Department of Labor Advisory Opinion Applies ERISA Anti-abuse Regulation, and Court Holds Prohibited Transaction Requires Pre-Existing Party in Interest Relationship
Raskin, Kenneth A., Hamilton, Mark T., Maglich, Marko C., McGeorge, Randall C.

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Employee benefit plans are subject to complex prohibited transaction rules under the Employee Retirement Income Security Act of 1974 (ERISA) and, in the case of tax-qualified pension plans, §4975 of the Internal Revenue Code of 1986 (Code). Individual retirement arrangements (IRAs, which, unless otherwise indicated, are also referred to as plans in this article) are subject to §4975 of the Code but are generally not subject to the requirements of ERISA. A recent advisory opinion of the US Department of Labor (DOL), which administers ERISA, and a recent district court case illustrate these prohibited transaction rules.

Section 406(a) of ERISA and §4975 of the Code categorically prohibit certain classes of transactions between a plan and a party in interest or disqualified person. These prohibited transactions include (among other things) a sale or exchange or leasing of property between a plan and a party in interest or disqualified person and a transfer of plan assets to, or use of plan assets by or for the benefit of, a party in interest or disqualified person. The term "disqualified person," which is used in §4975 of the Code, is slightly narrower than the corresponding term "party in interest," which is used in ERISA, and these terms are used interchangeably in this article. Essentially, disqualified persons have certain types of relationships with plans, such as acting as a fiduciary or service provider of the plan or an employer of employees covered by the plan. Section 406(b) of ERISA and §4975 of the Code prohibit a plan fiduciary from engaging in self-dealing. Section 406(b) of ERISA also prohibits a plan fiduciary from causing the plan to enter into transactions that would involve a conflict of interest of the fiduciary. An excise tax is generally levied under §4975 of the Code on a disqualified person that participates in a prohibited transaction, and the prohibited transaction must be rescinded. In the case of IRAs, when the disqualified person is the IRA beneficiary, a prohibited transaction results in a deemed distribution to the IRA beneficiary, in lieu of this excise tax, resulting in adverse income tax consequences. A fiduciary of an ERISA plan is personally liable to the plan for losses and disgorgement of profits from self-dealing or a violation of ERISA's other fiduciary rules and may be subject to equitable remedies, such as restitution.

DOL Advisory Opinion 2006-1A
The DOL concludes in Advisory Opinion 2006-1A (Jan. 6, 2006) that an investment by the IRA of a shareholder of a corporation in a limited liability company which owns a warehouse and leases it to the corporation is a prohibited transaction.

In the opinion, an existing business, which is structured as a corporation and taxable as an "S corporation" (S Corp.), is 68 percent owned by Mr. B and his wife, as community property, and 32 percent by Mr. G. Mr. R is S Corp.'s controller. A limited liability company (LLC) is formed to purchase land, build a warehouse and lease the property to S Corp. LLC is 49 percent owned by Mr. B's IRA, 31 percent by Mr. R's IRA and 20 percent by Mr. G. LLC is assumed to be a "real estate operating company," or REOC. Under a look-through rule in the DOL's plan assets regulation, when a plan invests in an equity interest of an entity, that entity's assets are deemed to be assets of investing plans unless an exception applies. One such exception is for REOCs. Accordingly, the opinion assumes that LLC does not hold plan assets. The lease between S Corp. and LLC is assumed to be an arm's-length transaction.

Mr. B is a fiduciary of his IRA, because he exercises authority or control over its assets and management, and therefore Mr. B is a disqualified person with respect to his IRA. S Corp. is a disqualified person with respect to Mr. B's IRA because it is 50 percent or more owned by Mr. B, who is a fiduciary of the IRA. Mr. R is a disqualified person with respect to Mr. B's IRA because he is an officer of a disqualified person (S Corp.). The opinion also states that because Mr. R is employed by S Corp. and S Corp. is 68 percent owned by Mr. B and his wife, Mr. R  "cannot be considered independent of Mr. B."
 
It is worth pausing to note that if Mr. B's IRA had purchased and leased property to S Corp., the lease would be a prohibited transaction between a plan (Mr. B's IRA) and a disqualified person (S Corp.). Perhaps the parties had hoped to avoid prohibited transactions by first investing Mr. B's IRA in an entity that is not considered to hold plan assets of its IRA investors because it is a REOC (LLC), and having that entity purchase and lease the property to the disqualified person (S Corp). Mr. B's IRA's ownership of LLC may have been kept at less than 50 percent to prevent LLC from being considered a disqualified person of the IRA, so that post-formation transactions between the IRA and LLC should not be prohibited transactions.¹

