3983 / What exemptions to the prohibited transaction rules are provided by the Internal Revenue Code?

The IRC lists specific exemptions from the broad prohibited transaction rules. These include:

(1)  the receipt of benefits under the terms of the plan;

(2)  the distribution of the assets of the plan meeting allocation requirements;

(3)  loans available to all plan participants or beneficiaries under certain circumstances (see Q 3984);

(4)  a loan to an employee stock ownership plan (ESOP, see Q 3817); and

(5)  the acquisition or sale of qualifying employer securities by an individual account profit sharing, stock bonus, thrift, savings plan, or ESOP for adequate consideration and without commission.¹

Another statutory exemption is for the provision of office space or services necessary for the establishment or operation of the plan under a reasonable arrangement for no more than reasonable compensation.² This exemption shields only the provision of services that would be prohibited transactions under (1), (3), and (4) in Q 3980, not fiduciary self-dealing. Thus, if an insurance agent is not a fiduciary, the agent’s sale of insurance to a plan and receipt of a commission is within this statutory exemption. If an agent is a fiduciary (for example, if the trustee relies on his or her investment advice) receipt of a commission for sale of insurance or annuities to a plan may be a prohibited transaction.³

Certain administrative exemptions (see Q 3985) permit receipt of fees or commissions by fiduciaries in connection with the sale of insurance and annuity contracts to plans and the transfer of insurance contracts between plan and plan participants or employers.

Final DOL regulations provide that compensation paid to certain service providers will not be considered reasonable for purposes of the prohibited transaction exemption unless the covered service provider satisfies a fee disclosure mandate.⁴ Failure to comply with the disclosure mandate will mean that compensation paid to the covered service provider does not qualify for the statutory prohibited transaction exemption.

The service providers covered by the mandate are fiduciaries, registered investment advisors, platform providers for participant directed defined contribution plans, and other indirectly compensated service providers who reasonably expect $1,000 or more in direct or indirect compensation in connection with providing covered services. Indirectly compensated services include accounting, auditing, actuarial, appraisal, banking, certain consulting related to the plan or plan investments, custodial, insurance, investment advisory, legal, recordkeeping, investment brokerage, third party administration, or valuation services provided to the plan for which the covered service provider, an affiliate, or subcontractor reasonably expects to receive indirect compensation.⁵

Direct compensation is compensation received directly from the plan. Indirect compensation is compensation received from any source other than the plan, the plan sponsor, the covered service provider, or an affiliate. Compensation received from a subcontractor is generally indirect compensation.⁶

The disclosure must include the following information:

(1)  A description of the services to be provided;

(2)  If applicable, a statement that the services will be provider as a fiduciary, as a registered investment advisor, or both;

(3)  A description of all direct and indirect compensation expected to be received;

(4)  If recordkeeping services will be provided to the plan, a description of the compensation expected to be received for the services and information about any arrangement where the recordkeeping services will be provided without explicit compensation;

(5)  Information about fiduciary services provided to investment products that the plan has a direct equity investment in;

(6)  Information about investment products made available through a platform in connection with recordkeeping and brokerage services; and

(7)  A description of the manner in which the compensation will be received, such as whether the plan will be billed or the compensation will be deducted directly from the plan’s accounts or investments.⁷

Except for the first two exemptions listed above, these statutory exemptions do not apply where a plan that covers owner-employees (1) lends assets or income, (2) pays any compensation for personal services rendered to the plan, or (3) except as described in the following paragraph, acquires property from or sells property to (x) an owner-employee ( Q 3932) or an employee who owns more than 5 percent of the outstanding shares of an S corporation, an individual retirement plan participant, beneficiary, or sponsoring employer or association, as the case may be, (y) a family member of a person described in (x), or (z) a corporation controlled by a person described in (x) through ownership of 50 percent or more of total combined voting power of all classes of stock or 50 percent or more of total shares of all classes of stock of the corporation.⁸

A transaction consisting of a sale of employer securities to an ESOP ( Q 3819) by a shareholder-employee, a member of his or her family, or a corporation in which he or she owns 50 percent or more of the stock generally will be exempt from the prohibited transaction rules. For this purpose, a shareholder-employee is an employee or officer of an S corporation who owns or is deemed to own, under the constructive ownership rules of IRC Section 318(a)(1), more than 5 percent of the outstanding stock of the corporation on any day during the corporation’s taxable year.⁹ For special rules applying to S corporation ESOPs that the IRS views as abusive, see Q 3825.

The Pension Protection Act of 2006 created an exemption from the prohibited transaction rules for certain fiduciary advisors who provide investment advice under an eligible investment advice arrangement ( Q 3793).¹⁰