by Fred Reish and Bruce Ashton

Even the best intentioned fiduciaries may make decisions which result in a loss to the plan participants. If those losses were due to fiduciary breaches under ERISA, the plan fiduciaries (e.g., the trustee, the plan committee members, the employer, the employer's board of directors) may be personally liable to restore those losses, plus reasonable earnings, to the trust. However, even if the employer--or the individual fiduciaries--wish to voluntarily restore the plan's losses, there is no formal procedure for doing so. In the last several years, though, the IRS has issued a number of private letter rulings (PLRs) which discuss the treatment of these payments for income tax and qualification purposes, which are generally referred to as "restoration" or "restorative" payments. (A partial list of the PLRs includes 9506030, 9506048, 9507030, 9513030, 9528034, 9601038, 9628031, 9727026, 9746039, 9807028, 9824041 and 9830022.

Keep in mind that a PLR has no precedential value and can only be relied on by the taxpayer who obtained the ruling. Nevertheless, PLRs reflect the IRS' thinking on the issues, and, especially where there is a series of rulings, can be useful to other taxpayers. In order to obtain more formal guidance on these issues, the ASPPA Government Affairs Committee has urged the IRS to issue a Revenue Ruling dealing with restoration payments. The Government Affairs Committee has also been working with the DOL for several years to develop a voluntary fiduciary breach correction program, similar to the IRS' remedial programs for plan qualification, to permit fiduciaries to make restoration payments without running the risk of the imposition of the 20% penalty under Section 502(l) of Title I of ERISA.

To put the issue in perspective, let's look at two fairly common examples:

Example 1: In 1995, a 401(k) plan purchased a group annuity contract which offered a number of investment fund options within the insurance contract. In 1998, the plan fiduciaries concluded that the fund options were not providing a satisfactory return for the participants and decide to switch to a family of mutual funds. In order to transfer the existing assets out of the group annuity contract, the plan will be assessed a surrender charge equal to 2% of the assets invested in the contract. The plan fiduciaries (who are officers of the plan sponsor) do not want the participant accounts to be reduced by the amount of the surrender charge and decide to have the plan sponsor make a payment to the plan to restore the "loss." (Another alternative would be for the sponsor to work out an arrangement with the insurance company which issued the group annuity contract to pay the surrender charge directly, but for these purposes that is the functional equivalent of making the payment directly to the plan.)

Example 2: The sole shareholder and president of a corporation also serves as trustee of the company profit sharing plan. His brother-in-law sells real estate limited partnership investments. Without conducting any investigation, the trustee causes the plan to purchase two units in the Last Stand Retirement Villas for $100,000, representing approximately 25% of the plan assets. The partnership is unable to obtain a building permit, and three years later declares bankruptcy. The plan's investment is lost. To avoid complaints by his employees, the trustee decides to have the company make up the loss (plus missed earnings) to the plan.

The Issues

Absent guidance from the IRS to the contrary, a payment to a plan by the plan sponsor would be treated as a contribution which would need to be allocated in accordance with the plan formula and would be subject to the contribution limits of Code section 415, the deduction limits of section 404 and the non-discrimination rules of section 401(a)(4). Briefly stated, the PLRs indicate that under certain circumstances, the restoration payment is not considered a contribution. But what are those circumstances? And what are the consequences of the payment not being treated as a contribution? Let's look at these issues in the context of our two examples.

The PLR Guidance

In the PLRs, the IRS has taken the position that, in order for a payment to be treated as a restoration payment, there must be a genuine controversy over whether the loss resulted from a fiduciary breach. This must be evidenced by the assertion of a fiduciary breach claim, such as actual litigation (see PLR 9807028); threats of lawsuits by participants and/or their attorneys (see PLRs 9746039 and 9628031); claims of fiduciary wrongdoing asserted by the participants, by the DOL's Pension and Welfare Benefits Administration (PWBA) or by another fiduciary (see, e.g., PLR 9601038). An investment loss by itself is not sufficient.

If a restoration payment is made and the IRS were later to determine that no real controversy regarding a fiduciary breach existed, then the payment would be treated as a contribution to the plan. Such an IRS finding would subject the plan to disqualification for failure to operate in accordance with its terms because a contribution must be allocated to participant accounts in accordance with the plan's contribution allocation formula and the restoration payment is allocated in proportion to the investment loss in each account.

The situation in example 1 might not fall within the "controversy" requirement. While it can be expected that participants will not like a 2% reduction in their accounts as a result of the surrender charge, it does not appear that there is a fiduciary breach issue in that situation. Again, merely because there is a loss does not mean that there is a fiduciary breach. In fact, the DOL has given tacit approval of surrender charges assessed at contract termination. This is seen in the regulations under the prohibited transaction rules of Title I of ERISA.

