A qualified plan may invest in loans to third parties. In this context, a third party loan is any loan other than a loan to a plan participant. While a third party loan might generate investment interest that exceeds the rate of investment return otherwise realized by the plan, there are a number of compliance issues that must be considered when a plan enters into a third-party loan transaction, or when a plan holds third party loans as plan assets. These concerns include possible IRC Section 401(a) failures, prohibited transactions under IRC Section 4975, valuation issues, and income tax adjustments. This issue snapshot considers some of the issues that should be scrutinized by examiners. IRC section and Treasury regulations IRC Section 61 IRC Section 401 IRC Section 412 IRC Section 430 IRC Section 4971 IRC Section 4975 Treas. Reg. Section 1.61-12 Treas. Reg. Section 1.1275-1 Resources Rev. Rul. 80-155, 1980-1 C.B. 84 Rev. Proc. 2024-2, 2024-1 I.R.B. 119 IRM 25.1.2, Fraud Handbook, Recognizing and Developing Fraud IRM 4.70.13.13 Fraud and Abusive Transaction Procedures Analysis Qualified retirement plans have wide latitude to make what they deem are appropriate investments. While a plan document may limit the ability of the plan trustee or a plan participant to invest in third party loans, neither the Internal Revenue Code nor Title I of the Employee Retirement Income Security Act of 1974 (ERISA) (which is within the exclusive jurisdiction of the Department of Labor (DOL)) specifically prevents a plan from investing in third party loans or holding third party loans as plan assets. However, the general requirement that the plan must be maintained for the exclusive benefit of plan participants and beneficiaries must still be satisfied. See IRC Section 401(a)(2). In addition, investment in third party loans might constitute a prohibited transaction under IRC Section 4975, and, if the loan becomes worthless or is forgiven, the borrower might be required to recognize forgiveness of indebtedness income. Prohibited transactions The first step in examining a third party loan is to determine if the loan constitutes a prohibited transaction under IRC Section 4975. IRC Section 4975(c)(1)(B) 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. For example, an accountant or attorney who provides services to a qualified plan would be considered a third party as neither the accountant nor the attorney is a participant in the plan. However, IRC Section 4975 treats parties providing services to a plan as disqualified persons even though those persons are third parties. See IRC Section 4975(e)(2)(B). Therefore, the examining agent should start by identifying the disqualified persons with respect to the plan. IRC Section 4975(e)(2) defines a disqualified person to include, among others, the employer, fiduciaries, persons providing services to the plan, and persons and corporations who own 50% or more interest in the employer. See Retirement Topics – Prohibited Transactions. Even if the loan is not made directly to a disqualified person, 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. For example, if a plan loans money to an entity that is not a disqualified person and that entity loans money to someone who is a disqualified person, then the original loan from the plan could be considered an indirect loan to the disqualified person to the extent the funds received from the plan were subsequently transferred to the disqualified person. Examining agents should closely scrutinize loans that offer unfavorable terms to the plan, provide for little to no interest, or are unsecured, as loans with these characteristics 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. In sum, a loan made to a third party should be examined carefully to determine whether the loan constitutes a prohibited transaction under IRC Section 4975. Exclusive benefit IRC Section 401(a)(2) provides that any corpus or income under a trust may not be used for, or diverted to, purposes other than the exclusive benefit of the employees or beneficiaries under the trust. The exclusive benefit test of IRC 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. See Shedco Inc. v. Commissioner, T.C. Memo. 1998-295. An agent who pursues an exclusive benefit rule violation must refer the case to DOL and obtain a technical advice memorandum from the Office of Associate Chief Counsel (Employee Benefits, Exempt Organizations, and Employment Taxes). See IRM 4.70.13.3.4.1.2(10), and Rev. Proc. 2024-2, Section 5.01. ERISA Title I, subtitle B, Part 4 establishes a comprehensive set of fiduciary standards applicable to plan asset management and administration. Among these are the prohibition against self-dealing with plan assets in ERISA section 406(b). These fiduciary standards are outside the jurisdiction of the IRS and are solely within the jurisdiction of DOL. If there are possible violations of these fiduciary standards, a DOL referral should be made using Form 6212-B, Examination Referral Checksheet B, prior to requesting a technical advice memorandum. Asset valuations Rev. Rul. 80-155 requires trust assets for defined contribution plans be valued at least once a year. This valuation must be performed for the purpose of assigning gains and losses to participant accounts and must reflect the fair market value of assets. See Valuation of Plan Assets at Fair Market Value. Most plan documents contain plan language to this effect as well, such that failure to do so might be a qualification failure under IRC Section 401(a) both for failing to conduct this valuation and failing to follow the written plan terms. Third party loans are investments just like any other asset subject to this valuation requirement. A loan’s valuation depends on a variety of factors, primarily the premium, discount/interest rate and the probability of collection. If the same or similar value for a plan loan asset is reported on Form 5500 (showing no reduction in principal) across multiple filings, it may indicate that payments under the loan contract are not being made and/or that the true fair market value of the loan is not being appraised or reported. 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. As a result, if third party loans are overvalued, the employer may have failed to satisfy the minimum funding requirements of IRC Section 412. Any plan investment involving third party loans that are deemed uncollectible could also impact the plan’s funding status under IRC Sections 412 and 430. The employer could owe IRC Section 4971 excise taxes as a result of any minimum funding deficiency. Overvalued and/or uncollectible third party loans could also cause a plan to fail to operate in accordance with applicable IRC Section 430 benefit restrictions. Once the correct value of the third party loan is determined by the examining agent, the examining agent should discuss with an actuary what effect overvalued or uncollectible loans have on the funded status of the defined benefit plan being examined. Income tax issues Third party loans that are in default and uncollectible raise potential income tax consequences to the borrower under IRC Section 61(a)(11) if the debt has been discharged. An issuer realizes income from the discharge of indebtedness upon the repurchase of a debt instrument for an amount less than its adjusted issue price (within the meaning of Treas. Reg. Section 1.1275-1(b)). The amount of discharge of indebtedness income is equal to the excess of the adjusted issue price over the repurchase price. See also Treas. Reg. Section 1.61-12. Although this would not necessarily affect the plan sponsor or its owners, as part of “package examination” procedures, a referral to another function business unit, such as the Small Business/Self-Employed (SB/SE) Division or Large Business and International (LB&I) Division, would be appropriate. Form 5666, TE/GE Referral Information Report, can be used for this purpose. Fraud The above list is not all-inclusive but describes some of the restrictions applicable to, and potential adverse results that can arise from, third party loans. A sponsor’s desire to avoid these adverse results may create an incentive for fraudulent reporting and recordation as the sponsor attempts to describe plan investments as compliant. Examiners should be alert to indicators of fraud when reviewing trust assets, but especially with regard to third party loans made from the plan. See IRM , 4.70.13, TE/GE Examinations, Executing the Examination, for more information about recognizing and developing fraud issues as part of an EP Examination. See also IRM 25.1.2, Recognizing and Developing Fraud. Audit tips Review Form 5500, Schedule H, Part 1, line 1(c)(7) or Schedule I, Part 1, line 3(f) for disclosure of 3rd party loans. If yes, determine if any of the third party loans were made to a disqualified person under IRC Section 4975. Review the plan document and ensure any third party loans that were made are in accordance with the terms of the plan document. Review plan assets to ensure they are appropriately valued. If the plan is subject to minimum funding, consider any valuation deficiencies for their effect on the employer’s plan funding obligations. Determine whether loans have been “written off” or otherwise deemed uncollectible such that a party has been discharged from debt. Consider a referral to SB/SE or LB&I as appropriate. Look for indicators of fraud.
