Self-dealing by a fiduciary or Trustee of Solo 401k Plan: Solo 401k Prohibited Transaction

A self-dealing prohibited transaction is one that involves a disqualified person (e.g., you as trustee/participant) who is a fiduciary or trustee of his or her Solo 401k. The transaction is prohibited if the fiduciary/trustee deals with the income or assets of the Solo 401k plan in his or her own interest (IRC 4975(c)(1)(E)), or if the fiduciary/trustee receives consideration from a party dealing with the Solo 401k plan in connection with the transaction. This is outlined in the following regulations: (IRC 4975(c)(1)(F)) and ERISA citation is ERISA 406(b)(1) and ERISA 406(b)(3).

Like the use-of-plan-assets transactions described in our previous blog posting dated 8/10/11, the determination of whether a self-dealing transaction has occurred depends upon the facts and circumstances, and is a subjective determination in many cases. The key factor is whether the trustee exercises the authority or control that makes that person a trustee in a way that:

(1) benefits the trustee (or a person in whom the trustee has an interest which may affect the trustee’s best judgment as a trustee), or

(2) causes the trustee to receive consideration from a third party.

Authority over Solo 401k transaction. The key to analyzing a potential self-dealing situation is whether the fiduciary/trustee had the authority to decide whether the solo 401k plan entered into the transaction, and by exercising such authority, the fiduciary/trustee was personally compensated either by the Solo 401k plan or by a third party involved in the transaction.

Noninvolvement of fiduciary/trustee in decision which would otherwise produce self-dealing issue.One key factor in the self-dealing issue is that the fiduciary/trustee must be exercising his or her authority or control with respect to the Solo 401k plan or plan assets which results in a benefit to the fiduciary/trustee, in order for the self-dealing provisions of the prohibited transaction rules to be violated. If the fiduciary/trustee can successfully eliminate himself or herself from the decision regarding a Solo 401k transaction, a prohibited transaction might be avoided. See DOL Reg. 2550.408b-2(e)(2), Advisory Opinion 99-09A and Advisory Opinion 91-37A.

Transactions which might raise self-dealing issues. There have been many court decisions and IRS or DOL rulings regarding the issue of self-dealing. A fiduciary/trustee may be self-dealing by receiving payment directly from the Solo 401k plan in connection with a transaction over which the fiduciary/trustee had authority or control. Sometimes the consideration is from a third party, such as a finder’s fee, or other compensation paid by another person involved in the transaction with the Solo 401k plan.

Solo 401k Prohibited Transaction EXAMPLE 1

Gratuities paid to trustees. In Secretary of Labor v. Carell, 17 EBC 1159 (M.D.Tenn. 1993), an administration firm reimbursed the plan trustees for expenses incurred by the trustees’ spouses when they attended trustee meetings. The court ruled the payments constituted consideration received by the trustees in connection with plan assets, and constituted self-dealing. Although plan assets were not directly used, the court noted that the gratuities influenced the trustees in their dealings with plan assets. For example, the trustees would be more likely to continue to retain the administration firm to perform services for the plan, and to be compensated with plan assets.

Solo 401k Prohibited Transaction EXAMPLE 2

Compensation received by fiduciary. In an information letter (published at ¶23,881M of the CCH Pension Plan Guide), DOL discussed the circumstances surrounding compensation paid to a trustee of a multiemployer plan for services he provided to the plan’s board of trustees. A self-dealing issue may arise with compensation if the fiduciary uses his/her authority to engage himself/herself in activities with the plan for which he will be paid compensation. According to the DOL, the exemption for reasonable compensation for services does not protect a fiduciary/trustee from self-dealing. To avoid a self-dealing violation, the fiduciary/trustee must not have any authority, control or responsibility over whether he is retained to perform the services for which he/she will be compensated from the Solo 401k plan or through consideration from a third party.

Solo 401k Prohibited Transaction EXAMPLE 3

Mere presence of independent fiduciary/trustee is not enough to ensure no self-dealing. The mere presence of an independent fiduciary/trustee acting on the recommendations of a consultant/adviser is not sufficient to insulate the consultant/adviser from fiduciary/trustee liability under the self-dealing rules. See Advisory Opinions 84-03A and 84-04A. The key is the nature of the services being rendered, and whether such services cause the person to be acting as a fiduciary, as discussed in abovein, and whether actions in such capacity result in self-dealing. If there is no explicit or implicit understanding, as manifested either by agreement or by conduct, between the second fiduciary and the consultant/adviser tha the second fiduciary will rely on the consultant’s/adviser’s recommendations, the DOL acknowledged in Advisory Opinions 84-03A and 84-04A there would not be a fiduciary relationship between the plan and the consultant/adviser and the self-dealing issues would not arise.

Solo 401k Prohibited Transaction EXAMPLE 4

Transactions with companies related to (or affiliated with) the fiduciary. Where there is a relationship or affiliation between a fiduciary/trustee and another entity or person, a self-dealing issue is raised when that other entity or person benefits, not just if the fiduciary/trustee benefits directly. Lowen v. Tower Asset Management, Inc., 829 F.2d 1209 (2nd Cir. 1987), is an example of self-dealing involving transactions between the plan and companies related to the fiduciary who caused the plans to engage in the transactions. In this case, the fiduciary was the investment manager for the plan. The related companies were a registered broker-dealer and an investment banking corporation. The fiduciary used his authority to invest in companies for which the related companies were engaged to perform services and receive commissions, fees and other consideration.

