SOLUTIONS IN A FLASH – RETIREMENT PLAN CORRECTION SOLUTION: THE DEVIL INVESTS IN REAL ESTATE

By: Alison J. Cohen, Esq.

Miranda is a strong-minded business owner and is always looking for a good deal. Andy, her third party administrator (“TPA”), is slightly frightened of Miranda and never wants to let her down. And honestly, Miranda isn’t happy unless everyone around her is panicked, nauseous, or suicidal. And so, when Andy attends a cocktail party and hears from a local accountant about how his client was able to purchase a great piece of real estate with funds from the company’s retirement plan, she immediately thinks of Miranda.

At the next annual meeting with Miranda, Andy mentions what she heard at the cocktail party and advises Miranda to discuss the option with her attorney and her CPA. Miranda sees the real estate option as a great opportunity and immediately afterwards takes action to sell the company’s business location (which she owns personally) to the Plan. From that moment forward, Andy starts reporting the value of this real property on the Plan’s valuation as an investment in Miranda’s account, never asking whether Miranda’s other advisors were consulted. (She also never probes why Miranda shows the value of the property each year at the original purchase price.) The company never pays rent to the Plan for the property.

Fast forward six years and Miranda is in the process of potentially selling her business. Her long-term business attorney, Nigel, is reviewing all assets to determine a reasonable offer to present to the prospective buyer. Nigel learns that the property housing the company is owned by Miranda’s account in the Plan and quickly realizes that there’s a problem. He immediately calls a meeting with Andy and the CPA, “All right everyone – gird your loins! Miranda is not going to like this.”

Nigel quickly explains that by using the company’s retirement Plan money to buy the business premises from Miranda, even though it was Miranda’s account only, there was a prohibited transaction. Another prohibited transaction resulted when the company used the property that was owned by the Plan to its own benefit (a rent-free windfall!). And, as a result, Miranda is going to owe excise taxes and the transaction will need to be reversed. Everyone gasps.

Miranda walks into the room. Everyone just stares. Miranda says dryly, “By all means, move at a glacial pace. You know how that thrills me.”

With a deep breath, Nigel outlines the problem.

Can a Retirement Plan Hold Real Estate?

Yes, absolutely. It can be an operational nightmare, but if done correctly, it is a perfectly good investment for a retirement plan. The devil is in the details, and some devils wear Jimmy Choos.

When a plan uses its assets to purchase real estate, even if those assets are in a participant’s individual account, that real estate must be purchased from, and used exclusively by, an unrelated third party. In other words, it was fine for Miranda to use her own account dollars to purchase commercial real estate from a third party. She could have then leased that office property to an unrelated company and been just fine.

However, under the Internal Revenue Code (the “Code”) and the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), certain parties are considered to be Disqualified Persons or Parties-in-Interest, respectively, and this can lead to prohibited transactions. These parties include people and entities such as the company whose employees are covered by the plan, the company’s owners, any additional plan sponsors, plan fiduciaries, certain relatives of the plan sponsor and its owners, some employees, and some business partners of the listed people and entities.

The company and Miranda are both Parties-in-Interest and so, by definition, Miranda’s sale of the property to the Plan and the use of the property by the company are both prohibited transactions.

There are some exemptions to the prohibited transaction rules. In particular, a plan may own “qualifying employer real property” and lease it to the employer. An answer! Not so fast: the law further requires (among other rules) that qualifying employer real property be a substantial number of parcels of property dispersed geographically, and that the company pay appropriate (i.e., market-driven) rent. In this instance, because the Plan’s only real estate is one parcel of land, and the Plan never charged the company for renting the property, it is not qualifying employer real property, and the exemption does not apply.  (In any event, this exemption would only have solved the rental-related prohibited transaction, but would not have made the initial purchase transaction permissible.)

Other prohibited transaction rules prohibit “self-dealing” by a fiduciary – i.e., a fiduciary benefiting from a plan transaction. By allowing the company to move into the property, and not pay any sort of rent, Miranda and the company – both of which are fiduciaries to the Plan — also benefited from the transaction.

How Can This Prohibited Transaction Be Corrected?

The Department of Labor (“DOL”) has the Voluntary Fiduciary Correction Program (“VFCP”), which is designed to fix prohibited transactions just like this one. What has happened to Miranda is a perfect example of when it should be used.

