PLR 201007077: Restorative payments for investment-fraud losses will not count as plan contributions and will be deductible business expenses

Plain-English summary

An employer sponsored a defined-contribution plan whose profit-sharing assets had been invested with a broker-dealer later accused of widespread fraud. The employer proposed payments to restore losses for affected participants, with allocations calculated by independent consultants and a fiduciary. The IRS ruled that the payments would be restorative payments rather than contributions, would not jeopardize the plan's qualified status or create taxable income for affected participants, and would be deductible to the employer as ordinary and necessary business expenses. The conclusions applied under IRC §§ 162, 401(a), 402(a)(1), 404, 415, and 4972, subject to the plan and trust otherwise meeting the stated requirements.

Ruling snapshot

• Question: May an employer make restorative payments to a defined-contribution plan for investment-fraud losses without treating the payments as contributions or taxable participant income?
• Outcome: Approved, four requested rulings granted
• Key authorities: IRC §§ 162, 401(a), 401(a)(4), 402(a)(1), 404, 415, 4972, and 501(a); Treas. Reg. § 1.415(c)-1(b)(2)(ii)(C); Rev. Rul. 2002-45

Full text (IRS public release)

201007077

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

NOV 24 2009
SE:T:EP:RA:T4

U.I.L. 162.02-00, 401.04-00, 402.00-00, 404.00-00, 415.02-00, 4972.04-03

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Legend:

Employer M = xxxxx
Plan X = XXXXX
Individual B = xxxxx
Company C = xxxxx
Date 1 = xxxxx
Date 2 = xxxxx
Year 1 = xxxxx

Date 3 = xxxxx
Amount N = xxxxx
Date 4 = xxx

Date 5 = xxxxx
Date 6 = xxxxx
Amount O = xxxxx
Company D = xxxxx

Date 7 = xxxxx

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Date 8 = xxxxx
Company E = xxxxx
Amount P = xxxxx

Amount Q = xxxxx

This is in response to a request dated April 14, 2009, as amended by
correspondence dated July 24, 2009, submitted by your authorized
representative on your behalf, concerning the characterization and tax
consequences of certain proposed payments to a defined contribution plan.

The following facts and representations in support of your request have been
submitted under penalties of perjury:

Employer M sponsors Plan X for the benefit of its employees. Plan X is a defined
contribution plan, established and originally effective Date 1. Plan X was
restated on Date 2.

Plan X is represented to be qualified under section 401(a) of the Internal
Revenue Code (“Code”) and its trust exempt from tax pursuant to section 501(a)
of the Code. Plan X is comprised of a profit-sharing component (the “P-S
component”) and a qualified cash or deferred arrangement described under
section 401(k)(2) of the Code (the “401(k) component”).

Employer M makes employer contributions on a discretionary basis to the P-S
component of Plan X. Employer M makes employer contributions on a matching
basis to the 401(k) component of Plan X. Participants contribute to the 401(k)
component on a pre-tax basis.

Decisions regarding investment of the P-S component of Plan X are made by
Employer M.

Decisions regarding investment of each Plan X participant’s interest in the 401(k)
component of Plan X are made by each participant with respect to his or her
individual account.

In Year 1, the investment management of a portion of the assets of the P-S
component of Plan X was shifted to Company C, a registered broker-dealer. For
each year of the 13 years following Year 1, Employer M made annual
discretionary contributions to the P-S component. For each year of the 13 years
following Year 1, the investment of Employer M’s annual contributions to the P-S
component were invested with Company C. Employer M represents that during

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this period it received regular account statements from Company C, the accounts
showed positive returns, distribution requests were honored on a timely basis,
and other related operations for this account were in order.

On Date 3, Individual B, the president and founder of Company C, was charged
publicly with engaging in a scheme which had resulted in the widespread
depletion of assets which had been placed under the management of Company
C for investment. One day following Date 3, the Securities Investor Protection
Corporation (SIPC) took control of Company C. Three days later, Company C
filed for protection under Chapter 11 of the Bankruptcy Act.

Upon learning of the charges against Individual B and of the status of Company
C, Employer M commenced a campaign to protect the interests of affected Plan
X participants. To that end, Employer M filed a claim with the SIPC on behalf of
Plan X and on behalf of each participant in Plan X.

Employer M also notified and requested coverage from its employee benefits
plan administration liability insurer, fiduciary liability insurer and crime loss
insurer. Employer M’s corporate bylaws provide that its officers are entitled to
indemnification from Employer M if a breach of fiduciary duty were found to have
occurred.

Employer M’s commitment to retrieve plan assets and restore the accounts of
P-S component participants is overshadowed by prediction that only a small
portion of the investments lost by Company C will be recovered. Depletion of the
assets of thousands of accounts of investors who had invested with Company C
over a period of several decades has overwhelmed the claim process under
SIPC.

The total amount of employer contributions to the P-S component which were
invested with Company C between Year 1 and Date 3 for affected participants
who suffered loss due to the Company C fraud is Amount N.

It is represented that no participant 401(k) or matching contributions to the 401(k)
component of Plan X were invested with Company C.

