Loans from qualified plans to owner-employees can be prohibited transactions.

• Author: Walker, David M.

Qualified employee benefit plans, including Sec. 401(k), pension and profit-sharing plans, are prohibited by the Employee Retirement Income Security Act of 1974 (ERISA) (Sections 406-407) and the Code (Sec. 4975) from engaging in certain transactions; engaging in such transactions can result in significant penalties. Among other things, the rules either prohibit or place limitations on the lending of money or extension of credit between a qualified plan and a related party.

Statutory exemptions allow certain types of plan-participant transactions that would otherwise be prohibited. Specifically, an exemption is available for certain participant-loan programs under ERISA Section 408(b)(1) and Sec. 4975(d)(1), provided the loan program meets certain conditions (e.g., the loan program is made available on the same basis to all participants, the loans bear a reasonable rate of interest, the loans are adequately secured, etc.). Unfortunately, due to an exception under ERISA Section 408(d) and Sec. 4975(d), this exemption does not extend to plan participants classified as "owner-employees." As a result, plan loans to owner-employees are prohibited transactions regardless of the borrowing terms, unless an individual exemption is obtained from the Department of Labor (DOL). For this purpose, an owner-employee includes self-employed individuals, more-than-10% partners in a partnership, more-than-5% S shareholders and participants or beneficiaries of an individual retirement arrangement (IRA), including an employer or group of employers that establishes IRAs for their employees.

In determining who is a more-than-5% S shareholder, certain family attribution rules apply.

Example: A is employed by an S corporation and is a participant in the corporation's Sec. 401(k) plan. A's parents own 4% of the S corporation and A owns 2% of the S corporation. Through attribution, A is considered to own...