Solo 401k Prohibited Transaction EXAMPLE 5

Partnership in which fiduciary is a partner. In TAM 9208001, the IRS ruled that a fiduciary engaged in self-dealing when he caused the plan to invest in a loan to a limited partnership in which the fiduciary was a 7.5% partner.

Solo 401k Prohibited Transaction EXAMPLE 6 (note that even though this refers to an IRA it still applies to a Solo 401k)

Transaction between IRA and company owned substantially by IRA owner. The issue of self-dealing was raised by the DOL in Advisory Opinion 2006-01A, where a lease between company owned 68% by the IRA owner (the disqualified person) and an LLC in which the IRA was an investor was determined to be an indirect lease between the IRA and the disqualified person.

Solo 401k Prohibited Transaction EXAMPLE 7

Employer’s exercise of fiduciary to retain entity could result in self-dealing. In DOL Advisory Opinion 97-23A, a plan owned 100% of a corporation that provided administrative services. The DOL discussed the self-dealing issues relating to a participating employer’s engaging the corporation to provide administrative services to other plans maintained by that employer. Since the plan-owned corporation is a plan asset, its financial success affects the rate of return of the plan, which, in turn, may reduce the need for employer contributions to the plan (the plan in question was a defined benefit plan). Such effect on the employer’s required contributions would constitute an act of self-dealing if the employer was acting as a fiduciary in the transaction.

Solo 401k Prohibited Transaction EXAMPLE 8 (note that even though this refers to an IRA it still applies to a Solo 401k)

IRA owner treated as fiduciary of IRA. In DOL Advisory Opinion 93-33A, the DOL notes that when an individual controls the investments in his IRA, he is a fiduciary for prohibited transaction purposes. (In that ruling, the IRA owner invested his IRA assets in his daughter’s business, and was found to be engaged in a self-dealing transaction). Therefore, if the IRA owner directs investment transactions with IRA assets that personally benefits him, he is engaging in an act of self-dealing under IRC 4975(c)(1)(E) or (F). In the IRA context, the consequence of engaging in a prohibited transaction is not excise taxes under 4975, but rather the loss the IRA’s tax-exempt status, pursuant to IRC 408(e)(1). Nonetheless, DOL Advisory Opinion 93-33A, and other Advisory Opinions that have dealt with IRA transactions (see, for example, Advisory Opinion 2000-10A, and Advisory Opinion 2006-01A, which have consistently applied the fiduciary concepts to the IRA owner that directs the investments of the IRA, but solely for purposes of determining whether the IRA engages in a prohibited transaction. Some court cases which have treated the IRA owner as fiduciary of his IRA includeSwanson v. Commissioner, 106 T.C. 76 (1996), and Harris v. Commissioner, 67 T.C.M. 1983 (1994).

Solo 401k Prohibited Transaction EXAMPLE 9 (note that even though this refers to an IRA it still applies to a Solo 401k)

IRA transactions that may raise self-dealing issues. The DOL has raised the issue of self-dealing when an IRA purchases stock in a company in which the IRA owner owns stock, or is a director or officer. The issue is a factual one – does the purchase result in a direct or indirect benefit to the IRA participant (other than in his capacity as the participant in the IRA)? In DOL Advisory Opinion 89-03A, an IRA owner directed the purchase of common stock in the company which employed the IRA owner. The IRA owner was also an owner in that company, but owned only slightly more than 1% of that company. The DOL’s discussion indicates that the degree of ownership is a factor here (i.e., the smaller the IRA owner’s personal stake in the company and the IRA’s ownership in the company, the less likely the investment will result in self-dealing). Also see DOL Advisory Opinion 90-20A (employee of approved nonbank trustee of IRA directing purchase of employer’s stock by IRA).

Solo 401k Prohibited Transaction EXAMPLE 10 (note that even though this refers to an IRA it still applies to a Solo 401k)

Investment of IRA in limited partnership in which IRA owner is a partner. DOL Advisory Opinion 2000-10A deals with an IRA invested in a limited partnership in which the IRA owner was the general partner and family members of the IRA owner had limited partnership interests. The DOL did not find a prohibited transaction arising from the sale of the partnership interest to the IRA because the partnership itself, based on its ownership structure, was not a disqualified person with respect to the IRA (the IRA only had a 39.38% limited partnership interest in the partnership). But the DOL cautioned about possible conflicts of interest that could result in prohibited transactions under IRC 4975(c)(1)(D) or (E), although it did not rule on these issues because of their factual nature. For example, there could be conflicts of interest later on with respect to the IRA’s investment in the partnership since the IRA owner also is the general manager of the partnership. Also, the IRA owner cannot be otherwise dependent upon the participation of the IRA in order for the IRA owner to continue his individual ownership in the partnership. The DOL also noted that, since the IRA owns more than 25% of the partnership, and the partnership is an investment club, the underlying assets of the partnership are treated as IRA assets pursuant to DOL Reg. 2510.3-101. Thus, any person who exercises discretionary authority or control over the partnership’s assets would be treated as a fiduciary of the IRA for purposes of applying the prohibited transaction rules under IRC 4975.

About Mark Nolan

Each day I speak with energetic entrepreneurs looking to take the plunge into a new venture and small business owners eager to take control of their retirement savings. I am passionate about helping others find their financial independence. Having worked for over 20 years with some of the top retirement account custodian and insurance companies I have a deep and extensive knowledge of the complexities of self-directed 401ks and IRAs as well as retirement plan regulations. Learn more about Mark Nolan and My Solo 401k Financial >>