A recent Tax Court decision interpreting the prohibited transaction rules will not likely apply to 401(k) plans.

The United States Tax Court recently ruled against a group of taxpayers in a significant case concerning the legality of transactions involving self-directed IRAs. 1 Peek v. Commissioner is the first Tax Court decision to consider whether the owner of a self-directed IRA is prohibited from personally guaranteeing a loan by a company owned in part by an IRA. The Tax Court broadly interpreted Internal Revenue Code Section 4975(c)(1)(B), which prohibits “any direct or indirect…extension of credit between a plan and a disqualified person,” and held that the taxpayers’ IRAs terminated when they engaged in a prohibited transaction by guaranteeing the company’s debt to a third party.

In the wake of this decision, some commentators have suggested that the Tax Court’s holding in Peek may impact another innovative technique for capitalizing a business using 401(k) plan assets, commonly referred to as “rollover as business start-ups” or ROBS arrangements. While the Peek case represents a significant development in the tax laws applicable to IRAs, the case should not adversely impact typical ROBS arrangements, which qualify for a special exemption to certain prohibited transaction rules under ERISA Section 408(e), and are generally subject to different regulatory requirements.

Peek v. Commissioner

In 2001, the taxpayers in Peek used their self-directed IRAs to fund the purchase of Abbott Fire & Safety, Inc. from an unrelated third party. At that time, Abbott was a successful business specializing in the sale of fire alarms, sprinklers and other fire suppression equipment. The taxpayers acquired Abbott through a newly formed corporation – FP Company – which the taxpayers capitalized exclusively with their IRA assets. Each of the taxpayers’ IRAs transferred cash to FP Company in exchange for the company’s stock. Following the transaction, the taxpayers’ IRAs collectively owned 100 percent of FP Company. FP Company then acquired Abbott using that cash (i.e., the proceeds from the stock sale to the IRAs), cash from a bank loan and promissory notes. The sellers required the taxpayers to personally guarantee the promissory note FP Company made to them. In subsequent years, the taxpayers rolled over the FP Company stock from traditional IRAs to Roth IRAs, which resulted in income to the taxpayers during those years. In 2006, the taxpayers sold FP Company for a substantial profit, which the taxpayers claimed was permanently shielded from tax on account of the FP Company stock being held by taxpayers’ Roth IRAs.

The IRS challenged the tax treatment of the 2006 sale by arguing that the taxpayers’ personal guarantees on behalf of FP Company were prohibited transactions that caused their IRAs to terminate as of 2001. The IRS argued that the consequence of the IRA terminations was that the assets of the IRAs (i.e., the FP Company stock) were deemed distributed in kind to the taxpayers as of 2001, and that the gain from the 2006 sale was fully taxable. The taxpayers countered that the separate identity of the FP Company must be respected under Department of Labor’s (DOL) plan asset regulations,2 and that their personal guarantees of the company’s debt obligation were not indirect extensions of credit to their IRAs in contravention of the prohibited transaction rules.

The Tax Court rejected the taxpayers’ protestation that they had not indirectly extended credit to “the plan” by guaranteeing the FP Company’s debt obligation to the sellers of Abbott. The Tax Court reasoned that the taxpayers’ interpretation would permit taxpayers to “easily and abusively” avoid the Code’s prohibited transaction rules “simply by having the IRA create a shell subsidiary to whom the disqualified person could then make a loan.” According to the Tax Court, such a narrow reading of the statute was inconstant with Congressional intent and would “rob it of its intended breadth.” The Tax Court noted further that under existing precedent, an individual who guarantees a loan is indirectly extending credit to the debtor.3 The Tax Court concluded that Section 4975(c)(1)(B) should be interpreted broadly and held that this Section prohibits taxpayers from “making loans or loan guaranties either directly to their IRAs or indirectly to their IRAs by way of the entity owned by the IRAs.”

Although this case presented an issue of first impression for the Tax Court, the fact pattern is almost identical to the proposed transaction described in DOL Advisory Opinion 90-23A (July 3, 1990).4 In that opinion, the DOL concluded more than 20 years ago that an IRA owner’s personal guarantee of a loan to a company of which his IRA owned a 50 percent interest and the IRA of an unrelated individual owned the remaining interest would be a prohibited transaction under Code Section 4957(c)(1)(B). Thus, the Tax Court’s opinion should be viewed as merely affirming the long-held position of the DOL with respect to such transactions, rather than a departure from existing law.

