Memorandum on Prohibited Transactions

Effective January 1, 1975, the Employee Retirement Income Security Act (“ERISA”) established federal standards of conduct for the fiduciaries of almost every type of employee benefit plan, qualified or nonqualified.  Of particular consequence are the stringent prohibited transaction rules.  The stated purposes of these rules are to prevent self-dealing by plan administrators and other fiduciaries, to eliminate inherently risky party in interest transactions, and to avoid possible mismanagement and imprudent plan administration.  Under ERISA, the term “prohibited transaction” includes any direct or indirect:

  1. Sale, exchange, or leasing of any property between a plan and a disqualified person;
  2. The lending of money or other extension of credit between a plan and a disqualified person;
  3. The furnishing of goods, services, or facilities between a plan and a disqualified person;
  4. The transfer to, or use by or for the benefit of a disqualified person, of the income or assets of a plan;
  5. An act by a disqualified person who is a fiduciary whereby the fiduciary deals with the income or the assets of a plan in his own interest or for his own account; or
  6. Receipt of any consideration by a disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

These prohibited transaction rules are contained in both the Internal Revenue Code and in Title I of ERISA.  The labor law provisions also prohibit fiduciaries from acquiring certain percentages of employer securities or real property.  Also, under the labor provisions, a fiduciary may not (1) deal with plan assets in his own interest, (2) act in any transaction involving a plan on behalf of a party whose interests are adverse to the plan’s interests or those of the participants or beneficiaries, and (3) receive any consideration for his own personal account from any party dealing with the plan in connection with a transaction involving the plan’s assets.

The Internal Revenue Code provisions impose upon the person participating in a prohibited transaction (other than a fiduciary acting in his fiduciary capacity) an automatic fifteen percent cumulative nondeductible penalty tax.  The tax is fifteen percent of the “amount involved” in the prohibited transaction and is imposed without regard to whether the persons participating knew that the transaction was prohibited.  If the prohibited transaction is not timely corrected, the IRS may impose a second tax of 100% of the amount involved.  Under the labor provisions, several civil penalties may be imposed by the Labor Department upon the persons participating in a prohibited transaction.  Moreover, any fiduciary participating in such a transaction is personally liable for any loss the plan may suffer as a result of the prohibited transaction.

Exemptions

ERISA provides exemptions for certain transactions that would otherwise be prohibited.  These exemptions include certain nondiscriminatory loans from a plan to a participant or beneficiary.  However, a plan may not loan or extend credit to the employer that established the plan, nor may an employer fund its contribution to the plan with its own promissory note or other debt obligation.

ERISA also exempts contracts or reasonable arrangements made with disqualified persons for office space, legal, accounting or other services necessary to establish or operate the plan, provided the plan pays no more than reasonable compensation in connection with the transaction.  The plan also may authorize a fiduciary bank or similar financial institution to invest plan funds in its own deposits.

In addition to the exemptions already listed, ERISA allows investment in certain life insurance contracts by an insurer; certain ancillary services by a fiduciary bank or similar financial institution; certain exercise of privileges to convert securities; certain transactions between a plan and a common trust fund maintained by a bank that is a disqualified person; receipt by a disqualified person of plan benefits to which he is entitled; receipt of reasonable compensation for services rendered or reimbursement for expenses properly incurred in performing duties for the plan by a disqualified person who is not otherwise receiving full pay from the employer; service by a disqualified person as a fiduciary in addition to being an officer, employer, agent or other representative of a disqualified person; a proper distribution of plan assets upon termination; and certain acquisitions, sales or leases of qualifying employer securities and real estate.

Except for the exemptions relating to receipt of plan benefits and proper distribution of plan assets upon termination, none of the specific exemptions listed applies to any self-employed person covered under an H.R. 10 plan (a Keogh plan) or to a 5% shareholder-employee covered under a corporate subchapter S plan if the transaction results in the plan directly or indirectly granting a loan to, paying any compensation for personal services to, or acquiring property from or selling any property to the self-employed person or the shareholder-employee or to certain members of his family.

Who is a Fiduciary

For purposes of ERISA, a fiduciary is anyone who exercises control or authority over a plan or the management of its assets.  The term “fiduciary” certainly includes the trustees of the plan, but the definition also may extend to the plan’s insurance adviser, attorney, actuary, accountant, and investment adviser.  The determination of who is a fiduciary with respect to a particular plan will be based upon an analysis of the authority and discretion that the person has in controlling or managing the plan.

Disqualified Person

The definition of “disqualified person” is broader than the definition of “fiduciary.”  The term “disqualified person” includes the plan administrator, the employer that established the plan, all persons providing services to the plan, a union and officials of the union whose members are covered by the plan, certain relatives of any of the foregoing persons, certain entities that are fifty percent or more controlled by any of the foregoing, certain highly compensated employees, officers, directors, and ten percent or more shareholders or partners of certain of the foregoing employers or entities.  Under the labor provisions, the term “party in interest” includes among other persons, certain officers and shareholders of the employer, plan fiduciaries, and certain others, including counsel and employees of the employee benefit plan.  The labor provisions also limit the definition of “employee” for certain purposes and expand the definition of “party in interest” as to persons providing services to the plan.

Leases of Property–Employer Stock

Before ERISA was enacted, trusts under many plans leased real property or personal property to the employer.  A limited exception exists for leases of qualifying real property to the employer, but only employers that have multistate operations will be able to meet the requirements of this exception.  A trust subject to ERISA many not lease any personal property to the employer.  Furthermore, unless a plan explicitly provides for the acquisition and holding of qualifying employer securities or real estate, ERISA limits the percentage of trust assets that may be invested in qualifying employer securities and real estate.

Conclusion

The prohibited transaction rules are quite complex.  Due to this complexity, it is not only difficult, but dangerous, to generalize.  Too often, under pre-ERISA law, plans consummated borderline prohibited transactions without consulting their advisors.  In many cases, plans escaped sanctions because the prohibited transaction rules were subjective.  The ERISA rules are much more specific.  Trustees and other fiduciaries should carefully scrutinize transactions that have any possibility of being prohibited.  For closely held corporations, it may be advisable to maintain a list of disqualified persons and parties in interest.  For large corporations, a list of this type is probably not practical.  Fiduciaries should consult their advisors before undertaking any transactions that could be classified as prohibited transactions.