Prohibited Transactions

This lesson covers who counts as a party in interest, the two prohibited-transaction categories under ERISA, and the statutory exemptions that let plans still hire ordinary service providers.

ERISA's prohibited-transaction rules ban certain transactions between the plan and parties in interest to prevent conflicts of interest and self-dealing. Violations subject fiduciaries to personal liability for plan losses, plus an excise tax imposed by the IRS.

The Department of Labor (DOL) enforces ERISA's fiduciary and reporting duties, but the prohibited-transaction excise tax itself is a Treasury matter, not a DOL one.

What Does It Take to Correct a Prohibited Transaction?

• Returning the money is not enough. The fiduciary must make the plan whole, which means putting the plan back where it would have been if the transaction had never happened
• That is the principal plus the earnings the plan lost while the assets were out of the plan
• The fiduciary must also give up any profit they made from using plan assets, on top of restoring the plan's loss

Exam Tip: Gotchas

• "Make whole" means principal plus lost earnings, not principal alone. A prohibited $200,000 loan outstanding for two years while the plan would have earned 6% a year is corrected by returning roughly $224,000, not $200,000. Watch for the bare principal offered as a distractor.

Who Counts as a Party in Interest?

A party in interest is anyone with a close relationship to the plan:

• Plan fiduciaries (administrator, trustee, investment committee members)
• Service providers to the plan (accountants, attorneys, recordkeepers)
• The sponsoring employer
• Employee organizations (unions) whose members are covered
• 50%+ owners of the sponsoring employer or of a covered employee organization
• Relatives (spouse, ancestor, lineal descendant, or spouse of a lineal descendant) of any party in interest
• Entities 50%+ owned by a fiduciary, a service provider, the sponsoring employer, a covered union, or a 50%+ owner (relatives are not an independent basis for this category)

Exam Tip: Gotchas

• A party in interest must fall into one of the listed categories: a fiduciary, service provider, the sponsoring employer, a covered union, a 50%+ owner, a relative of any of those, or an entity 50%+ owned by a fiduciary, service provider, the sponsoring employer, a covered union, or a 50%+ owner. Having some other business or professional connection to the employer isn't enough; the connection has to run to the plan itself.

What Transactions Are Prohibited With a Party in Interest?

A fiduciary shall not cause the plan to engage in any of the following with a party in interest:

1. Sale, exchange, or lease of property between the plan and a party in interest
2. Lending money or extending credit between the plan and a party in interest
3. Furnishing goods, services, or facilities between the plan and a party in interest
4. Transfer of plan assets to, or use by or for the benefit of, a party in interest
5. Acquisition of employer securities or employer real property above the 10% limit described below

How Much Employer Stock May a Plan Hold?

• A plan may not acquire qualifying employer securities or employer real property if, immediately afterward, they would exceed 10% of the plan's assets
• That ceiling does not apply to an eligible individual account plan: a profit-sharing, stock bonus, thrift, or savings plan, or an employee stock ownership plan (ESOP)
• The plan document must explicitly provide for holding employer securities or real property before the exception is available

Exam Tip: Gotchas

• The 10% cap is not a universal ERISA rule. It binds defined benefit pension plans. It does not bind the plan types most students picture, because a 401(k) is a profit-sharing plan with a cash-or-deferred arrangement, which makes it an eligible individual account plan. An ESOP, whose whole purpose is to hold employer stock, is exempt for the same reason.
• A plan cannot force deferrals into employer stock and keep the exemption. If the plan requires elective deferrals to be invested in employer securities, that portion is treated as a separate plan, and the 10% limit applies to it.
• The same exemption runs through the duty to diversify. An eligible individual account plan does not breach the diversification duty by holding employer stock, which is why an ESOP concentrated in one company is not automatically a fiduciary breach.

What Counts as Fiduciary Self-Dealing?

A fiduciary shall not:

1. Deal with plan assets in their own interest or for their own account
2. Act in a transaction involving the plan on behalf of a party adverse to the plan or its participants
3. Receive personal consideration (kickbacks) from any party dealing with the plan in connection with a plan transaction

Exam Tip: Gotchas

• Prohibited transaction rules are strict liability. Intent does not matter. Even a well-intentioned transaction (e.g., a short-term loan from the plan to the employer to cover payroll) is prohibited if it falls within the prohibited-transaction rules and no exemption applies.

What Statutory Exemptions Apply?

Not every transaction between a plan and a party in interest is prohibited. ERISA lists statutory exemptions that apply automatically, with no application to anyone. Key exemptions include:

• Reasonable compensation for necessary services: a party in interest may provide services to the plan if the services are necessary, the arrangement is reasonable, and compensation is no more than reasonable
• The service contract must permit termination by the plan without penalty on reasonably short notice
• Loans to participants, which must satisfy all five conditions: available to all participants and beneficiaries on a reasonably equivalent basis, not available to highly compensated employees in greater amounts than to other employees, made under specific loan provisions set out in the plan document, bearing a reasonable rate of interest, and adequately secured
• Distribution of plan assets in accordance with plan terms

Exam Tip: Gotchas

• Paying a party in interest for necessary services at reasonable compensation is NOT prohibited under the necessary-services exemption. Without this exemption, a plan could not hire any service provider since every service provider is automatically a party in interest.
• "Necessary" is a low bar. The service only has to be appropriate and helpful in carrying out the plan's purposes. It does not have to be indispensable.
• Do not confuse the statutory exemptions with a "prohibited transaction exemption" (PTE). The exemptions above are written into ERISA and apply on their own terms. A PTE is a separate, individual or class exemption the Department of Labor grants on application. If a question turns on whether anyone had to ask permission, the statutory list is the "no" answer.
• A termination fee is not automatically a penalty. A charge that reasonably compensates the provider for its actual loss, such as recovering reasonable start-up costs, is allowed. A charge that exceeds the actual loss, or that lets the provider skip mitigating its damages, is a penalty and makes the contract unreasonable.
• The reasonable-compensation exemption does not license self-dealing. It excuses the transaction from the party-in-interest rules only. A fiduciary who uses its own authority to steer extra fees to itself still commits self-dealing.

What Do Common Exam Scenarios Look Like?

What Should You Check on Exam Day?

• A party in interest includes fiduciaries, service providers, the sponsoring employer, covered unions, 50%+ owners of the employer or a covered union, their relatives (spouse, ancestor, lineal descendant, or spouse of a lineal descendant), and entities 50%+ owned by a fiduciary, service provider, the sponsoring employer, a covered union, or a 50%+ owner.
• Prohibited-transaction rules are strict liability. A well-intentioned deal, like a short-term loan from the plan to the employer, is still prohibited if it falls within the rules and no exemption applies.
• Violations create personal fiduciary liability for plan losses, plus an excise tax imposed by the IRS, not the DOL: the DOL enforces the fiduciary duties, but the excise tax itself is a Treasury matter.
• Correcting a prohibited transaction means making the plan whole, so the fiduciary returns the principal plus the earnings the plan lost, and separately gives up any profit they made.
• Reasonable compensation for necessary services is exempt; without that exemption, a plan could not hire any service provider, since every service provider is automatically a party in interest.
• The exemptions listed in ERISA apply automatically. A prohibited transaction exemption (PTE) is a different thing: a separate exemption the DOL grants on application.
• The 10% ceiling on employer securities does not apply to an eligible individual account plan such as a 401(k), profit-sharing plan, or ESOP, provided the plan document explicitly allows the holding.