Prohibited transactions for qualified employee benefits plans.

• Author: Carnes, Gregory A.
• Position: Excise taxes

While determining if a person is disqualified from participating in a transaction with an employee benefit plan is usually quite straightforward, classifying which transactions are prohibited can be extremely complex. Practitioners who are not aware of the rules in this area may discover that their clients are subject to very large excise taxes, with little recourse, since the prohibited transaction rules are strictly enforced. In turn, they may face a malpractice claim.

This article will analyze the various legislative and judicial directives concerning the excise taxes imposed on prohibited transactions; explain the computation of the taxes; define who is subject to the taxes and the types of transactions that may be prohibited; focus on three of the more common types of prohibited transactions between disqualified persons and qualified plans: (1) sales and exchanges of property (including a recent Supreme Court decision and its implications), (2) leasing of property and (3) loans; and provide planning opportunities for avoiding the prohibited transaction excise taxes.

Legislative Background of Excise Taxes

Before the Employee Retirement Income Security Act of 1974 (ERISA) was enacted, when a disqualified person engaged in a prohibited transaction with a qualified employee benefits plan (hereinafter, "qualified plan"), the penalty under Sec. 503 was to disqualify the plan. Since this was considered to be a rather harsh consequence for the plan's participants (who usually had no involvement in the prohibited transaction), these rules were amended.

A dual enforcement procedure was established to provide retirement security for plan participants. First, the IRS enforces penalty excise taxes on parties that engage in prohibited transactions with qualified plans. Second, the Department of Labor (DOL) enforces civil and criminal sanctions against parties that use qualified plans to promote their own self-interests.

Under Sec. 4975 (which defines the excise taxes imposed on participants in prohibited transactions), persons with a close relationship to a qualified plan are prevented from benefiting from the plan at the expense of plan beneficiaries. Any disqualified party that engages in a prohibited transaction with a qualified plan must pay a 5% initial excise tax on the amount involved in the transaction. Furthermore, if the transaction is not corrected within a specified time period, an additional excise tax equal to 100% of the amount involved is also assessed.

These taxes have proven to be quite onerous for several reasons. (1) The excise taxes can be very large, because they are based on the "amount involved," which is basically defined as the fair market value (FMV) of all property involved in the transaction. (2) They are imposed regardless of whether the violation was inadvertent or entered into in good faith, even if the disqualified person acted on the advice of attorneys or other financial advisers.(1) (3) The IRS has very broad authority to assess the tax in a strict manner. If the letter of the law is violated, the excise taxes will be imposed even if the plan was better off as a result of the transaction.(2) (4) If more than one party is liable for the excise tax, all disqualified parties are jointly and severally liable.

The types of plans that typically fall under the prohibited transactions rules include individual retirement accounts, individual retirement annuities, and qualified pension, profit-sharing, stock bonus and annuity plans. A disqualified person subject to the excise tax is required to report such tax on Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, for each prohibited transaction. Disqualified persons must file a Form 5330 for each tax year that includes any part of the time period extending from the day the prohibited transaction occurred until the transaction is corrected.(3)

* Calculating the excise taxes

Sec. 4975 dictates two levels of excise taxes on any disqualified person who participates in a prohibited transaction with a qualified plan. Sec. 4975(a) imposes a 5% excise tax on the amount involved for each prohibited transaction. Under Sec. 4975(f)(4), the "amount involved" generally is the greater of (1) the amount of money and the FMV of the other property involved in the transaction or (2) the amount of money and the FMV of the property paid by the plan as a result of the transaction. This tax is imposed for each of the disqualified person's tax years, or part of a year, in the taxable period. The taxable period begins with the date of the prohibited transaction and ends on the earliest of the date (1) a deficiency notice for the 5% excise tax is mailed, (2) the 5% excise tax is assessed or (3) correction is completed.(4) Since the taxable period can extend over more than one tax year of the disqualified person, the excise tax can apply for more than one year to the same underlying prohibited transaction. If the 5% excise tax is assessed, Sec. 4975(b) imposes an additional 100% tax on any prohibited transaction not corrected within the prescribed correction period. The correction period begins on the date the prohibited transaction occurred and ends 90 days after the mailing of a deficiency notice with respect to the prohibited transaction.

Example 1: E, a calendar-year employer, sells land with an FMV of $40,000 to a qualified plan for $50,000 on July 1, 1993. The IRS mails a deficiency notice to E on Aug. 1, 1993. E corrects the transaction on Dec. 31, 1993. The amount involved is $50,000. The taxable period begins on July 1, 1993 and ends on Aug. 1, 1993, the date on which the notice of deficiency was mailed. The correction period begins on July 1, 1993 and ends on Oct. 30, 1993, 90 days after the notice of deficiency was mailed.

Since this is a prohibited transaction, a Sec. 4975(a) excise tax of $2,500 ($50,000 x 5%) may be assessed against E. Although E corrected the transaction by returning the $50,000 to the plan and taking back the property, he did not do so by the end of the correction period. Therefore, E must also pay the 100% excise tax of $50,000, and report these taxes on Form 5330 for the calendar year ending Dec. 31, 1993.

Note: Both of these excise taxes would apply even if the property had been sold to the plan for its FMV of $40,000, regardless of whether the sale is a good or bad investment for the plan. For the same reason, an even more surprising result is that the excise taxes would apply even if the property was sold to the plan for less than its FMV.

Prohibited transactions can have a substantial impact on the financial position of an individual, family or corporation. If the taxable period extends over more than one tax year, the first-tier tax will be due for each year. If the transaction is not corrected within the correction period, the second-tier 100% tax will also be assessed. If the prohibited transaction is engaged in by both a husband and a wife, they may both be considered liable for the full amount of these taxes, thereby doubling the total Sec. 4975 excise tax to the family. In...