The Internal Revenue Code levies an excise tax on certain failures made by, or with respect to, employee benefit plans; section 4975 and the Income Tax Regulations there under describe certain prohibited transactions (PTs) involving plan assets and persons with responsibility for those assets. This section requires an initial excise tax (currently 15%) on the value of direct and indirect transfers or uses of plan assets between the plan and related parties (disqualified persons). The Code requires correction of prohibited transactions by rescission, unwinding, or other method that restores the plan to the same condition it would have enjoyed if the transaction had never occurred; failure to correct activates a second level excise tax (of 100% of the amount involved). Details of these transactions and the computation of the tax are reported to the IRS on Form 5330; the tax liability applies jointly and severally to all parties of a prohibited transaction.
Computation of the tax is complicated due to differing tax treatments for two sub-types of prohibited transactions – discrete (a one time transfer of an asset, such as a sale of stock), or continuing transactions (such as the lending of money or property). In addition, the Code requires the use of a “reasonable” rate of interest for the use of the asset for the duration of the transaction. Calculations are affected by other factors such as multiple tax periods or the presence or absence of interim payments.
Form 5330 is also used for a variety of taxes other than that imposed on prohibited transactions by Code section 4975. Form 5330 may be filed by plan sponsors, trusts, trustees, or other disqualified persons.
The project goals were to determine if the correct computation of taxes on Forms 5330 filed, to ascertain the types of acts that created prohibited transactions, and to ensure proper correction of those prohibited transactions.
Project examination cases were predominantly defined contribution plans, although there were a small number of both defined benefit plans and health/welfare plans; there was also one individual retirement account. There were several bankruptcies, frozen or terminated plans, merged plans, and sponsor mergers. The population included tax-exempt entities as well as for-profit employers. In total, we contacted almost 600 taxpayers.
As preliminary results accumulated, it became apparent that a problematic subset included employers who withheld elective deferrals but did not timely remit them to the plan; this failure constitutes a use of plan assets and is a prohibited transaction. The ensuing reporting error appeared to be due to a misunderstanding by employers that the tax applied to the amount of money rather than the value of the use of the money; as a consequence, many filers were overpaying. The EPCU corrected errors after discussions with the filers and initiated refunds of overpayments where appropriate. The EPCU then contacted other employers in this subset to advise them of the probability of this same error in their plan and how to correct this mistake.
Results of the Project
The Prohibited Transactions encountered in the project originated from a variety of dealings; these included the late deferrals discussed above (42%); improper loans, investments, and distributions (45%); excessive or improper compensation paid to disqualified persons for services (8%); and other kinds (4%). These transactions were either corrected at the conclusion of the examinations or the plans were referred to EP Examination.
Tax calculations reviewed during the examinations showed significant taxpayer errors (69%) in determining the amounts of tax; we found substantially correct calculations in fewer than 25% of returns.
Correction of PTs resulted in restitution to the plans involved of approximately $1.6M. Refunds of overpaid tax for the late deferral segment were in excess of $440,000.