Section 408(b)(2) of Title I of ERISA exempts from the prohibited transaction restrictions payments to a party in interest for services necessary for the establishment or maintenance of the plan so long as no more than reasonable compensation is paid. The DOL expands on the requirements of the exemption in DOL Reg. Section 2550.408b-2, indicating that the contract for the services must be reasonable. The DOL goes on to say that a contract is reasonable so long as it may be terminated without penalty on reasonably short notice. Finally, the DOL states that "a provision in a contract or other arrangement which reasonably compensates the service provider...for loss upon early termination of the contract...is not a penalty." (DOL Reg. Section 2550.408b-2(c))

The surrender charge under a group annuity contract is generally designed to reimburse the insurance company for the commission paid to the agent or broker who sold the contract. This is also sometimes referred to as a deferred sales charge. While the insurer normally recoups the commission expense over a five to seven year period, if the contract is terminated before that time, the deferred sales charge is imposed to compensate the insurer for the loss which it would otherwise incur. Although arising in a different context, the rule set forth in the regulations under Section 408(b)(2) indicates that the DOL would not consider a reasonable surrender charge to be impermissible.

Thus, in our example, it seems unlikely that a 2% surrender charge would give rise to a valid breach of fiduciary duty claim. That being the case, a payment by the plan sponsor to reimburse the participants for the amount of this charge would not fall within the "controversy" requirement of the PLRs and would not be treated as a restoration payment.

Contrast that, however, with a substantially larger deferred sales charge of, say, 20% which is imposed on a declining scale over 20 years. It would seem that the initial commission charged at the time of issuance of the group annuity contract would not be considered "reasonable compensation" and that purchasing a contract with such a large deferred sales charge would be viewed as imprudent. Therefore, a claim for breach of fiduciary duty asserted by the participants in connection with a surrender of the contract would appear to be sufficient to meet the "controversy" requirement of the PLRs.

Similarly, in the case of the limited partnership investment, where the plan fiduciary made no investigation in purchasing the partnership units and the partnership ultimately became insolvent because it could not obtain the necessary building permits (a condition that presumably could have been discovered with proper diligence), a payment to restore the plan assets could properly be treated as a restoration payment. This is true because the payment would be made to avoid a fiduciary breach lawsuit by the participants.

In addition to the determination that there is a genuine controversy regarding a fiduciary breach, there are three important, non-tax issues which must also be considered before the restoration payment is made. First, under many fiduciary liability insurance policies, the fiduciaries may lose coverage if they admit to a fiduciary breach. Thus, before such a step is taken, the fiduciaries should coordinate with the insurer. Second, care must be taken in how a restoration payment is structured to avoid having the transaction be a prohibited transaction. Third, there may be a question of whether the plan sponsor is the proper party to make the restoration payment if the investment decisions were made by a plan committee or other fiduciaries.

Assuming the threshold "controversy" requirement is met, the restoration payment will not be treated as a contribution. Therefore, the IRS has also reached the following conclusions, among others (note that not every issue is addressed in every PLR, and this list is distilled from the various letters):

(1) The restoration payment is not an annual addition subject to the limits of Code section 415(c) either for the year in which the payment is made or for the year(s) for which it is allocated.

(2) The restoration payment will not be treated as a contribution for Code section 401(a)(4) discrimination testing purposes. Keep in mind that the restoration payment is put into the plan to make up for losses on contributions which were previously made. Therefore, the allocations to participants' accounts have been tested previously for these purposes, and there is no need to test them again. Properly done, the restoration payments should be allocated in proportion to the participants' accounts in the year(s) that the losses occurred (not in the year when the restoration payment is made) rather than under the plan's allocation formula for contributions. In effect, the plan must be "re-administrated" to make sure it is allocated to the proper year(s).

(3) The restoration payment is not subject to the deduction limitations of Code section 404 or to the excise tax on nondeductible contributions of Code section 4972.

The IRS has also determined that a restoration payment is deductible under Code section 162(a), which permits a business to deduct amounts incurred as ordinary and necessary business expenses. It is important to recognize, however, that the deduction of a restoration payment under section 162 is available only to a person or entity which is financially responsible for the breach giving rise to the payment and which is engaged in "carrying on a trade or business" directly related to the fiduciary duties which were breached. As a result, if a fiduciary other than the plan sponsor caused the breach, the plan sponsor would not be able to deduct its payment to the plan absent a duty to indemnify the fiduciary. Similarly, the fiduciary might not be able to take the deduction because it may not be carrying on a relevant trade or business. If, however, under the terms of the plan or trust document, the plan sponsor's articles of incorporation or other governing documents or a separate written agreement, the sponsor has an affirmative duty to indemnify the fiduciary, the PLR guidance permits the sponsor to deduct the restoration payment under Code section 162.

Conclusion

The PLRs do not answer all of the questions concerning restoration payments. However, they are a useful beginning point. The most important principle to keep in mind is the requirement of a fiduciary breach or, at least, a controversy regarding an asserted breach. Without that, the payment would have to be treated as a contribution subject to the Code section 404, 415 and 401(a)(4) requirements in the year of the payment and allocated in accordance with the plan's terms. If these requirements are not met, then the attempt to correct one problem--the losses to the participant accounts--could lead to much more serious plan qualification issues.

Reprinted with permission from the American Society of Pension Actuaries.