Compliance December 20, 2006

Final Regs Issued Concerning Prohibited ESOP Allocations

The Internal Revenue Service (IRS) and Treasury Department have issued final regulations that provide guidance concerning prohibited allocations and disqualified person requirements under section 409(p) of the Internal Revenue Code for employee stock ownership plans (ESOPs) holding stock of Subchapter S corporations.
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Section 409, intended to prevent the concentration of ownership among ESOP participants, provides that, during an allocation year, no employer securities may accrue (or be allocated directly or indirectly) for the benefit of a disqualified person. In general, a disqualified person is any person whose deemed-owned ESOP shares are at least 10% of the number of deemed-owned shares held by an ESOP, or for whom the aggregate number of shares owned by the person and members of the person’s family is at least 20% of deemed-owned ESOP shares.

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A non-allocation year, under the section, includes any plan year during which the ownership of the S corporation is so concentrated among disqualified persons that they own or are deemed to own at least 50% of its shares.

Under the final regulations, in the event of a non-allocation year, S corporation shares held in a disqualified person’s account and all other ESOP assets attributable to S corporation stock, including distributions, sales proceeds, and earnings, are treated as an impermissible accrual whether attributable to contributions in the current year or a prior year.

If there is a prohibited allocation during a non-allocation year, the ESOP ceases to be an ESOP, according to the final regulations. As a result, the exemption from the excise tax on prohibited transactions for loans to leveraged ESOPs would also cease to apply to any loan, and the employer would owe an excise tax with respect to any previously exempt loan. In addition, a prohibited allocation is a deemed distribution that is not an eligible rollover distribution.

The final regulations clarify that a prohibited allocation would also result in plan disqualification. The IRS and Treasury provide an example of the impact of the final rules on S Corporations.

Guidance on prevention of a non-allocation year is included in the publication, as well as guidance on the calculation of number of shares of synthetic equity to which a person is entitled for purposes of determining whether he or she is a disqualified person.

The regulations generally are applicable for plan years beginning on or after January 1, 2006, but retain the 2004 regulations for plan years beginning before January 1, 2006.

The publication of 26 CFR Part 1 is scheduled to be in the Federal Register for December 20, 2006.

Compliance December 20, 2006

Plan Sponsor Sues Principal over 401(k) Fund Revenue Sharing

The sponsor of a 401(k) plan for employees at an Illinois racetrack is suing Principal Financial Group for fiduciary breach over revenue sharing arrangements with mutual funds whose offerings are in Principal’s 401(k) product.
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Joseph Ruppert, vice president of Fairmount Park Inc., which runs the Fairmount Park Racetrack in Collinsville, Illinois near St. Louis, alleged in the suit the revenue sharing practice violated the Employee Retirement Income Security Act (ERISA). Ruppert acts as trustee for the plan.

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According to the suit, the violation occurred within Principal’s pre-packaged 401(k) product such as the one sold to Fairmount Park, Inc. for its Retirement Savings Plan.

In trying to build a case that Principal should be considered a fiduciary, the suit asserted the plan provider had “a special relationship of confidence, trust, or superior knowledge or control” with both plan sponsors and participants in Principal’s pre-packaged plans because the firm:

  • assumed responsibility to employers and employees to negotiate favorable investment management fees with mutual funds and their advisors arising from Principal’s exclusive control over the selection of mutual funds to be included in the pre-packaged plans,

  • held “itself out to employers and employees as highly-skilled financial experts, possessing special knowledge and expertise,”

  • encouraged employers and participating employees “to place their utmost trust and confidence in Principal’s management of their 401(k) plans,” and

  • assumed responsibility to provide unbiased expertise and 401(k) plan management to employers and employees.

The suit, which seeks certification as a class action on behalf of Principal 401(k) plans in which Principal uses revenue sharing, alleged that Principal breached its fiduciary duties by:

  • not disclosing the revenue sharing to the Fairmount plan or its participants; and

  • effectively violating ERISA’s prohibited transaction rule through “using plan assets to generate revenue sharing kickbacks for Principal’s own interest and for its own account.”

Not only that, but the revenue sharing fees Principal receives “bear no relationship to Principal’s costs of providing services to plans or participants” and are in addition to the fees Principal charges for those services, the suit claimed. Also, Ruppert charged affected plans and their participants do not get any additional services outside of those for which they already pay.

The complaint said Principal should have used its revenue sharing revenue “to defray the reasonable expenses of administering the plan.”

The Principal suit asked a federal judge to rule that revenue sharing violates ERISA, to prohibit Principal from accepting revenue sharing payments and to require Principal to return revenue sharing fees generated as part of Fairmount’s plan back to the plan.

Filed by East Alton, Illinois attorney Rosalind Robertson, the case has been assigned to US District Judge David Herndon of the US District Court for the Southern District of Illinois. The case is Ruppert v. Principal Life Insurance Co., S.D. Ill., No. 3:06-co-00903-DRH-PMF, complaint filed 11/8/06.

Last month, a Florida Sheriff’s Department sued Nationwide Life Insurance Co., over allegations Nationwide’s fees unfairly allowed the company to make a profit through its revenue sharing arrangement. The suit was filed by Orange County Sheriff Kevin Beary and charged that Nationwide, the agency’s former provider, would offer mutual funds to deputies and other investors only if the family of funds also paid the company a fee (See FL Sheriff Sues Nationwide Over Fees).

The general issue of plan fees has been a major hot button issue of late and has been the subject of numerous lawsuits including a recent one against a plan provider (See Deere Workers Hit Fidelity with Excessive 401(k) Fee Suit), as well as numerous others against plan sponsors (See Fee for All).

Principal spokeswoman Terri Hale responded Tuesday: “It is our policy not to comment on pending litigation. The Principal takes seriously our commitment to our plan sponsor clients and their participants and places the highest priority on providing excellent customer service.”

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