What is the Plan Asset Rule?

The plan asset rule, among other things, is used to determine whether or not a retirement plan is involved in a prohibited transaction.

A PT happens when a plan enters into a transaction with a disqualified person. In our previous post, we covered how to make a list of disqualified persons for a specific plan. This included determining whether a partnership, LLC, corporation (or other entity) is a DQP itself because of significant ownership by other DQPs.

A prohibited transaction occurs when all three factors are present: a DQP, a plan, and a transaction between the two. So, from the previous post we know how to determine if an entity is considered to be a DQP itself. But how do we know if an entity is considered to be a plan?

Plan asset look-through

…is the term DOL uses (The U.S. Department of Labor, DOL, is the government entity that solely has the authority and responsibility to interpret prohibited transactions code). If a situation does have plan asset look-through it means that you look through an entity to the plan and consider the assets of the entity to be the assets of the plan itself. This also means that when you do have plan asset look-through, that entity is treated as if it is the plan itself for PT purposes. That would mean that that entity could not transact with a disqualified person.

When is there plan asset look-through?

The first hard and fast rule is that when an entity is owned 100% by a plan, there is plan asset look-through. So if your Solo 401(k) was 100% owner of an LLC (or any other type of entity) then that LLC would be seen as if it were the plan itself for purposes of PT determination.

The second rule is that when a plan owns 25% or more of an entity, there is plan asset look-through. I know you have a scrunched up face right now because the second rule seemingly makes the first rule unnecessary. This second rule isn’t hard and fast like the first rule. This rule does not apply if you have an “operating company”.

What is an operating company?

This is where the fun starts.

An operating company is one that primarily makes or sells a product or service other than the investment of money.

A real estate operating company is one where at least 50% of its assets (valued at cost) are invested into managed real estate or real estate development, provided that the entity is directly engaged in the management or development activities.

So, back to plan asset look-through… If you have an operating company, the there is only look through if a plan owns 100% of the operating company. If you don’t have an operating company, there is look through if the plan owns 25% or more of the company.

At first glance you may think “wow, there are some major benefits to investing in an operating company”. I partially disagree. Firstly, your plan is intended for passive investment. An operating company suggests that its owners are engaging in a business activity which might subject the plan to UBIT tax (35% tax on almost all of the income from the entity rather than just the income attributable to leveraged) and it might even create a PT if the accountholder/participant is engaged in the management or development activities. You see, a plan can’t operate a business, so if it owns something that is a business, the reality is that the plan’s accountholder or participant is operating the business, and that is a no-no.

Secondly, the only benefit to intentionally creating an operating company for the purposes of skirting the plan asset rule would be if you intend to involve a DQP with your plan. That intent alone starts you off on the wrong foot.

To simplify, an entity is a plan if significantly (25% or more) owned by a plan. An entity is a DQP if it is significantly (50% or more) owned by other DQPs.

Let’s use an example. XYZ Corp is 35% owned by Rachel’s IRA. Rachel’s mother owns 60% of ABC, LLC. Rachel and her mom are thinking of directing XYZ to lease a property it owns to ABC, LLC. Because of the significant ownership on both sides, this is what it looks like:

ABC, LLC XYZ Corp
Owned 60% by Rachel’s mother Owned 35% by Rachel’s IRA
A Prohibited Transaction

…and it is a prohibited transaction. Some people even go to the extent of officially requesting a PT exception from DOL in order to execute a transaction such as this. To me, this is silly. DOL would only consider granting such an exception if the lease were for market value to ensure that a DQP isn’t getting special use of plan assets or vice versa. If the proposed lease were for market value, then ABC, LLC shouldn’t have a problem finding another leasee who isn’t a DQP. With the same logic, XYZ Corp shouldn’t have a problem finding another leasor who isn’t a plan. All things considered, this type of transaction should just be avoided completely.

Finding out if a proposed transaction is possibly a PT should follow this simple process:

  1. Is there a plan? (follow the plan asset look-through rules) If yes, continue to next question…
  2. Is there a disqualified person? (refer to the DQP list you made) If yes, continue to next question…
  3. Is there a transaction between the two? If yes, you probably have a PT; don’t follow through with it.

