• Employee organizations whose members are covered by the plan.
• Fiduciaries of the plan.
• Lawyers and accountants that service the plan.
• Plan recordkeepers.
• Corporations, partnerships, trusts and estates holding a 50 percent interest.
• Family members (e.g., spouse, ancestor and lineal descendant).
• 10 percent owners or partners.
Types of Exemptions
Not all transactions are prohibited, however. The U.S. Department of Labor (DOL) has granted class exemptions for certain types of transactions under conditions that are low risk and protect the safety and security of the plan assets. Examples of this type of blanket exemption include transfers of individual life insurance contracts between plans and their participants; sales of customer notes to plans by their sponsoring employers; and interest-free loans made to plans by their sponsoring employers.
Statutory exemptions are routine transactions that have very low risk of abuse and include exemptions for, among other things, participant loans, providing services to the plan for a reasonable amount of pay, and loans to employee stock ownership plans.
A plan sponsor may apply to the DOL to obtain an administrative exemption for a particular proposed transaction that would otherwise be a prohibited transaction after proving that the transaction is in the best interest of the plan. The DOL must find that the exemption is feasible administratively, in the interest of the plan and of its participants and beneficiaries, and protective of the rights of participants and beneficiaries of the plan. Many of these types of transactions are unique and must be analyzed individually by the DOL.
In addition, individual exemptions are granted under certain circumstances. A detailed list of information must be provided in order for the DOL to grant an individual exemption.
Prohibited transactions are not to be taken lightly. They can even occur inadvertently when a company is creating a plan. For example, hiring the owner’s wife to act as the administrator of the plan and paying her an unreasonably large salary for doing so would be considered a prohibited transaction.
A disqualified person that engages in such an action must correct the transaction and pay an excise tax that begins at 15 percent of the amount involved for each year or partial year in the taxable period. If the prohibited transaction is not corrected within the taxable period, an excise tax of 100 percent of the amount involved is imposed on the disqualified person. If more than one disqualified person participated in the transaction, each individual can be held responsible individually or jointly for the entire tax.
To avoid being taxed 100 percent of the amount involved, the disqualified person can correct the mistake as soon as possible. If the correction cannot be completed within 90 days, an extension can usually be obtained from the IRS. If the correction is made within the required time period, the IRS usually will refund the 100 percent tax.
Making the plan whole again or undoing the transaction as much as possible is required to achieve this goal. The plan must be in no worse financial position than it would have been if the disqualified person had acted under the highest financial standards in the first place. This is generally done using the DOL’s Voluntary Fiduciary Correction Program (VFCP).
Patricia Look has been the editor of the BottomLine Benefits & Compensation newsletter for J.J. Keller & Associates since its inception in 2007. She has worked in benefits and compensation management, with a focus on retirement plans and executive compensation, for over 25 years. In particular, her expertise includes 401(k) plans, qualified pension plans, deferred compensation and supplemental plans for executives.
What Is a Fiduciary, SHRM HR Q&As, December 2010
Fiduciaries Can Avoid Becoming Defendants, SHRM Online Benefits Discipline, June 2010
Retirement Plan Sponsors Unclear on 'Fiduciary Responsibility,' SHRM Online Benefits Discipline, February 2010
Exemptions From Certain Prohibited Transaction Restrictions, Federal Register, May 2011
SHRM Online Benefits Discipline