Applicability of Peek to ROBS Arrangements

ROBS arrangements typically involve rolling over a prior IRA or 401(k) plan account into a newly established 401(k) plan which a start-up business sponsored, and then investing the rollover funds in the stock of the new corporation.5 At first blush, the IRA transaction in Peek shares some similarities with common ROBS arrangements. ROBS transactions typically involve the following sequential steps: (i) an aspiring entrepreneur establishes a new corporation; (ii) the corporation adopts a prototype 401(k) plan that specifically permits plan participants to direct the investment of their plan accounts into a selection of investments options, including employer stock; (iii) the entrepreneur elects to participate in the new 401(k) plan and, as permitted by the plan, directs a rollover or trustee-to-trustee transfer of retirement funds from another qualified retirement plan into the newly established corporate plan; (iv) the entrepreneur then directs the investment of his or her 401(k) plan account to purchase the corporation’s newly issued stock at par value (i.e., the amount that the entrepreneur wishes to invest in the new business); and finally (v) the company utilizes the proceeds from the sale of stock to purchase an existing business or to begin a new venture.6 Frequently, the newly formed business will also borrow from third parties, pay salaries to employees (including shareholders/plan participants), and engage in other routine business transactions with disqualified persons.7 Commonly a corporate officer or shareholder will make or guarantee loans to the business, as the taxpayers did in Peek.

So why should the result in Peek be any different for 401(k) plans that hold employer securities? The most critical distinction is that most 401(k) plans which offer employer securities as an investment option, including typical ROBS arrangements, operate under a specific exemption from the prohibited transaction rules (i.e, ERISA Section 408(e))— which permit certain types of retirement plans to acquire, hold and sell “qualifying employer securities.” Specifically, these rules permit an “eligible individual account plan” to acquire or sell qualifying employer securities (commonly referred to as “QES Stock”) if: (i) the acquisition, sale or lease is for adequate consideration; (ii) no commission is charged; and (iii) the plan is an eligible individual account plan as defined in ERISA Section 407(d)(3).”8 ROBS arrangements typically involve 401(k) profit sharing plans, which fall within the definition of an “individual account plan” and satisfy the requirements of this exemption. In contrast, an IRA is not an “individual account plan” and is not eligible for this exemption.

ERISA Section 408(e) should be viewed as sufficiently broad to shield employers from scrutiny of routine (non-abusive) corporate transactions by the plan sponsor and other “disqualified persons,” which might otherwise constitute technical violations of the prohibited transaction rules (due to the employer-sponsored retirement plan’s ownership of employer securities). If the plan sponsor and other fiduciaries’ routine corporate transactions did not fall within the purview of ERISA Section 408(e), the prohibited transaction rules would needlessly prohibit a myriad of legitimate business transactions and would ultimately nullify the exemption that Congress intended to provide. To accomplish its intended effect, ERISA Section 408(e) must be read to exempt the natural and necessary commercial consequences of owning corporate stock, rather than just the stock purchase or divestiture.

Another important distinction between self-directed IRA transactions and ROBS arrangements involving 401(k) plans is that 401(k) plans do not present the same compliance risks that troubled the Tax Court or the IRS in Peek. In Peek, the Tax Court was concerned about opening the door for taxpayers to “easily and abusively” avoid the Code’s prohibited transaction rules “simply by having the IRA create a shell subsidiary.” In the context of 401(k) plans, that risk is not present because of the “exclusive benefit rule.”9 In order to be qualified under Section 401(a), an employer sponsored retirement plan must be operated for the exclusive benefit of the company’s employees or their beneficiaries.10 The exclusive benefit rule of Section 401(a) would not be satisfied if the plan sponsor were merely a “shell subsidiary.” In addition, 401(k) plans must comply with a whole host of other statutory and regulatory requirements that are not applicable to IRAs, such as performing annual valuations, compliance testing and filing annual detailed information returns (Forms 5500).

Important tax and economic policy considerations also compel a different result for 401(k) plans than IRAs. Congress specifically intended to encourage 401(k) plans to invest in employer securities, within certain limits. The opportunity to invest in employer securities through retirement plans benefits employers and employees alike by aligning their economic interests.

Outside the context of ROBS arrangements, many 401(k) plans permit participants to invest in employer stock. A number of large 401(k) plans, including plans sponsored by Coca-Cola and General Electric, include substantial allocations of employer stock. According to a 2012 report by Morningstar, as of 2010 employer stock constituted approximately eight percent of total 401(k) plan assets in the United States. Another recent report by the Employee Benefit Research Institute notes that as of 2009, 66 percent of plans with more than 5,000 participants offered employer stock as an investment opinion. Extending Peek to include transactions involving 401(k) plans could have a chilling effect on employer offers of such benefits.

