A recent IRS issue snapshot addresses compliance concerns about qualified plan investments in third-party loans. Although issue snapshots don’t provide new guidance or information, they highlight the issues IRS agents may review during plan audits.
Third-party loans raise compliance concerns
Neither the Internal Revenue Code (IRC) nor ERISA prohibits a qualified retirement plan from investing in third-party loans, but IRS considers such transactions especially susceptible to fraudulent reporting. The snapshot flags several potential concerns, including the following of most interest to plan sponsors:
- Prohibited transactions. Plans may not lend money — even indirectly — to disqualified persons, including the employer, fiduciaries and service providers like accountants and attorneys. Plans also may not make a loan that benefits a disqualified person. The snapshot directs auditors to scrutinize loans offering obviously unfavorable terms to the plan.
- Exclusive benefit. Plan assets may only be used for the exclusive benefit of plan participants and beneficiaries. While this doesn’t rule out third-party loans, auditors will look to confirm that the primary purpose of a loan is to benefit participants. IRS agents pursuing a potential violation of the exclusive benefit rule or a violation of ERISA’s fiduciary standards on plan asset management must refer the case to the Department of Labor.
- Asset valuations. IRC Section 401(a) requires defined contribution plans to value plan assets at least once a year and derive the fair market value, so auditors will review Form 5500 filings for asset loan values that vary little from year to year. Filings with little variation may indicate that loan payments aren’t being made or the fair market value isn’t being determined or reported.
- Minimum funding. Overvaluing a plan loan — including failing to properly account for any defaulted loans deemed uncollectible — will overstate a defined benefit plan’s funded status. This could lead to a plan failing to satisfy its minimum funding requirements or to fully comply with IRC Section 436 benefit restrictions.
- Third-party loans from plans (IRS, Aug. 23, 2022)