I would follow that actual order so that you can reach your answer as quick as possible. There’s no harm in walking away from a transaction because it might be prohibited, but inversely if you are pretty sure something is not a PT, but there is a DQP involved somewhere/somehow… check with a qualified attorney before proceeding.

Following that step by step process to attain the peace of mind that your transactions are building your wealth rather than risking it to hefty tax penalties.

Reader Interactions

Comments

  1. Hi,
    How does intellectual property play into the plan asset rule? I have a motion picture that contains original songs, etc. that I would like to have the plan own certain parts of. In light of the swanson decision, can one just assign rights to the plan and begin collecting royalities?
    Thanks,
    Jon

    PS: I know this is a blog and not legal/tax advice. Just curious what you think.

  2. Hi Jon. It’s great to see you are thinking outside the box. Intellectual property will be treated the same as any other property when it comes to the prospect of the plan acquiring it.

    It sounds like you, personally, own some IP that you’d like to get into your plan. If that’s the case, unfortunately, to transfer ownership from yourself (a DQP) to your plan would likely be a prohibited transaction. If you haven’t already done so, also check out the post called “Prohibited Transaction Basics”.

    On the other hand, if the IP you are referring to is owned by someone else (who isn’t a DQP), then it may be possible for your plan to buy it from them. The challenge would be in substantiating that you personally receive no direct or indirect benefit from directing your plan to do so. That may be tough or impossible.

    I’m not sure what “I have a motion picture” means. It sounds like you wrote, produced, directed, and/or invested in (or something similar) this film. If that’s the case, I’d suggest you keep your plan out of what you’re in, and consider using your connections in the motion picture business to find an alternative IP investment that passes the PT sniff test with flying colors – one in which you have no personal involvement.

  3. Thanks Jeff for the fast response. To your question about “having a motion picture” and what that means, I will elaborate. Last year I raised about fifty grand and founded an LLC to produce a motion picture. In case you (or your readers) don’t know, fifty grand as a movie budget is significantly less than most films in theaters. So it’s probably not going to go anywhere and do significant business, but I think as an example it’s illustrative of what I would like to do on future projects. All of the copyrights and such belong to the LLC. Anyways, so now I have this LLC and all of the property rights associated with it and I would like to splinter the international distribution rights off and assign it to the plan.

    Based on what you’ve said, this is not possible at this stage in the game. Frankly, I figured as much. The self dealing rules are pretty straightforward. However, if I had founded the movie LLC through the plan or somehow found a way to work it in, could it be possible to have some of the profits flow into the plan?
    -Jon
    PS: For clarity, again, I am aware this is just a blog and does not in any way constitute legal or tax advice. As you can tell, I am very curious how to take advantage of retirement planning. Thanks!

  4. It may have been possible to involve the plan from the beginning without breaking the rules. I’ll elaborate in a new post in the near future. If you haven’t already done so, feel free to subscribe to this blog. Read the post “How to use my blog” for details.

  5. Jeff – do family attribution rules of 4975(e)(2)(F) apply in determining whether or not an operating company is 100% owned by the IRA and IRA Owner? In our case, we have an opeating company that is currently owned 1/3 by a husband and wife LLC and two other unrelated parties. The husband and wife want to buy out the unrelated parties using IRA funds (their own and the IRA funds of the husband’s mother). So the ending owners after the buyout would be the original husband and wife LLC, the husband’s IRA, the wife’s IRA and the mother’s IRA. Does this make the assets of the operating company “plan assets” thereby paying salary to the husband a prohibited transaction?

  6. Jeff, I am currently a physician in a 2 member group. I would like to relinquish my ownership and remain an employee only. I would then form an Roth IRA owned billing service and provide the previous corporation with health information technology that it didn’t have previously. Since I would no longer be an owner, would I be a disqualified person as a non-owner employee?
    Thanks, CG

  7. If a corporation has no assets, no capital, no employees, and no operations, but there is still a pension plan that exists with assets, and has not been terminated exclusively because its real property assets have not been sold.
    Is the corporation liable for any franchise taxes for 2013?

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