Prohibited Transactions


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Overview

Perhaps the main policy reason that ERISA was enacted in 1974 was to help ensure that employees and their beneficiaries would receive the money that had been promised them by their employers.  One of the several provisions enacted to accomplish this goal were rules prohibiting certain transactions between retirement plans and welfare plans, and individuals or entities having a financial interest in these plans.  These individuals or entities are known as either “parties-in-interest” or “disqualified persons” (see below) with respect to the plans.  Collectively, the transactions that are disallowed between these persons and ERISA-covered plans are known as “prohibited transactions.”

The reason that these particular transactions are forbidden is because of the perceived danger of a conflict of interest between a plan and a party that is financially interested in the plan.  Such a conflict might tend to improperly influence decisions that could adversely affect the plan’s participants and beneficiaries.  Because the ERISA and Internal Revenue Code (“Code”) descriptions of “prohibited transaction” are extremely broad, certain statutory and other exceptions have been carved out.  The reason is because the benefit to plan participants and beneficiaries is thought to outweigh the risk of harm to the plan, and because appropriate safeguards have been built in to protect participants and beneficiaries.

Who Is a “Party-In-Interest” or “Disqualified Person?”

Under ERISA, a “party-in-interest” is almost any individual or entity having a financial interest in, or fiduciary relationship to, the plan, including:

Under the Code, these same types of individuals or entities are known by a different term: “disqualified persons.”  Although the two terms are very similar in meaning, the Code definition includes, for example, some highly technical stock ownership rules that are beyond the scope of this article.  For purposes of this general overview, the terms “party-in-interest” and “disqualified person” will be used interchangeably.

Which Transactions Are Prohibited?

As stated above, the prohibited transaction rules apply to financial transactions between plans and parties-in-interest (disqualified persons).  But an ERISA plan, although a legal entity in its own right, cannot act on its own behalf.  Therefore, acting on behalf of an ERISA-covered plan – and assuming legal responsibility and financial liability for such plan – is one or more fiduciariesTooltipSee 401(k) Fiduciary Responsibilities: ERISA’s Duty of Care and Liability for details as to who is a fiduciary, and for a general discussion of fiduciary liability

In addition to there being two sides to every prohibited transaction, prohibited transactions are broken down into two types, depending upon who is the chief actor: (1) Party-In-Interest Transactions; and (2) Fiduciary Transactions.  Each of these is generally described below.

1. Party-In-Interest Transactions:

Under the prohibited transaction rules, a fiduciary is prohibited from causing an ERISA plan to engage in a transaction, if the fiduciary knows, or should know, that the transaction constitutes a direct or indirect:

2. Fiduciary Transactions:

Secondly, the prohibited transaction rules prohibit a fiduciary from:

These restrictions tend to be interpreted broadly.  The only time a transaction that falls under one of the above categories is ever permissible is if it fits within a specific statutory or other exemption (see below).

Prohibited Transaction Exemptions

If there were no exemptions to the prohibited transaction rules, it would be difficult to operate most retirement and welfare plans.  The nature of the industry is such that, for example, many persons or entities who function as service providers happen to have some financial connection, however tangential, to plans they service — thereby being parties-in-interest.  Similarly, a financial institution serving as plan trustee may also offer investment products that are offered under the plan.  Moreover, participant loans under 401(k) plans would be impossible, as they would constitute lending of money between a plan and parties-in-interest (i.e., participants in the plan; see below).

1. Statutory Exemptions:

Recognizing this, ERISA and the Code contain certain exemptions to the prohibited transaction rules that are written directly into the statutes themselves.  Of the twenty or so statutory exemptions, examples include exemptions for:

Generally stated, statutory exemptions require that the transaction meet specific enumerated conditions detailed within the statue in order to fit into the exemption.  These conditions are designed to help ensure that the transaction does not pose any of the risks to plan participants that may otherwise arise out of a similar transaction that does not meet these conditions (and is therefore not exempted).  A failure to meet any of these conditions will cause the transaction to be a prohibited transaction.

