Can The Plan Pay This Expense?

By Nick White and Stephanie Bennett

The answer to this question is, like many others ... it depends.

We recently worked with a client on a situation involving the payment of expenses from plan assets. The expenses at issue were very large, and not all of them were eligible for payment from the plan. So, our task was not only to correct the violations of law, but also to find a way to mitigate the prohibited transaction impact and potentially severe excise tax consequences.

Before getting into the specific facts of the case, let's examine generally whether an expense can be paid from plan assets. The first step is to verify whether the plan - by its written terms - permits the payment of expenses from plan assets. A typical plan expense provision will permit "all reasonable administrative expenses" to be paid from the plan. The quoted language raises the second point in the analysis. That is, is the expense reasonable? If the answer to either one of these questions is no, the plan cannot pay the expense. If, however, the plan document permits the payment of expenses from plan assets and the expense is reasonable, the analysis is still not complete.

The next step in the analysis involves how to categorize the expense. DOL guidance on the subject divides expenses into two types. The first is "settlor expenses," which must be borne by the employer. In general, settlor expenses include the cost of any services provided to establish, terminate or design the plan. The second category is administrative expenses, which - if they are reasonable under all the relevant facts and circumstances - may be paid from the plan. Administrative expenses include fees and costs associated with (i) amending the plan to keep it in compliance with tax laws, (ii) nondiscrimination testing, (iii) obtaining an IRS determination letter ruling and (iv) providing plan information to participants.

Now, with that background in hand, let's move on to the next step in the analysis of whether an expense can be paid from plan assets. That is, who is being paid? In general, if it is non-fiduciary (i.e., a third-party service provider), then the expense can be paid from the plan. This is true notwithstanding ERISA's rule that "parties-in-interest" may not engage in self-dealing with respect to a plan. There is a specific exception for the payment of expenses associated with the provision of reasonable and necessary services to the plan. If, however, the expense relates to services provided by a plan fiduciary, the payment of that expense will more likely result in a prohibited transaction (PT) and the imposition of excise tax. This is because there is no reasonable-and-necessary-services exception under ERISA when it comes to situations in which a fiduciary uses its power to cause itself to be paid additional money. In effect, there is an absolute prohibition against the payment of expenses in this case, unless the expense is approved by another fiduciary unrelated to the fiduciary providing the service. This is especially the case where the employer pays itself or an affiliated entity out of assets of the plan it sponsors for service rendered to that plan.

Now let's turn to the case of our client (the "Client"), which was part of a large controlled group of companies sponsoring a number of retirement plans. The Client, through its related companies, provided a number of administrative services to the various plans of the controlled group. The Client paid the fees for these administrative services out of its corporate assets and then reimbursed itself out of the assets of the plan to which the particular service was rendered. Thus, ultimately, the administrative expenses were all paid from plan assets. The Client was aware of ERISA's rules against self-dealing, but believed all the expenses at issue were eligible for payment from plan assets based on the exception for reasonable and necessary administrative expenses. The Client was unaware, however, that this exception doesn't apply in the case of a plan fiduciary using its power to cause itself to be paid additional money. In addition, the Client had not otherwise understood that in exercising this type of discretion, it had made itself a fiduciary of each of the plans at issue.

We were engaged to help not only with correcting the PTs, but to also determining whether anything could be done to reduce the potentially enormous amount of excise tax due.

Relying on the rule that permits a fiduciary to reimburse itself for its out-of-pocket expenses - that is, its direct costs incurred in performing services for a plan - we engaged in a sophisticated analysis to determine the extent to which the amounts reimbursed to the Client represented direct costs. Our task was difficult due to the absence of records clearly indicating how much of the expense represented actual cost, as opposed to overhead and profit. Therefore, it was necessary for us to develop a set of assumptions, which we believed were reasonable in making this determination.

To gain a sense of comfort regarding those assumptions, we approached Department of Labor (DOL) officials on a no-names basis, and reviewed the assumptions with them. While those communications were non-binding on the government, they did enable us to gain confidence that our correction methodology would be acceptable under any remedial program. Ultimately, we determined the amount of the direct costs to be substantial. This had the effect of significantly reducing the amount that had to be repaid to the plans, as well as the amount of the related excise taxes. We filed an application with the DOL under its Voluntary Fiduciary Correction Program ("VFC").

Under VFC, individuals who could be liable for a fiduciary breach can avoid a DOL civil investigation or other DOL action with respect to that breach. Ultimately, we obtained a "no action" on behalf of our Client, which protected it from penalties under ERISA section 502(1) (which imposes a 20% penalty on the "applicable recovery amount" in a civil action or settlement involving the DOL), and the civil penalties under ERISA Section 502(i).

Even after the favorable result we obtained under VFC, the Client still faced substantial excise taxes for engaging in PTs that involved large amounts and spanned multiple years. Unfortunately, there is not a mechanism under VFC or the IRSf Employee Plans Compliance Resolution System (EPCRS) to mitigate excise taxes. However, we were aware of a seldom-used program that permits the IRS to enter into closing agreements regarding issues that can't be addressed under other correction programs. We will discuss this program, as well as the application we filed on behalf of the Client to resolve the excise tax issues, in a subsequent issue of this newsletter.