ERISA Prohibited Transactions: Audit Procedures for the Plan Auditor

An employee benefit plan audit tests more than the numbers. The plan sits inside a web of relationships with the employer, the recordkeeper, the trustee and the people who run it, and ERISA restricts the deals that can pass between the plan and those insiders. A plan auditor who tests balances and ignores the relationships can sign an opinion on statements that omit a disclosure the plan needs. This guide reads the two statutory sections that matter, then turns them into audit procedures.

Section 406: the prohibitions

Section 406 of ERISA, codified at 29 U.S.C. 1106, has two parts that matter to the auditor.

Plan and party in interest. Under Section 406(a)(1), a fiduciary may not cause the plan to engage in a transaction that the fiduciary knows or should know constitutes a direct or indirect:

• (A) sale or exchange, or leasing, of any property between the plan and a party in interest;
• (B) lending of money or other extension of credit between the plan and a party in interest;
• (C) furnishing of goods, services or facilities between the plan and a party in interest;
• (D) transfer to, or use by or for the benefit of, a party in interest of any assets of the plan; or
• (E) acquisition, on behalf of the plan, of any employer security or employer real property in violation of Section 407(a).

Plan and fiduciary. Under Section 406(b), a fiduciary may not deal with the assets of the plan in his own interest or for his own account, may not act in a transaction involving the plan on behalf of a party whose interests are adverse to the plan's, and may not receive consideration for his own personal account from any party dealing with the plan in connection with a plan transaction.

Section 406(c) treats a transfer of property from a party in interest to the plan as a sale or exchange in two situations: when the plan assumes a mortgage or similar lien on the property, and when a party in interest placed a lien on the property within the ten-year period ending on the date of the transfer.

Who is a party in interest

The list in 29 U.S.C. 1002(14) is wide. It includes:

• any fiduciary, including an administrator, officer, trustee or custodian, and any counsel or employee of the plan;
• a person providing services to the plan;
• an employer any of whose employees are covered by the plan;
• an employee organization any of whose members are covered;
• an owner, direct or indirect, of 50 percent or more of an employer or employee organization described above;
• a relative of an individual in those categories;
• a corporation, partnership, trust or estate in which 50 percent or more is owned by those persons;
• an employee, officer, director or 10 percent or more shareholder of the service providers, employer, owners or entities above, or of the plan; and
• a 10 percent or more partner or joint venturer of those persons or entities.

The service provider is the one that surprises auditors. The recordkeeper, the investment adviser and the third-party administrator are parties in interest because they provide services to the plan. A payment of fees to them is a transaction with a party in interest and needs an exemption.

Section 408: the exemptions

Section 408 of ERISA, 29 U.S.C. 1108, lets the Secretary of Labor grant exemptions from Sections 406 and 407(a) after findings that an exemption is administratively feasible, in the interests of the plan and its participants and beneficiaries, and protective of their rights. It also lists statutory exemptions. Two do most of the work in an audit.

Participant loans, Section 408(b)(1). Loans to participants or beneficiaries who are parties in interest are exempt if they are available to all participants and beneficiaries on a reasonably equivalent basis, do not favor highly compensated employees, follow the loan provisions specified in the plan, bear a reasonable rate of interest and are adequately secured.

Services, Section 408(b)(2)(A). A plan may contract or make reasonable arrangements with a party in interest for office space, or legal, accounting or other services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid. Section 408(b)(2)(B) adds disclosure requirements for covered service providers to group health plans. For pension plans, the disclosure rule that makes a service arrangement reasonable is in 29 CFR 2550.408b-2(c)(1).

An exemption has conditions. A transaction that is covered by the label but fails a condition is prohibited.

