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The IRS Issue Snapshot-Third Party Loans from Plans dated August 23, 2022 is a short advice document for examiners to use when auditing tax-qualified retirement plans that invest in mortgages or other third party loans. IRS Issue Snapshots are often  indicators of likely future audit targets. In the Snapshot the IRS discusses the following issues that may be triggered by third party loans:  (1) a possible prohibited transaction; (2) violation of the exclusive benefit requirement; (3) proper asset valuation; (4) minimum funding violations in defined benefit plans; (5) income tax issues (primarily for the borrower); and (5) fraud.

A prohibited transaction would be triggered if the borrower is a “disqualified person.” The term disqualified person includes the employer, fiduciaries to the plan, service providers to the plan (e.g. attorneys, accountants and actuaries), individuals and entities which have a direct or indirect ownership interest in the employer in excess of a specified percentage, and certain relatives of disqualified persons.

Due to the direct and indirect ownership rules and the inclusion of certain relatives within the definition of disqualified person, determining who is a disqualified person may not be readily apparent to a plan fiduciary when considering extending a loan to a third party.  The first audit step after determining whether there are third party loans held by the plan is whether the loan is made to a disqualified person.  A plan fiduciary considering making loans to third parties must do the same disqualified person analysis.

Rev. Rul. 80-155 requires trust assets for defined contribution plans be valued at least once a year. Failure to properly value the third party loans may trigger qualification problems for defined contribution plans.  For defined benefit plans, funding is determined using the value of plan assets. If the third party loans are overstated or are deemed to be uncollectable they may trigger excise taxes for failure to satisfy minimum funding requirements under Internal Revenue Code Section 412 and/or failure to limit the form of payment options under Internal Revenue Code Section 430 due to plan underfunding.

The Snapshot directs examiners to be alert for fraud. “Attempting to avoid [possible adverse consequences of third party loans] may present opportunities for fraudulent reporting and recordation to attempt to otherwise describe plan investments as compliant.”  The IRS strongly suggests that fraud may permeate third party loans.

If there are third party loans in your plan’s investment portfolio, this is a good time to conduct a self-audit.  The members of our Employee Benefits Section are happy to assist you with the self-audit process and, if necessary, corrections of any problems detected. Please contact Sharon Freilich, George Kasper, or Zachary Zeid.