The Internal Revenue Service has updated its discussion of third-party loans and plans

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A qualifying plan may invest in third-party loans, that is, loans to individuals or businesses other than plan members.

Where a scheme engages in such a transaction, or where a scheme holds third-party loans as plan assets, compliance issues need to be considered. The Internal Revenue Service (IRS) has updated discussion on its website of the issues its reviewers are looking for with these loans.

Here are some of the concerns with these loans:

probable violations of Section 401(a) of the Internal Revenue Code (IRC); transactions prohibited by IRC Section 4975; evaluation issues; and income tax adjustments.

Third party plans and loans

According to the Internal Revenue Service, qualified pension plans have ample leeway to make investments they deem acceptable.

The IRC and Title I of ERISA do not specifically prohibit a plan from investing in third-party loans or holding such loans as plan assets; however, a plan document may limit the ability of the plan trustee or a plan participant to invest in third party loans. In addition, a plan may limit the ability of plan participants to invest in third-party loans.

However, federal regulation is not entirely free from free market capitalism. It is nevertheless necessary to fulfill the general condition that the scheme must be maintained for the sole purpose of benefiting the participants and beneficiaries of the scheme.

Investing in loans issued by third parties may also be considered a prohibited transaction under Section 4975 of the Tax Code. If the loan is written off or canceled, the borrower may be required to include the amount written off or canceled as income on their tax return.

A look at the considerations made by the IRS

Below is a list of considerations that the Internal Revenue Service (IRS) and plan reviewers make about third-party loans in which a plan invests or retains as plan assets.

Unauthorized Transactions. According to the Internal Revenue Service (IRS), the first step in analyzing a loan from a third party is to determine whether or not the loan constitutes a prohibited transaction under Section 4975.

It is important to note that a prohibited transaction is defined by section 4975(c)(1)(B) to include the lending of money or the granting of credit by the plan to a disqualified person. According to what the brief says, “it is essential to keep in mind that a party may be a third party to the plan and still be a disqualified person under IRC Section 4975.”

According to the Internal Revenue Service (IRS), a reviewing officer must begin by identifying people who are not eligible to participate in the plan. For purposes of this discussion, the following individuals are considered disqualified pursuant to Section 4975(e)(2):

the employer, trustees, individuals or companies who provide services to the plan and individuals or companies who own at least a fifty percent interest in the employer.

However, the fact that a loan was granted to an ineligible person is not the only consideration taken into account in deciding whether or not a prohibited transaction has taken place.

According to the Internal Revenue Service (IRS), a loan may still be considered a prohibited transaction even if it is not granted directly to a disqualified person. This is the case if the loan was made indirectly to a disqualified person or if a disqualified person benefited from the loan in some way.

In addition, the brief recommends that auditors “must rigorously investigate loans” that meet the following criteria:

have low or no interest rates, are unsecured and have terms that are detrimental to the plan.
According to the Internal Revenue Service, these loans are evidence that the plan was pushed into entering into the loan transaction for reasons other than financial ones.

According to the disclaimer in the document, “In other words, loans that are obviously bad investments are more likely to have been made for the benefit of a disqualified individual.”

Exclusive advantage. According to the brief, the exclusive benefit test of 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. This is true as long as the transaction benefits the primary objective of the investment.

When an IRS agent investigates a possible violation of the exclusive benefit rule, they are required to report the incident to the Department of Labor and request a technical memorandum of opinion from the attorney’s office in Associate Chief (Benefits, Exempt Organizations and Employment). taxes).

Asset valuations. Tax Ruling 80-155 requires that trust assets for defined contribution plans be valued at least annually, as the brief points out, so that profits and losses can be attributed to participants’ accounts and that the fair market value of the assets can be determined.

According to the Internal Revenue Service (IRS), assets subject to this assessment requirement include third-party loans. The valuation of a loan depends on several elements, the most important of which are:

The premium, discount or interest rate and probable recovery rate are the three components.

Minimum funding. The value of plan assets is used to calculate the amount of funding allocated to defined benefit plans. The Internal Revenue Service (IRS) warns that the plan’s funding percentage will also be exaggerated if the plan’s asset values ​​are overstated.

If third-party loans are overstated, the employer may not have met the minimum funding standards specified in Section 412 of the Internal Revenue Code. In addition, the plan’s funded status could be affected by any investment by the plan involving third party loans deemed uncollectible.

And if there is a shortfall in the minimum required funds, an employer may be liable for excise taxes under Section 4975 of the Internal Revenue Code. According to the Internal Revenue Service (IRS), which recognizes this possibility, overstated and/or uncollectible third-party loans could lead to a plan violating IRC Section 430 benefit restrictions.

Income tax issues. According to information provided by the IRS, a borrower may be subject to tax implications if third-party loans are in default and uncollectible, but the obligation has been discharged.

When an issuer successfully redeems a debt instrument for less than the instrument’s adjusted issue price, the issuer may receive debt clearance proceeds.

Fraud. The Internal Revenue Service (IRS) warns that there is a risk of fraudulent reporting and recording if an individual tries to circumvent applicable restrictions and the potential negative outcomes that can result from lending to third parties.

This is done to otherwise portray the scheme’s investments as complying with applicable regulations. According to the memorandum, “reviewers should be alert to symptoms of fraud when assessing the management of all assets of the trust, but particularly with respect to third-party loans made from the plan.”

Verification Tips

When reviewing loans of this nature, the Internal Revenue Service has provided its reviewers with the following advice.

Read more:-

1. Examine the plan’s records to see if it has any loans, direct or indirect, from third parties to the plan. If so, you should check to see if any of the third-party loans were made to someone who is not qualified under Section 4975.

2. Carry out a thorough review of the plan document and ensure that any loans to third parties have been made in accordance with the provisions set out in the plan document.

3. Make sure plan assets are properly valued by reviewing them.

4. If the plan is required to maintain a certain minimum funding level, consider any valuation deficiency in light of the impact it will have on the employer’s funding obligations of the plan.

5. Determine whether or not the loans were “written off” or otherwise deemed uncollectible such that a party was released from its obligation to repay the loan. Consider making a referral to the Large Business and International (LB&I) Division or the Small Business and Self-Employed (SB/SE) Division, whichever is most applicable.

6. Keep an eye out for signs of fraudulent activity.

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