The first thing Nigel explains to Miranda is that she will either need to sell the real estate to an unrelated third party, rebuy the asset from the Plan at its current fair market value (or, if greater, the amount paid for the property by the Plan, plus lost earnings on that amount for the interim period), or move the company out of the location. While none of these solutions sound appealing, Miranda eventually comes to realize that she can easily sell the property for a reasonable amount. As she’s going to be selling the business, she wouldn’t need the property moving forward, so it all works out.

The next challenge is to identify the value of the property, both now and at the time of purchase, and determine what the rent should have been for the years during which the company was using the real estate. For this process, Nigel consults with a real estate appraiser, Emily, who provides him with an opinion on both issues. The company must pay the Plan fair market value, adjusted for earnings. Also, an excise tax equal to 15% of the fair market rental amount may need to be paid to the IRS for each year, plus interest and late payment penalties.

Last, a filing should be made to the DOL under VFCP. If this is done and accepted by the DOL, Miranda will receive a letter, advising her that the DOL will take no further enforcement action in relation to the transaction. In some circumstances, this filing will qualify the situation for excise tax relief under DOL Prohibited Transaction Exemption 2002-51 (as modified in 2025). Nigel needs to review the requirements for that exemption to see if it applies. If it does, that will save Miranda a lot of money.

If the above exemption from excise taxes does not apply, Nigel has one additional tool in his toolbelt. He could also file with the Internal Revenue Service (“IRS”) Voluntary Closing Agreement Program (“VCAP”) to fully protect his client from potential liability. VCAP is designed to resolve tax-related issues involving retirement plans that cannot be resolved through the IRS’s Voluntary Correction Program. The value of this type of filing is that the IRS will negotiate with Nigel in relation to the amount of taxes and penalties due and no Forms 5330 usually need to be filed. It is likely that the full excise tax and interest will still be due, but the IRS may waive or reduce any late filing and late payment penalties. With so many years involved, those penalties may be significant.

The downside to VCAP is that the process is very time consuming, often taking two to three years to come to a resolution during which the IRS may continue to accrue interest. Further, there is no guarantee that the IRS will waive the penalties as part of the program.

Where Does This Leave Poor Andy?

Needless to say, Miranda isn’t a real ‘forgive and forget’ kind of woman and mitigating details of what she sees as incompetence don’t interest her. She insists that Nigel threaten Andy with a massive lawsuit for the damages and penalties Miranda will incur, including legal fees. Andy is completely overwhelmed but has the presence of mind to file a claim with her errors and omissions (“E&O”) insurance carrier.

A TPA’s E&O policy typically only covers services that the TPA outlines in its service agreement. Sadly, for Andy, the failure in this instance was due to providing ‘investment advice’ to Miranda. The E&O insurer, therefore, denies the claim; Andy won’t have any financial support to get through this experience.

Lessons Learned

When something sounds too good to be true, it usually is. Before anyone grabs a piece of advice at a cocktail party, along with a glass of wine, it is critical to make sure that the accuracy of that advice is thoroughly vetted. And, always know your boundaries. The best intentions can leave you out in the cold without a cerulean sweater.

Second, as a TPA, Andy should learn to keep her eyes open for situations that reek of danger. When Andy saw the real estate as a Plan asset, she should have asked Miranda about whether she got the professional advice Andy told her to get, what the real property was being used for, and whether it was being rented (so that rent income was expected). It would also have been wise for Andy to ask Miranda for proof of ownership by the Plan, as it is common that company owners “accidentally” put the deed in their own name to facilitate the transaction, and often have personal mortgages against the property. That could be interpreted as an improper distribution (a possible disqualifying failure) or a misuse of plan assets by the owner.

Third, it would have helped if Andy had followed up her “you should buy real estate” conversation with Miranda with an email that outlined that she heard this at a cocktail party, that she was not making a recommendation but just letting Miranda know about a possible opportunity, and that Miranda must get legal and accounting advice before taking such a step. This would have gone a long way toward defraying any claim by Miranda that Andy gave investment advice and was liable for the ramifications of the transaction.

And, finally, if you find yourself with a client like Miranda, and real estate that reeks of prohibited transaction, remember that the Ferenczy Nerd Herd™ is here to be your ERISA Solution.

For more information about real estate transactions in retirement plans, check out Ilene’s article from the Journal of Pension Benefits on the topic.