The parallel excise tax

For plans qualified under IRC 401(a), IRC 4975 imposes its own tax on each prohibited transaction. The initial tax is 15 percent of the amount involved for each year or part of a year in the taxable period, and it falls on the disqualified person who participates, other than a fiduciary acting only as such. If the transaction is not corrected within the taxable period, an additional tax of 100 percent of the amount involved applies (IRC 4975(a) and (b)). The tax is the disqualified person's, not the plan's, but its existence raises the stakes of the conclusion the auditor documents.

Worked example

Redfield Machining sponsors a 401(k) plan. Three items turn up in the audit.

1. Rent. The plan's administrative office is in a building owned by Redfield's founder, who owns 50 percent or more of the employer. Under Section 406(a)(1)(A), a lease between the plan and a party in interest is within the prohibition. The auditor asks for the lease and evidence that the space is necessary for the plan's operation and that the rent is reasonable, to test the Section 408(b)(2)(A) exemption. The only evidence in the file is that rent equals what the founder's other tenants pay. That does not establish that the plan needs the space. The auditor raises it with the administrator and the plan's counsel.
2. Participant loans. The plan has 41 loans. The auditor reads the plan document's loan provisions, selects loans, and tests each against the Section 408(b)(1) conditions: equal availability, no favoring of highly compensated employees, documented terms, interest rate and security. One loan to an officer carries an interest rate below the rate in the loan policy, and the file notes the exception.
3. Fee payment. The plan paid $38,000 to an investment adviser owned by a relative of an officer. The adviser provides services to the plan and is a party in interest under 29 U.S.C. 1002(14)(B). The auditor asks for the contract and evidence that the compensation is reasonable.

Audit procedures

1. Build the party-in-interest list. Start from the 29 U.S.C. 1002(14) categories. Ask management for the plan sponsor's owners, officers and directors, their relatives, all service providers and the sponsor's affiliates. Update it each year.
2. Inquire. Ask the plan administrator, trustee and sponsor's management in writing about transactions with parties in interest, and include the inquiry in the representation letter.
3. Scan the activity. Read the minutes, review the general ledger and the trust statements for payments to unusual payees, loans, leases and transfers, and compare each payee to the list.
4. Test each identified transaction. Record the Section 406 category, the exemption relied on, and the evidence for each condition.
5. Evaluate the consequences. A transaction that fails an exemption is a nonexempt prohibited transaction. Consider the effect on the financial statements and disclosure, the plan's supplemental schedules, and the auditor's communication responsibilities. See AU-C 250 on laws and regulations and AU-C 550 on related parties.
6. Check Section 407 limits on employer securities. Where the plan holds employer stock, test the acquisition against the limits that Section 406(a)(1)(E) incorporates.
7. Document the conclusion. Record what was tested, what was found and why the conclusion follows.

Red flags

• Plan assets used to pay sponsor expenses.
• A lease, loan or sale with an insider and no appraisal.
• Fees to a related service provider without a contract.
• Participant loans that do not follow the written policy.
• Employer contributions remitted to the plan late. See participant data, contributions and late deposits.

Related reading

The DOL's focus on audit quality is covered in what EBSA looks for. For the filing frame, see Form 5500 filing guide.

Where CORAA fits

CORAA prepares ready-to-review audit files for US CPA firms, including party-in-interest schedules and loan testing workpapers. The firm keeps the client, the review and the signature. See /us.

Sources

• Legal Information Institute, 29 U.S.C. 1106, Prohibited transactions: https://www.law.cornell.edu/uscode/text/29/1106
• Legal Information Institute, 29 U.S.C. 1108, Exemptions from prohibited transactions: https://www.law.cornell.edu/uscode/text/29/1108
• Legal Information Institute, 29 U.S.C. 1002, Definitions: https://www.law.cornell.edu/uscode/text/29/1002
• Legal Information Institute, 26 U.S.C. 4975, Tax on prohibited transactions: https://www.law.cornell.edu/uscode/text/26/4975
• Legal Information Institute, 29 CFR 2550.408b-2, General statutory exemption for services or office space: https://www.law.cornell.edu/cfr/text/29/2550.408b-2

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error