The DOL's analysis is based on an ERISA anti-abuse regulation, 29 CFR §2509.75-2(a), that originated as an Interpretive Bulletin issued by the DOL in 1975. This regulation explains that a transaction between a disqualified person, in this case S Corp., and a corporation in which a plan has invested, in this case LLC, is generally not a prohibited transaction. However, the opinion states that "a prohibited transaction occurs when a plan invests in a corporation as part of an arrangement or understanding under which it is expected that the corporation will engage in a transaction with a...disqualified person." According to the DOL, Mr. B's IRA apparently would invest in LLC under an arrangement or understanding that anticipated that LLC would engage in a lease with S Corp., a disqualified person. Therefore, the lease would amount to a transaction between Mr. B's IRA and S Corp. This transaction would be a prohibited leasing of property between a plan and a disqualified person and a prohibited transfer to, or use by or for the benefit of, a disqualified person of plan assets. The DOL also says that this lease may be a self-dealing prohibited transaction by Mr. B, as a fiduciary of his IRA.

The DOL also notes that the anti-abuse regulation "emphasizes that [the DOL] would consider a fiduciary who makes or retains an investment in a corporation or partnership for the purpose of avoiding the application of the fiduciary responsibility provisions of [ERISA] to be in contravention of the provisions of section 404(a) [the general fiduciary duty standards] of [ERISA]. "Thus, the DOL states, the lease would have to be referred to the Internal Revenue Service "for a determination as to whether it would consider the transaction a violation of the exclusive benefit rule of section 401(a)(2) of the Code, which is the Code's analogue to the fiduciary responsibility provisions of section 404(a) of ERISA." This is a curious statement because an IRA is not subject to §401(a) of the Code. The DOL must have essentially meant that the case would have to be referred to the IRS for a determination whether the prohibited transaction would result in a deemed distribution of Mr. B's IRA under §408(e)(2) of the Code.

This DOL advisory opinion is noteworthy for its broad interpretation, and potentially broad application, of this ERISA anti-abuse regulation. For example, where plans invest in an entity, and the look-through rule of the DOL's plan assets regulation does not apply, because, for example, benefit plan investors own less than 25 percent of the entity's equity interests or the entity is a "venture capital operating company" (VCOC) or REOC, transactions by the entity are not typically thought to present a significant risk of prohibited transactions. However, this DOL advisory opinion indicates that just because a transaction is not between a plan, or an entity using plan assets, and a disqualified person, potential prohibited transactions cannot be categorically ruled out. If plans or plan assets are indirectly involved, the transaction (or series of related transactions) needs to be analyzed to determine whether it involves an  "arrangement or understanding" for an entity in which a plan invests to engage in a transaction with a disqualified person or may otherwise be considered as being structured to avoid the prohibited transaction rules.

UFCW Local Health and Welfare Fund v. Brandywine Operating Partnership
In an unpublished decision issued in October 2005, a Federal district court in New Jersey considered when a person becomes a party in interest of a plan. In the case, UFCW Local Health and Welfare Fund v. Brandywine Operating Partnership, a multiemployer welfare benefit plan governed by ERISA (the Fund) sued a real estate investment trust (Brandywine) seeking to be released from a lease between the Fund and Brandywine. When they executed the lease, the Fund and Brandywine had no other relationship. The Fund argues that when the lease was executed Brandywine became a service provider, and therefore a party in interest, of the Fund. Therefore, following the Fund's logic, the lease is a prohibited transaction under ERISA.  "Essentially," the court observes,  "the Fund argues that the allegedly prohibited transaction itself makes Brandywine a party in interest, and therefore the transaction is void under ERISA." The court disagrees with this logic. The prohibited transaction rules are intended to prevent plan fiduciaries from engaging in transactions at the expense of plan participants.  "In particular, the prohibited transaction rules seek to prevent 'self-dealing' and 'sweetheart deals' that carry a high risk of 'corruption and loss of plan assets,' "the court states. In light of this goal, the court refuses to interpret "party in interest" to include a party with no existing relationship to a plan that engages in an arm's-length transaction with the plan. The court holds that  "To be a 'person providing services' under [ERISA's party in interest definition], a party must have a relationship with the pension plan that preexists, or is independent of, the relationship created by the allegedly prohibited transaction."

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¹Code §4975(e) incorporates the constructive ownership rules of §267(c), which provide, in relevant part, that interests owned directly or indirectly by or for a trust are considered as being owned proportionately by or for the trust's beneficiaries. Mr. B would be considered to own all of the LLC interests owned by his IRA if the IRA is considered to be a trust of which Mr. B is the sole beneficiary. If so considered, after investment by the IRA in 50% or more of LLC, LLC would be a disqualified person because it would be considered as being 50% or more owned by Mr. B, a fiduciary of his IRA. See Swanson v. Comm'r, 106 T.C. 76 (1996).

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