Computing the Sec. 4975 Excise Tax for Failure to Timely Deposit Elective Deferrals

Sec. 4975(a) imposes a 15% excise tax (first-tier excise tax) on a prohibited transaction. In addition, Sec. 4975(b) imposes a 100% excise tax (second-tier excise tax) on a prohibited transaction that is not corrected during the tax period. The tax applies to any disqualified person who participates in the prohibited transaction (other than a fiduciary acting only as such). The excise tax applies to the “amount involved” in the prohibited transaction, which, for purposes of calculating the excise tax, was recently addressed by the IRS.

Rev. Rul. 2006-38

In the ruling, an employer sponsors a calendar-year, qualified profit-sharing plan that contains a Sec. 401(k) cash or deferred arrangement. Employees are paid on a payment date following the close of each payroll period. A portion of each employee’s compensation is withheld in accordance with the election he or she makes under the plan. The aggregate amount withheld for all employees for the payroll period in question is $100,000. The employer could have reasonably segregated this amount from its general assets and deposited the funds with the plan on Dec. 8, 2004, but failed to do so. It did not correct the failure until Dec. 30, 2005. The underpayment interest rate under Sec. 6621(a)(2) was 5% on Dec. 8, 2004 and on Jan. 1, 2005.

Definitions

Prohibited transaction: Under Sec. 4975(c)(1)(D), a prohibited transaction is any direct or indirect transfer to, or use by or for the benefit of, a disqualified person, of a plan’s income or assets. In addition, a prohibited transaction includes any act by a disqualified person who is a fiduciary when he or she deals with the plan’s income or assets for his or her own interest or account; see Sec. 4975(c)(1)(E). Sec. 4975(e)(2) includes in its definition of a disqualified person an employer with employees covered by the plan.

Amount involved: Under Sec. 4975(f)(4), the “amount involved,” generally, is the greater of the amount of money and the fair market value (FMV) of the other property (1) given or (2) received in such transaction. The FMV is determined as of the date on which the prohibited transaction occurs, for the first-tier tax. For purposes of the second-tier tax, it is the highest FMV during the tax period described in Sec. 4975(f)(2).

Tax period: The “tax period” begins with the date on which the prohibited transaction occurs and ends on the earliest of the date (1) of the mailing of a statutory deficiency notice, (2) on which the first-tier tax is assessed or (3) on which correction of the prohibited transaction is completed.

Correction: A “correction” is de-fined as undoing the transaction to the extent possible. The plan must be placed in a financial position not worse than it would have been in had the disqualified person been acting under the highest fiduciary standards; see Sec. 4975(f)(5).

Which Rules Control?

Section 141.4975-13 of the Temporary Pension Excise Tax Regulations provides that, under Sec. 4975(f)(4) and (5), Section 53.4941(e)-1 of the Foundation Excise Tax Regulations is controlling to the extent those regulations describe terms appearing both in Secs. 4941(e) and 4975(f). The term “amount involved” appears in both Secs. 4941(e) and 4975(f).

According to Section 53.4941(e)-1(b)(2)(ii), when the transaction in-volves the use of money or other property, the amount involved is the greater of the amount paid for such use or the FMV of such use for the period for which the money or other property is used and the amount involved is determined for the entire period that the money or other property is used. In addition, for a prohibited transaction that is a loan, an additional prohibited transaction is deemed to occur on the first day of each tax year in the tax period after the tax year in which the use occurred. This is illustrated in Example (2) of Section 53.4941(e)-1(b)(4), in which principal and interest have already been repaid. The amount involved is the principal times the percentage that constitutes the FMV of the use of money on the date of the transaction for each year or partial year in the tax period.

Rev. Rul. 2002-43

This ruling addressed a prohibited transaction that spanned multiple tax years in a tax period in which the first-tier excise tax rate changed. It illustrates that interest not repaid in a given year is added to the principal amount in the subsequent year.

Section 2510.3-102 of the Department of Labor regulations provides that for Sec. 4975 purposes, amounts withheld from a participant’s wages for contributions to a plan become plan assets as of the earliest date on which such contributions can reasonably be segregated from the employer’s general assets. However, in the case of a plan such as a Sec. 401(k) plan, in no event does the date on which such contributions become plan assets occur later than the 15th business day of the month immediately following the month in which the participant contributions are received by the employer (in the case of amounts that a participant or beneficiary pays to an employer), or the 15th business day of the month following the month in which such amounts would otherwise have been payable to the participant in cash (in the case of amounts withheld by an employer from a participant’s wages).

IRS’s Stance

In Rev. Rul. 2006-38, the Service determined that failing to transmit the contribution until Dec. 30, 2005 was a prohibited transaction for 2004 and 2005. Accordingly, the amount in-volved for the 2004 prohibited transaction is interest on $100,000 from Dec. 8, 2004 to Dec. 31, 2004. The amount involved for the 2005 prohibited transaction is interest on the new balance owed to the plan, after increasing the principal because there was no correction of the 2004 prohibited transaction, and is calculated from Jan. 1, 2005 to Dec. 30, 2005. The tax period for the 2004 prohibited transaction began on Dec. 8, 2004 and ended on Dec. 30, 2005 (the date of the correction); the tax period for the 2005 prohibited transaction began on Jan. 1, 2005 and ended on Dec. 30, 2005 (the date of the correction)

For purposes of calculating the Sec. 4975 excise tax on a timely filed Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, for a failure to transmit participant contributions or amounts otherwise payable to the participant in cash, under the authority of Sec. 7805, use of the interest rate for underpayments described in Sec. 6621(a)(2) on the date of the prohibited transaction is appropriate to calculate the amount involved. The exhibit below illustrates the application of this rate to the ruling’s facts (taking only the first-tier excise tax into account). The Sec. 4975(a) first-tier excise tax is $844 ($47 + $797).

The Service concluded that, solely for purposes of calculating the prohibited transaction excise tax under Sec. 4975, the amount involved if an employer does not timely pay participant deferrals or contributions to a qualified plan is based on interest on such deferrals. The cost associated with failing to timely remit a deposit can be significant. Employers and their advisers should take the steps needed to ensure that deposits are remitted timely.

From John W. Lindbloom, CPA/PFS, Huber, Ring, Helm & Co., P.C., St. Louis, MO