Correcting a prohibited transaction is essential to avoid the 100% tax imposed by the Internal Revenue Code (“Code”). The Employee Retirement Income Security Act (ERISA) of 1974 was enacted to ensure that employees and their beneficiaries receive the money promised to them by their employers. One of the provisions of ERISA is the prohibition of certain transactions between retirement plans and social assistance plans, and individuals or entities that have a financial interest in these plans. These transactions are known as “prohibited transactions”.
The only way to legally carry out a prohibited transaction is if it meets a specific legal or other exemption. Exemptions are established because it is believed that the benefit to the participants and beneficiaries of the plan outweighs the risk of damaging the plan, and because appropriate security measures have been incorporated to protect participants and beneficiaries. In order to correct a prohibited transaction, it must be undone as far as possible without putting the plan in a worse financial position than if it had acted under the highest fiduciary standards. The affected party must also take into account any losses resulting from the transaction, and return any profits made through the prohibited use of the asset.
The Voluntary Trust Correction Program (VFCP) is an effective way to eliminate prohibited transactions under the Code through a specific class exemption from the Department of Labor (DOL). If a prohibited transaction is corrected by VFCP, it is exempt from the provisions of the Code on prohibited transactions that would otherwise be applicable. However, if VFCP is not followed in its entirety, or if it does not cover the prohibited transaction, then it would still constitute a prohibited transaction, subject to sanctions of the Code. ERISA requires a complete and rapid correction of prohibited transactions.
This means that the plan must be completed and any benefits resulting from the transaction must be disbursed. Being “healed” generally means that all parties will occupy the exact position they would have been in if the prohibited transaction had never occurred. Fortunately, certain transactions are legally exempt from being prohibited transactions, including loans to participants who meet certain requirements. Assuming all relevant requirements are met, a loan between a 401 (k) plan and a plan participant pursuant to that loan program would not constitute a prohibited transaction or require any corrective action.