Employer M represents that it became concerned that participants would initiate
legal action against it. In addition, on Date 4, Employer M received notice from
the U.S. Department of Labor (DOL) that the DOL was conducting an
investigation of Plan X to determine whether any person had violated Title I of
Employee Retirement Income Security Act of 1974 (ERISA). Enclosed with the
notice was a subpoena requiring Employer M to produce documents and
records.

In response to these events, Employer M proposes to make a restorative
payment to Plan X that would put the P-S component of Plan X in the financial

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position it would have been in had employer contributions been invested other
than with Company C during the relevant period. The proposed restorative
payment is intended to apply to all current and former participants whose
accounts were adversely affected by the investment with Company C.
Effective Date 5, an addendum to the adoption agreement to Plan X was
amended to permit Employer M to make a restorative payment, as defined in
section 1.415(c)-1(b)(2)(ii)(C) of the Income Tax Regulations (Regulations), to
the P-S component of Plan X.

On Date 6, as an interim remedial measure, Employer M made a cash payment
of Amount O, representing a material percentage of the Employer M
contributions made to Plan X and invested in Company C, adjusted by an
earnings rate that Plan X would have experienced had it invested in a typical
blend of securities during the period. The determination as to the appropriate
earnings rate was made by Company D, an independent financial consulting firm
which advises plan fiduciaries with respect to plan investment matters, and which
was engaged by Employer M for this purpose.

After Company D determined the appropriate earnings rate, the specific
allocations to participant accounts was performed by Company E, an
independent fiduciary engaged to complete that task and determine whether the
remedial plan as a whole is fair to participants and serves their best interests.
Prior to this engagement, an affiliate of Company E served as an investment
advisor to the 401(k) component of Plan X with respect to the selection of
investment options available to participants. Employer M represents that neither
Company D nor Company E has other relationships with Employer M, and each
has acted as an independent consultant and as an independent fiduciary,
respectively, with respect to this matter.

Employer M represents that the interim remedial payment to Plan X in the
amount of Amount O on Date 6 has been invested within Plan X and will be
allocated to affected participants’ accounts, adjusted by earnings or losses, upon
receipt of a favorable ruling.

With respect to the remaining Employer M contributions lost due to the Company
C fraud, as adjusted by the earnings rate determined by Company D, plus an
amount representing forfeitures for the period at issue, Employer M proposes to
make additional restorative payments to Plan X. The first additional restorative
payment would be in the amount of Amount P and allocation would be deferred
until receipt of a ruling from IRS. The amount of the final restorative payment
would be an amount that when combined with the initial and additional restorative
payments would equal Company M contributions made to Plan X and invested
with Company C with respect to affected Plan X participants, adjusted for
earnings and losses at the rate determined by Company D, with such amount to
be allocated to affected participants in accordance with the calculations prepared
by Company E. The final restorative payment amount will be increased by

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Amount Q, which represents no less than the total amount of all forfeitures for the
relevant period.

Based on the preceding facts and representations, your authorized
representative has requested the following rulings on your behalf:

1. The payments made pursuant to the proposed transaction will not constitute a
“contribution” or other payment subject to the provisions of either Code section
404 or Code section 4972.

2. The payments made pursuant to the proposed transaction will not adversely
affect the qualified status of the Plan pursuant to either Code section 401(a)(4) or
Code section 415.

3. The payments made pursuant to the proposed transaction will not, when
made, result in taxable income to affected Plan participants or beneficiaries
under Code section 402(a)(1).

4. The payments made pursuant to the proposed transaction will be deductible
by the Employer under Code section 162 as an ordinary and necessary business
expense.

With respect to ruling requests one, two and three, section 401(a)(4) of the Code
provides generally that the contributions or benefits provided under a qualified
plan may not discriminate in favor of highly compensated employees.

Section 402(a) of the Code generally provides that any amount actually
distributed to any distributee by an employees’ trust described in section Code
401(a) which is exempt from tax under Code section 501(a) shall not be taxable
to a participant until actually distributed to the participant.

Section 404(a) of the Code generally provides that contributions paid by an
employer to or under a stock bonus, pension, profit-sharing, or annuity plan, if
otherwise deductible, are deductible under section 404, subject to the limitations
under section 404(a).

Section 415(a) of the Code provides, in part, that a trust which is part of a
pension, profit-sharing or stock bonus plan shall not constitute a qualified trust
under Code section 401(a) if in the case of a defined contribution plan,
contributions and other additions under the plan with respect to any participant
for any taxable year exceed the limitations of section 415(c).

