The situation is this: Plan of a small sole proprietor is being wound down as the sole proprietor has retired. One of the assets it holds is life insurance on the sole proprietor, a plan participant. Normally, the sole proprietor's spouse ignores the premiums on the life insurance when they come due, simply allowing the premium to be assessed by the insurance company against the investment portion of the policy.

Spouse is out of town when a quarterly premium statement comes to their home in 2007. The sole proprietor simply writes out a personal check for the quarterly premium to the insurance company. There are no earnings for 2007, so there can be no 'contribution'. And it was not claimed in any way as a contribution.

Looks like a prohibited transaction, personal assets of a disqualified person being used to benefit the plan being an "extension of credit", and anticipating (a) repayment (with interest) and (b) filing a Form 5330. Section 6.09 of Rev Proc 2008-50 provides that PT's cannot be corrected using EPCRS.

Anyone else dealt with a similar situation?

Comments and suggestions regarding this situation will be appreciated.

Seems about right. Only other solution I could think of (consider it a non-deductible contribution) is worse, because you have 10% penalty for each of two years, plus a reversion tax when it goes back to the employer. The route you describe should be cheaper.

Any chance the participant could have purchased the policy as an arms length transaction before he made the payment?