2. Class Exemptions:

In addition to statutory exemptions, the Department of Labor (“DOL”) has, under authority granted by ERISA, granted a number of “class exemptions” covering a variety of types of investments and circumstances.  Like statutory exemptions, class exemptions must meet certain strict conditions that are meant to protect the safety and security of the plan’s assets.  Failure to meet such conditions results in a prohibited transaction.  A few of the more common class exemptions involve:

From time to time, there are often proposed class exemptions that are in the process of being approved and finalized.

3. Individual Exemptions:

Finally, a plan sponsor may apply to the DOL to obtain an administrative exemption (“Individual exemption”) covering a particular proposed transaction or situation that would otherwise constitute a prohibited transaction.  Individual exemptions are generally propelled by a set of narrow, individual circumstances, and must be formally applied for by a plan sponsor or its authorized representative. TooltipSee DOL: Employee Benefits Security Administration, “Individual Exemptions” for how to apply

Consequences of Prohibited Transactions

Uncorrected prohibited transactions can lead to separate liability under both ERISA and the Code, along with imposition of monetary penalties in the form of excise taxes. The Code’s rules are not identical to ERISA’s rulesIt is technically possible for a transaction to be a prohibited transaction under ERISA but not under the Code, and vice versa.  Therefore, as a “best practice,” both sets of rules should be consulted to ascertain whether a transaction might be prohibited under either, or both, ERISA and the Code.

1. Internal Revenue Code Implications:

Generally stated, under the Code, a disqualified person who takes part in a prohibited transaction must correct the transaction (i.e., fully repay to the plan the amount required to make the plan whole), and also must pay an excise tax based on the amount involved in the transaction. The amount subject to the tax is the amount involved in the transaction. (For example, the amount of a prohibited transaction involving a plan loan that was made incorrectly is the original amount of the loan.)

The initial tax on a prohibited transaction is fifteen percent (15%) of the amount involved for each year (or part of a year) during the taxable period in which the transaction occurred.

If the transaction is not corrected within the taxable period, an additional tax of one hundred percent (100%) of the amount involved is imposed. Both taxes are payable by any disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax.  The tax is paid by filing IRS Form 5330.

 2. Correction Via VFCP:

In certain limited circumstances, full correction of a prohibited transaction by means of the DOL’s Voluntary Fiduciary Correction Program (“VFCP”) effectively eliminates the prohibited transaction problem under the Code by means of a specific DOL class exemption (see above list). TooltipSee 401(k) DOL Correction Program (VFCP) for further details Pursuant to this special class exemption, certain prohibited transactions that are corrected via VFCP are granted relief from the otherwise applicable prohibited transaction provisions of the Code.

Examples of prohibited transactions that may be corrected by using VFCP include:

Prohibited transactions that are fully and appropriately corrected via VFCP are not treated as prohibited transactions under the Code, and are therefore not subject to the Code’s penalty taxes for prohibited transactions.  However, if a prohibited transaction is not covered by VFCP – or if the steps of VFCP are not followed entirely – the transaction would still constitute a prohibited transaction, subject to Code penalties.

ERISA Implications

Importantly – and perhaps counterintuitively — no relief is provided from the prohibited transaction provisions of ERISA simply because such relief is provided under the VFCP.  Therefore, ERISA sanctions applicable to prohibited transactions will apply to all transactions prohibited under ERISA, even if they are corrected via VFCP.

Generally stated, ERISA requires a full, prompt correction of prohibited transactions.  This means that the plan must be made whole, and the party or parties involved must disgorge any profits resulting from the transaction.  Being “made whole” generally means that the parties will, in the end, occupy the exact position they would have been in, had the prohibited transaction never occurred.

 EXAMPLE:  Participant Loans and Prohibited Transactions

Because a participant in a qualified plan is, by definition, a party-in-interest (disqualified person), a loan between the plan and the participant would constitute a prohibited transaction with respect to the plan.  Accordingly, participant loan programs, which are a common feature under 401(k) plans, would not be possible unless there were a statutory or other exemption from the prohibited transaction rules.  Fortunately, the law statutorily exempts certain transactions, including participant loans that meet certain requirements, from being prohibited transactions.  Assuming all of the pertinent requirements are met, then a loan between a 401(k) plan and a participant in the plan pursuant to such loan program would not constitute a prohibited transaction, nor necessitate any corrective
action. TooltipSee Participant Loans and Prohibited Transactions for more details