Section 1.415(c)-1(b)(2)(i) of the Regulations provides that the term “annual
additions” includes employer contributions credited to the participant’s account
for the limitation year. Section 1.415(c)-1(b)(2)(ii)(C) of the Regulations provides
that a restorative payment that is allocated to a participant’s account does not

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give rise to an annual addition for any limitation year. For this purpose,
restorative payments are payments made to restore losses to a plan resulting
from actions by a fiduciary for which there is reasonable risk of liability for breach
of a fiduciary duty under Title 1 of ERISA or under other applicable federal or
state law, where plan participants who are similarly situated are treated similarly
with respect to the payments. Generally, payments to a defined contribution plan
are restorative payments only if the payments are made in order to restore some
or all of the plan’s losses due to an action (or a failure to act) that creates a
reasonable risk of liability for such a breach of fiduciary duty (other than a breach
of fiduciary duty arising from failure to remit contributions to the plan). This
includes payments to a plan made pursuant to a Department of Labor order, the
Department of Labor’s Voluntary Fiduciary Correction Program, or a court-
approved settlement to restore losses to a qualified defined contribution plan on
account of the breach of fiduciary duty (other than a breach of fiduciary duty
arising from failure to remit contributions to the plan). Payments made to a plan
to make up for losses due merely to market fluctuations and other payments that
are not made on account of a reasonable risk of liability for breach of a fiduciary
duty under Title 1 of ERISA are not restorative payments and generally constitute
contributions that give rise to annual additions.

Section 4972 of the Code imposes on an employer a ten percent excise tax on
the amount of the nondeductible contributions made to any “qualified employer
plan”, including a plan qualified under Code section 401(a).

Section 4972(c) of the Code defines “nondeductible contributions” as the excess
(if any) of the amount contributed for the taxable year by the employer to or
under such plan over the amount allowable as a deduction under Code section
404 for such contributions (determined without regard to subsection (e) thereof),
and the amount determined under subsection (c) for the preceding year reduced
by the sum of the portion of the amount so determined returned to the employer
during the taxable year and the portion of the amount so determined deductible
under Code section 404 for the taxable year (determined without regard to
subsection (e) thereof).

Revenue Ruling 2002-45, 2002-2 C.B. 116 ("Rev. Rul. 2002-45"), applies a facts
and circumstances test to determine whether a payment to a plan qualified under
Code section 401(a) is a restorative payment or a contribution to the plan. Under
Rev. Rul. 2002-45, payments made merely to replenish a participant's account in
a defined contribution plan after investment losses are to be treated as
contributions. On the other hand, payments that are made to restore some or all
of the account's losses due to an action (or failure to act) that creates a
reasonable risk of liability are restorative payments. In addition, in order to be a
restorative payment, the payment does not need to be the result of legal action; it
only needs to be made as a result of a reasonable determination that there is a
reasonable risk of liability. Rev. Rul. 2002-45 also provides that the amount of a
restorative payment cannot exceed the initial amount of the investment.

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Applying the reasoning of Rev. Rul. 2002-45 in this case, Employer M has made
a reasonable determination that there was a reasonable risk of liability for breach
of fiduciary duty as a result of the losses sustained by Plan X through the
fraudulent action of Company C. In addition, the payments which Employer M
intends to make to Plan X are designed to ensure that the affected participants of
the P-S component of Plan X recover a significant portion of their account
balances and that such participants are restored to a position similar to that in
which such participants would have been in the absence of Employer M’s
decision to invest assets of the P-S component of Plan X with Company C.

Thus, it is reasonable to characterize this payment as a restorative payment
rather than as a plan contribution or as an annual addition.

As indicated by the facts of this case, the restorative payments will be allocated
to all affected participants according to the value of the accounts of the affected
Plan X participants as determined by Employer M and as calculated
independently by Company E.

Thus, based on the above, we conclude that the restorative payments both paid
and to be paid pursuant to the proposed transaction will not constitute a
contribution or other payment subject to the provisions of either Code section 404
or Code section 4972; will not adversely affect the qualified status of
Plan X pursuant to either Code section 401(a)(4) or Code section 415; and will
not, when made, result in taxable income to affected Plan X participants or
beneficiaries under Code section 402(a)(1).

With respect to ruling request four, section 162 of the Code provides that there
shall be allowed as a deduction all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or business.

The situation in which Employer M finds itself arose in the ordinary course of its
trade or business. There is no serious question of its business origin.
Substantial authority holds that payments of the type described herein are
ordinary and necessary and therefore deductible as business expenses. See
Welch v. Helvering, 290 U.S. 111 (1933); Laurence M. Marks v. Commissioner,
27 T.C. 464 (1956), acq., 1966-2 C.B. 2; Old Town Corp. v. Commissioner, 37
T.C. 845, (1962), acq., 1962-2 C.B. 5.

Therefore, with respect to ruling request four, we conclude that the restorative
payments made by Employer M to Plan X are deductible by Employer M under
Code section 162 as ordinary and necessary business expenses.

This ruling is based on the assumption that Plan X otherwise meets the
requirements of section 401(a) of the Code and that its related trust is tax-exempt
within the meaning of Code section 501(a). No opinion is expressed as to the
Federal income tax consequences of the transactions described above under
any other provisions of the Code.

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This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)
of the Code provides that it may not be used or cited as precedent.

Pursuant to a power of attorney on file with this office, a copy of this letter ruling
is being sent to your authorized representative.

If you wish to inquire about this ruling, please contact xxxxx, I.D. # xxxxx, by
telephone at xxxxx. Please address all correspondence to SE:T:EP:RA:T4.

Sincerely yours,

Laura B. Warshawsky, Manager
Employee Plans Technical Group 4

Enclosures:
Deleted copy of ruling letter
Notice of Intention to Disclose

cc: xxxxx
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