An individual is proposing to set up a C Corporation that will meet the definition of an operating company. The company will then sponsor a 401(k) plan, technically an Eligible Individual Account Plan. This owner will roll over an IRA into the plan and put it into an individually directed account. These assets will be invested into the Corporation and will comprise 95% of the ownership of the Corporation. The other 5% is owned directly by this individual. The Corporation then acquires an existing manufacturing business through an asset purchase.

Is this legal? Is there a prohibited transaction in there somewhere or is there one looming in the future in some way? Is this dangerous or on the Abusive Transaction list of the IRS?

Could the plan incur UBTI from the activities of the Corporation?

!Absolutely it is a prohibited transaction!

B2Kates, would you be able to assist me with cites for why this would not be permitted. This individual is taking his information from www.guidantfinancial.com. Thank you for your help.

IRC section 4975( c)(1) (E) and (F) are likely suspects. Read Flaherty's Arden Bowl, Inc. v. Commissioner, 115 T.C. 269, for good measure. I suspect the owner will also be an employee, which will seal the analysis.

Would his source of information like to sell him anythng, perchance?

So even though the transaction may meet the exception to the pt rules for Qualifying Employer Securities, it does not override other pt rules and that it would be deemed to be self dealing or a use of plan assets?

In looking at the reference referred to it appeared that the issue was over loans made and not QES. Do you think it would make a difference if it were an investment in QES and not loans?

Just wondering because I have received two calls this month on the same subject.

QDROphile -Thank you for the cites. "E" and "F" are what I think of as the self-dealing provisions. "E" says a disqualified person cannot deal with the assets of the plan for the benefit of his own account. "F" says that a disqualified person cannot receive consideration into his own account from any party dealing with the plan in connection with the income or assets of the plan.
This individual intends to hold an investment inside his self-direct 401(k) account of employer stock. He is not planning on investing or using any plan assets other than what he has rolled over. The Arden Bowl case has the owner taking out a loan from the plan. This individual is not taking a loan, he is only planning on holding an investment inside his individual 401(k) account of employer stock.

Would you think that "F" would apply in this case?

You missed the point. The individual is using IRA and plan assets to finance a business in which he has a personal interest OUTSIDE OF THE PLAN. Therefore, he is using plan assets to benefit the business which is also a benefit to his personal interest. It does not have to go to this degree, but what if the individual could not start the business with only the money that individual has outside of the IRA? He would be providing for a personal benefit (starting the business, which, among other things, will pay him a salary) with the IRA assets. Enabling his 5% share of ownership (which would not be possible without the 95% ownership of the plan) outside the plan also provides a personal benefit.

What would you say about an independent fiduciary (not related to any plan particpant) who used plan assets to do the same thing -- start a business in which the fiduciary would have a personal ownership interest and pay the fiduciary a salary? It is not so much about the 95% as it is about the 5%.

"You missed the point. The individual is using IRA and plan assets to finance a business in which he has a personal interest OUTSIDE OF THE PLAN. Therefore, he is using plan assets to benefit the business which is also a benefit to his personal interest."

We have a personal tax client who is the majority owner of a C-Corp (through attribution) and is one of the named fiduciaries of the C-Corp's qualified retirement plan. They have an option to invest in Company stock and has invested about 80% of his retirement plan account balance in this stock.

He certainly has a personal interest in the Company outside of the Plan. Would you say he has engaged in a prohibitive transaction?

I do appreciate your input!

Thanks.

Do a google search on the term "ersop" this is a marketing term used by some to describe this arrangement. Here are a couple of links.

http://www.businessweek.com/smallbiz/conte..._0799_sb006.htm
http://www.irstaxtrouble.com/2005/11/entre...k-purchase.html

Also this is from the 2003 ABA Q&A's with the IRS


9. §401(a)(4) – Nondiscrimination
Does the use of rollover proceeds to indirectly acquire a business violate nondiscrimination or other Code requirements? The situation involves an individual (Executive) who establishes a new company (Newco), which adopts a §401(k) plan. Executive is the sole director and officer of Newco. Executive rolls over to the Newco §401(k) plan funds from an eligible rollover plan. Executive then elects to invest the rollover proceeds in 100% of the stock of Newco. Newco uses the proceeds from the sale of stock directly or indirectly to acquire a target company. Once target or target's assets are acquired, new employeesa associated with target's business begin making §401(k) deferrals to the Newco plan, but will not have the option to direct investment in Newco stock because the offering will have closed.

Proposed response: No, the situation described does not violate any nondiscrimination or other Code requirement. The right to make particular investment choices is a benefit, right or feature. However, at the time Newco stock is available for purchase, Executive, who is Newco's sole employee and the sole participant in the plan, is not an HCE. In future years if Executive becomes an HCE, the right of Executive to continue the self-directed investment in Newco stock is not subject to the BRF requirements.

IRS response: The IRS disagrees with the proposed answer. The proposed answer discusses current availability testing with regard to the benefit, right or feature, but it doesn’t resolve the effective availability requirement, which has a timing element. The timing of the transaction appears to structure the transaction in a year where the individual is not an HCE and there may not be any other employees, but after the transaction the individual becomes an HCE. The IRS noted the fact situation may also violate the requirement that the timing of a plan amendment not discriminate in favor of HCEs. The IRS also noted its concern about investment options with inherent restrictions, such as a $100,000 minimum investment requirement. While the IRS is aware some commenters believe such inherent restrictions do not violate the nondiscrimination standards, because the investment restriction is not part of the terms of the plan, the IRS does not agree.

(Interesting the IRS did not raise any PT issues but not sure if I would take their silence on this point as saying that having qualifiying employer securities is enough to get you off the PT hook).

ERSOPs have been discussed before

See the above link that was started in July 1993.

At the Mid-Atlantic benefits conference in late April, the IRS made a comment that ERSOP arrangements were definitely something they were going to be looking at closely.

I am not very familiar with business laws, but I know that there are business rules that prohibit that, you have to be able to keep a relative equilibrium between investment and profit. I know things are more complicated than that but we have to keep the main line to better understand the context.