January 16, 1996
Ms. Evelyn Petschek
Director, Employee Plans Division
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224
Dear Ms. Petschek:
On October 13, 1994, the Internal Revenue Service (the Service) issued National Office Technical Advice Memorandum 9503002 (the TAM) regarding the use of pre-tax salary reduction contributions to repay an exempt loan to a leveraged ESOP. While the TAM was limited to the application of sections 401(a)(2) and 4975(e)(7) of the Internal Revenue Code of 1986 (the Code), the issues addressed in the TAM also implicate the fiduciary provisions under Title I of ERISA. As a result, the Department has received a number of inquiries as to how the Department's analysis of the fiduciary provisions under Title I comports with the Service's interpretation of Treasury regulations, as reflected in the subject TAM. Inasmuch as the Department's analysis under Title I differs from the Service's interpretation under the Code, we request that the Service reconsider its views on this matter.
Specifically, the TAM addressed the issue of the permissibility of the application of pre-tax salary reduction contributions to the repayment of an exempt ESOP loan under the exclusive benefit rule of section 401(a)(2) of the Code and the regulation which provides the permissible assets for repayment of an exempt loan at § 54.4975-7(b)(5). The Service concluded that because such contributions constitute employer contributions under the regulation at § 1.401(k)-1(a)(4)(ii), such contributions could be applied to payments under an exempt loan without violating the exclusive benefit rule under the Code.
We believe the use of pre-tax salary reduction contributions for payments under an exempt loan raises issues both with respect to the primary benefit test under section 408(b)(3) of ERISA as well as with respect to the exclusive purpose requirements of sections 403 and 404 of ERISA.
Unlike the Service's position under the Code, it is the Department's view that amounts that a participant pays to or has withheld by an employer, whether pursuant to a salary reduction agreement or otherwise, for contribution to an employee benefit plan constitute participant contributions for purposes of Subtitle A of Parts 1 and 4 of Subtitle B of Title I of ERISA and for purposes of the prohibited transaction provisions of section 4975 of the Code. (See 29 C.F.R. 2510.3-102 and Preamble to Final Regulations under Section 401(k), 53 FR 29660, (August 8, 1988)).
Section 406(a)(1)(B) of ERISA prohibits the lending of money or other extension of credit, including a guarantee of a loan,(1) between a plan and a party in interest. An employer that sponsors a plan is a party in interest with respect to the plan, under section 3(14)(C) of ERISA. Therefore, a sponsor's loan to a plan or guarantee of a loan to a plan would be prohibited in the absence of a statutory or administrative exemption. Section 408(b)(3) of ERISA provides a conditional exemption for loans to employee stock ownership plans if, among other requirements, the loan is "primarily for the benefit of the participants and beneficiaries."
It is generally understood that an exempt loan to an ESOP is secured primarily by an employer's guarantee of the loan and agreement to make annual contributions to the plan sufficient to meet the plan's obligation to repay the principal and interest due under the loan arrangement.(2) As recognized in the TAM regarding the arrangement in question, the employer, by using the salary reduction contributions to satisfy part of the loan obligation, is able to reduce the total amount of matching and discretionary contributions it must pay. The use of participant contributions to repay the exempt loan thus serves directly to relieve the employer of its obligation to contribute to the plan. In addition, such use of participant contributions causes participants to forego other investment opportunities which might prove more beneficial to the participants than the securities purchased under the loan. For these reasons we do not believe that a loan which is structured to be repaid with participant contributions would satisfy the general requirement under ERISA section 408(b)(3) that an exempt loan must be primarily for the benefit of the ESOP's participants and beneficiaries.
In addition, the Department believes that the use of the participant contributions to repay the acquisition loan raises additional concerns under sections 403 and 404 of ERISA. Section 403(c)(1) of ERISA provides, in part, that:
The assets of a plan shall never inure to the benefit of any employer and shall be held for the exclusive purposes of providing benefits to participants in the plan and their beneficiaries and defraying reasonable expenses of administering the plan.
ERISA section 404(a)(1)(A) provides, in part, that:
A fiduciary shall discharge his [or her] duties solely in the interest of the participants and their beneficiaries and (A) for the exclusive purpose of (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan.
It is the view of the Department that when the primary benefit requirement is not met, then there would also be a violation of the "exclusive purpose" and "solely in the interest" requirements of sections 403 and 404 of ERISA.
We hope this information is of assistance to you. Should you have any questions regarding this matter, please do not hesitate to contact me.
Robert J. Doyle
Director of Regulations and Interpretations
- See Conference Report accompanying ERISA, H.R. Rep. No. 1280, 93rd Cong., 2d Sess. 308 (1974).
- See S. Rep. No. 94-34, 94th Cong., 1st Sess., 58-59 (1975).