The IRS Rules on Reimbursing Plans for Deferred Sales Charges

By Fred Reish and Bruce Ashton

The investments sold by brokers to 401(k) plans often impose a back-end charge if the plan switches investment providers within a specified time after the initial investment. The purpose of the charge (often called a "contingent deferred sales charge") is to protect the insurance company or mutual fund family from loss because of the brokerage commissions and start-up costs it incurs. The amount and duration of the charge are determined primarily by the amount of the commission paid to the broker.

When plan sponsors decide to switch from one investment provider to another, they typically confront the real impact of the back-end sales charge for the first time. Most are reluctant to have the participants' accounts reduced by these charges. To avoid this, plan sponsors have historically used one of the following "solutions":

• Direct Payment Method: Contribute an amount equal to the sales charge to the plan and allocate it to the accounts of the affected participants to cover the losses in their accounts due to the charges.
• Indirect Payment Method: Pay an amount to the mutual fund family or insurance company equal to the bank-end charge in return for a "waiver" of the charge.
• Transfer Method: Have the successor investment provider pay the charge; the successor provider then increases its fees and expenses such that it recoups the amount paid, together with a reasonable amount of interest.

  NOTE: This is not an exhaustive list of the alternatives that employers have used for dealing with this problem, but a description of the most common methods.

The IRS recently issued Private Letter Ruling (PLR) 200137064 holding that, under the facts in that case, the plan sponsor's payment of the withdrawal charge would be considered a contribution to the plan subject to IRC §401(a)(4) discrimination testing, §401(m) nondiscrimination testing for matching contributions, §404 deduction limits, §415 limit on annual additions, §4972 excise taxes on nondeductible contributions, and §4979 taxes on excess contributions. Since the §§401(a)(4), 401(m) and 415 provisions are qualification requirements, the violation of these rules would subject the plan to disqualification.

The IRS points out that the only time employer deposits into a plan are not subject to all of the provisions listed above are where the payments are made by a plan sponsor to restore losses to a plan due to a breach of fiduciary duty (or, at least, due to a reasonable belief of a fiduciary breach). These payments are called "restoration" or "restorative" payments. Losses due to ordinary market risk and fluctuations - and payments to make up for back-end charges -- would not be treated as restorative payments.

Based on conversations with IRS officials, their concern is that some plan sponsors may attempt to make up investment losses or ordinary investment expenses by making additional contributions to plans. In their view, those additional contributions would have to comply with the tax qualification requirements cited above. In addition, in our opinion, there may be a further qualification risk due to the failure to allocate the additional contribution according to the terms of the plan document. That is, restoration payments are typically allocated in proportion to account balances, while contributions are allocated according to the plan's allocation provisions, e.g., in proportion to compensation.

In the PLR, the IRS considered the back-end charges on group annuity contracts issued to a participant-directed 401(k) plan. The annuity contracts provided for withdrawal charges of 8% for the first five years, 4% for years six through ten, and no charge thereafter. In analyzing these facts, the IRS held that there was not a sufficient basis to find a reasonable risk of liability for breach of fiduciary duty in entering into annuity contracts with the withdrawal charges considererd in this case. As a result, the IRS held that the proposed payments by the plan sponsor would be considered to be employer contributions subject to IRC §§401(a)(4), 401(m), 404, 415, 4972 and 4979 and not restorative payments. (Even if the IRS had concluded that the back-end charge was excessive, only the "excess" amount could have been restored. That is, a portion of withdrawal charges would be considered reasonable, and only the excess over that amount could be restored as a loss due to a fiduciary breach.)

Applying this rationale to common 401(k) scenarios, plan sponsors who use either of the first two methods--direct or indirect restoration-- fall within the reasoning and conclusions of the PLR. While the ruling only addresses the direct payment method, it would also apply to the indirect method because the two methods are functionally identical. That is, a payment by the sponsor to the plan to gross up participant accounts after deduction of the back-end charge vs. a payment directly to the investment provider in lieu of the back-end charge leaves the participant accounts in exactly the same place.

In our experience, if payment of the withdrawal charges is treated as an employer contribution (rather than as a restorative payment), in most cases it will disqualify the plan (either because of violation of the sections cited by the IRS or because the allocation is made disproportionately to the accounts of the highly compensated employees in violation of the IRC §401(a)(4) discrimination rules). However, that is not always the case. Thus, where the applicable Code sections can be satisfied, a plan sponsor may be able to make a restorative-type payment even where there has not been a fiduciary breach and the payment is treated as a contribution. As a word of caution, though, the plan should be amended to provide for the proper allocation (i.e., in proportion to the losses) for this one-time payment.

The third scenario--where the charges are paid by the successor investment provider--is more difficult to analyze in the context of the PLR. In the third scenario, there is no new payment to the plan by the sponsor. Further, the payment of the expenses is shifted from one time period (i.e., when the contract is surrendered) to another (each year in the future in which the successor investment provider imposes its additional charges). Also, it is probably shifted from one group of participants (those in the plan on the date of surrender) to another (those continuing in the plan, excluding those who take distributions, but including new participants). These, and other, distinctions make the analysis difficult. However, a plan sponsor should be extremely cautious about transferring expenses from one time period to another and from one group of participants to another, without the advice of its ERISA attorneys. The issues are complex and the consequences are significant.

© 2001 Reish Luftman & Reicher. All rights reserved. The Business Advisor Report is published as a general informational source. Articles are general in nature and are not intended to constitute legal advice in any particular matter. Transmission of this report does not create an attorney-client relationship. Reish Luftman & Reicher does not warrant and is not responsible for errors or omissions in the content of this report.

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