In conclusion, Peek’s prohibition of indirect extensions of credit to a plan, through entities owned by the plan, should not apply to ROBS arrangements or other employer sponsored plans that qualify for a statutory prohibited transaction exemption under ERISA Section 408(e). Any other result is inconsistent with the statutory framework, would eviscerate the intent of Congress to encourage investment in employer securities by retirement plans and would have adverse economic and tax policy consequences.11

Will the IRS Attempt to Apply Peek to ROBS Arrangements?

The IRS has not indicated it intends to argue that Peek applies to ROBS or other arrangements involving 401(k) plans. The IRS has scrutinized ROBS arrangements for more than a decade and has not previously pursued arguments similar to those it asserted in Peek. The IRS is undoubtedly sensitive to the fact that the stakes are much higher for businesses with ROBS arrangements than for taxpayers like Mr. Peek; due to the requirements that 401(k) plans unwind prohibited transactions and pay substantial penalties. And the IRS is also likely cognizant of the collateral impact such a challenge would have on other retirement plans holding employer securities. In the case of a 401(k) plan, an excise tax equal to 15 percent of the “amount involved” in the prohibited transaction is imposed on the disqualified person who participated in the prohibited transaction.12 And, if the prohibited transaction is not corrected within the taxable period, an excise tax of 100 percent of the “amount involved” may be imposed. For many small businesses that have adopted retirement plans with ROBS features, “correcting” a corporate loan or shareholder guarantee to a lender without shutting down the business would be almost impossible. If the IRS were to challenge ROBS arrangements on this basis, well over 10,000 successful small businesses would face the devastating prospect of immediately shutting down and laying off tens of thousands of employees.13 Particularly in these challenging economic conditions, the IRS, and ultimately the administration and Congress, are likely to recognize the turmoil that would ensue.

Significantly, as recently as February 2013, the IRS publicly released a summary report from TE/GE’s Employee Plans Compliance Unit describing the results of a compliance project examining ROBS..14 The IRS’s ROBS project began in 2009 and continued through September 2010. According to the IRS report, the Service examined “a cross section of businesses including those in senior care, cleaning services, fitness, health food, real estate, machinery, daycare, pet products and services, and consulting.” The Service noted that some ROBS arrangements were start-ups while others involved purchases of existing businesses. Presumably most, if not all, of the plan sponsors had paid salaries, borrowed funds or entered into arrangements that could be viewed as indirect extensions of credit under Peek. Yet the IRS has not pursued arguments similar to those it asserted in Peek in its examination of plans with ROBS features. Likewise, the IRS ROBS project report did not raise any of the arguments the IRS asserted in Peek, even though the ROBS report was published eight months after the final round of briefing in Peek.15 Nor were these types of issues raised in an earlier October 1, 2008 memorandum entitled “Guidelines regarding rollovers as business start-ups,” which addressed certain concerns the Service had identified regarding ROBS arrangements at that time. At the very least, the Service’s decision not to pursue the issues it raised in Peek in the context of ROBS arrangements could be viewed as a tacit acknowledgement that the IRS believes the issues in Peek are not applicable to ROBS and other 401(k) arrangements involving employer securities on account of ERISA Section 408(e).

The Future of IRS Scrutiny of ROBS Arrangements

Since 2008, IRS officials have publicly recognized that employers may utilize ROBS arrangements to serve legitimate business, tax and retirement planning purposes. The IRS has also identified valid concerns with some ROBS arrangements, particularly some plan sponsors’ failure to ensure that the plan is administered in compliance with the plan qualification requirements of Code Section 401(a) and related regulations. The IRS is also cognizant that ROBS arrangements pose the potential for abuse. But, for the most part, the IRS’ recent compliance concerns with ROBS arrangements have focused on routine administrative issues that can easily be corrected, such as plans neglecting to file Form 5500. Administrators and sponsors of ROBS arrangements should expect that the IRS will continue to closely monitor ROBS plans to ensure that they remain in compliance with the requirements of Code Section 401(a). The IRS, in turn, should continue to focus its efforts to educate inexperienced plan administrators regarding their compliance obligations and identifying areas of noncompliance.

While there is some risk that the Service could reverse course and pursue ROBS or other 401(k) plan arrangements for “indirect” prohibited transactions, as it did in Peek, there is no reason to believe the Service will attempt do so. It is likely that the IRS will recognize that it can avoid potentially adverse economic and tax policy consequences by resisting any urge to extend its victory in Peek to 401(k) arrangements. And the Service is on solid legal footing if it does so. 401(k) plans are distinguishable from self-directed IRAs due to the applicability of ERISA Section 408(e), robust compliance requirements, and clear congressional intent to encourage retirements plan participants to invest in employer securities.