Imagine the following scenario: A CPA and owner of a public accounting firm is sole trustee of the firm’s 401(k) plan and is responsible for investing, managing, and controlling the plan’s assets. Over a span of three years, the CPA decides that the plan can loan money to a number of companies in which the CPA owns a minority interest. The loans which amount to around $700,000 will bear interest at 12%, and will provide a good return for the plan. Because the CPA does not own 50% or more of the companies to which the plan will be loaning money, the CPA figures he won’t run afoul of the prohibited transaction provisions. (Under Code Sec. 4975 , a tax is imposed on a disqualified person (e.g., a plan fiduciary or a 50% or more owner of the plan sponsor) who participates in a prohibited transaction which includes a loan between a plan and a disqualified person.) Those were the facts in the recent Tax Court case of Joseph R. Rollins, TC Memo 2004-260.
However, the IRS had a different view of the transactions in that case. The IRS pulled out its arsenal of sections 4975(c)(1)(D) and (E) of the Internal Revenue Code and claimed that the CPA had committed prohibited transactions. Under those provisions, the IRS claimed that the “loans were transfers of the [p]lan’s assets that benefited” the CPA under sec. 4975(c)(1)(D) of the Code, and that the the loans were dealings with the plan’s assets in the CPA’s own interest under sec. 4975(c)(1)(E) of the Code. The IRS contended that the CPA was a disqualified person with respect to the plan in two capacities: (a) A fiduciary of the Plan (sec. 4975(e)(2)(A)), and (b) the 100-percent owner of the employer sponsoring the plan. The IRS held that the CPA benefited from the loans in that the loans enabled the borrowers–all entities in which the CPA owned interests–“to operate without having to borrow funds at arm’s length from other sources.”
When the Tax Court reviewed the facts, the court agreed with the IRS that the loans were prohibited transactions under section 4975(c)(1)(D), but held that it was unnecessary to decide whether the the CPA had also violated section 4975(c)(1)(E).
What were the CPA’s excise taxes that he had to pay for the prohibited transactions? Roughly $164,000, a hefty penalty for what in the end looked like a fairly good deal for the plan. The Tax Court reiterated its position that, just because an investment is good for a plan, doesn’t matter when it comes to applying the prohibited transaction rules:
After a review of the statutory framework and legislative history of section 4975 and the case law interpreting ERISA section 406, we conclude that the prohibited transactions contained in section 4975(c)(1) are just that. The fact that the transaction would qualify as a prudent investment when judged under the highest fiduciary standards is of no consequence. Furthermore, the fact that the plan benefits from the transaction is irrelevant. Good intentions and a pure heart are no defense.
Moral of the story: No matter how good an investment looks for a plan, ERISA fiduciaries, trustees, and certain owners and entities should get competent legal advice regarding application of the prohibited transaction rules when entering into transactions with retirement plans, especially in cases where common ownership exists or conflicts of interest issues are present. In the end, the court, in the portion of the opinion where it addressed the issue of whether or not it should impose the additional tax for failure to file an excise tax return, actually seemed to penalize the CPA for not obtaining competent advice:
Relying on his own understanding of the law, petitioner chose to sit “on both sides of the table in each transaction.” . . . Relying on his own understanding of the law, petitioner did not see any need to file section 4975 tax returns to report any of the transactions. . . . Petitioner’s good-faith belief that he was not required to file tax returns does not constitute reasonable cause under section 6651(a)(1) unless bolstered by advice from competent tax counsel who has been informed of all the relevant facts. Stevens Bros. Foundation, Inc. v. Commissioner, 39 T.C. 93, 133 (1962), affd. on this point 324 F.2d 633, 646 (8th Cir. 1963). There is no such evidence in the record in the instant case.
Also, the case is worth reading alone for its detailed discussion of the history behind the prohibited transaction rules.