A qualified plan may invest in loans to third parties — loans other than those to a plan participant. There are compliance issues to consider, however, when a plan enters into such a transaction, or when a plan holds third-party loans as plan assets, and the IRS has updated the discussion on its website of issues its examiners look for regarding such loans.
Concerns regarding such loans include:
- possible Internal Revenue Code (IRC) Section 401(a) failures;
- prohibited transactions under IRC Section 4975;
- valuation issues; and
- income tax adjustments.
Plans and Third-Party Loans
Qualified retirement plans have fairly wide latitude to make what they deem are appropriate investments, the IRS says. A plan document may limit the ability of the plan trustee or a plan participant to invest in third-party loans, but the IRC and Title I of ERISA do not specifically prevent a plan from investing in third-party loans or holding such loans as plan assets.
Federal regulation is not totally laissez faire, however. The general requirement that the plan must be maintained for the exclusive benefit of plan participants and beneficiaries must still be satisfied. Also, investment in third-party loans might constitute a prohibited transaction under Section 4975; if the loan becomes worthless or is forgiven, the borrower might be required to recognize forgiveness of indebtedness income.
Factors the IRS Considers
Following are factors that the IRS and examiners consider regarding third-party loans a plan invests in or holds as plan assets.
Prohibited Transactions. The first step in examining a third-party loan, the IRS says, is to determine if the loan constitutes a prohibited transaction under Section 4975. Section 4975(c)(1)(B), it notes, defines a prohibited transaction to include the lending of money or extension of credit between the plan and a disqualified person. “It is important to keep in mind that a party can be a third party with respect to the plan and still be a disqualified person under IRC Section 4975,” says the brief.
An examining agent should start by identifying the disqualified persons regarding the plan, the IRS says. Section 4975(e)(2) defines a disqualified person in this context to include:
- the employer;
- fiduciaries;
- persons providing services to the plan; and
- persons and corporations that own 50% or more interest in the employer.
But whether a loan is made to a disqualified person is not the only factor determining if a prohibited transaction has taken place. Even if the loan is not made directly to a disqualified person, says the IRS, the loan can still be considered a prohibited transaction if the loan was indirectly made to a disqualified person or if the loan benefited a disqualified person.
Further, says the brief, examiners “should closely scrutinize loans” that:
- offer unfavorable terms to the plan;
- provide for little-to-no interest rate; or
- are unsecured.
Such loans, the IRS says, suggest the plan was motivated to enter into the lending transaction for non-investment reasons. “In other words, loans that are obviously poor investments are more likely to have been made for the benefit of a disqualified person,” warns the brief.
Exclusive Benefit. The exclusive benefit test of Section 401(a)(2) does not prohibit others from benefiting from a transaction as long as the primary purpose of the investment is to benefit employees or their beneficiaries, says the brief.
An IRS agent who pursues an exclusive-benefit rule violation must refer the case to Department of Labor and obtain a technical advice memorandum from the Office of Associate Chief Counsel (Employee Benefits, Exempt Organizations, and Employment Taxes).
Asset Valuations. Revenue Ruling 80-155 requires trust assets for defined contribution plans be valued at least once a year, the brief reminds, to assign gains and losses to participant accounts and derive the fair market value of assets.
The assets subject to this valuation requirement include third-party loans, the IRS says. And a loan’s valuation depends on a variety of factors; primarily:
- the premium;
- the discount/interest rate; and
- the probability of collection.
Minimum Funding. For defined benefit plans, funding is determined using the value of plan assets. If plan asset values are overstated, then the plan’s funding percentage will also be overstated, the IRS warns.
If third-party loans are overvalued, the employer may have failed to satisfy the minimum funding requirements of IRC Section 412. Further, any plan investment involving third-party loans deemed uncollectible also could affect the plan’s funding status. And if there is a minimum funding deficiency, an employer could owe excise taxes under IRC Section 4975. In addition, the IRS notes, overvalued and/or uncollectible third-party loans could result in a plan violating applicable IRC Section 430 benefit restrictions.
Income Tax Issues. There could be income tax consequences for a borrower when third-party loans are in default and uncollectible, but the debt has been discharged, the IRS says. An issuer realizes income from the discharge of debt when the repurchase of a debt instrument for an amount less than its adjusted issue price takes place.
Fraud. Attempting to avoid the applicable restrictions and potential adverse results that can arise from third-party loans may present opportunities for fraudulent reporting and recording in an attempt to otherwise describe plan investments as being in compliance, the IRS cautions. “Examiners should be alert to indicators of fraud when reviewing the handling of all trust assets, but especially with regard to third-party loans made from the plan,” says the brief.
Audit Tips
The IRS has given the following tips to its examiners in looking at such loans.
1. Inspect the plan’s records to determine whether it has direct or indirect loans between third parties and the plan. If it does, determine if any of the third-party loans were made to a disqualified person under Section 4975.
2. Review the plan document and ensure any third-party loans that were made are in accordance with the terms of the plan document.
3. Review plan assets to ensure they are appropriately valued.
4. If the plan is subject to minimum funding, consider any valuation deficiencies for their effect on the employer’s plan funding obligations.
5. Determine whether loans have been “written off” or otherwise deemed uncollectible such that a party has been discharged from debt. Consider a referral to the Small Business / Self-Employed (SB/SE) Division or Large Business and International (LB&I) Division as appropriate.
6. Look for indicators of fraud.
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