ERISA Section 406: Prohibited Transactions Explained

The Employee Retirement Income Security Act of 1974 (ERISA) establishes standards for most private industry retirement and health plans. A central piece of this regulation, Section 406, outlines a set of prohibited transactions designed to prevent conflicts of interest. The primary objective is to safeguard plan assets by requiring them to be used for the exclusive purpose of providing benefits to participants and their beneficiaries.

These regulations forbid plan fiduciaries from causing a plan to engage in transactions that could benefit certain affiliated individuals or entities, known as “parties in interest,” at the expense of the plan’s participants. The law restricts the financial interactions these parties can have with the plan to ensure fiduciaries act with undivided loyalty. Understanding these rules is important for plan administrators to avoid significant penalties.

Defining a Party in Interest

A “party in interest” is a broad term under ERISA that encompasses any individual or entity with a close relationship to an employee benefit plan. The definition is extensive to prevent insiders from using their connection to the plan for personal gain. The most direct parties in interest are plan fiduciaries, such as administrators or trustees who control plan management. The term also includes:

• Any person providing services to the plan, including accountants or legal counsel.
• The employer whose employees are covered by the plan.
• An employee organization, like a union, whose members are covered.
• A direct or indirect owner of 50% or more of the sponsoring employer.
• Relatives of any of the specified individuals, such as a spouse, ancestor, lineal descendant, or spouse of a lineal descendant.
• Any corporation, partnership, or trust that is 50% or more owned by any of the previously mentioned parties.

This wide net ensures that nearly every entity directly involved with the plan’s operation is subject to the prohibited transaction rules.

Transactions Prohibited with a Party in Interest

ERISA Section 406(a) explicitly lists several types of transactions between a plan and a party in interest that are strictly forbidden. These dealings are considered inherently risky to the plan’s financial health, regardless of whether they seem fair or result in an actual loss. The prohibitions cover both direct and indirect interactions. Prohibited transactions include:

• The sale, exchange, or leasing of any property between the plan and a party in interest. For example, a 401(k) plan cannot purchase real estate from the sponsoring company.
• The lending of money or other extensions of credit between the plan and a party in interest. A plan is not permitted to lend money to the employer.
• The furnishing of goods, services, or facilities between the plan and a party in interest, such as a plan hiring a consulting firm owned by a fiduciary’s relative without an exemption.
• The transfer of any plan assets to, or the use of those assets by or for the benefit of, a party in interest.
• The acquisition or holding of certain employer securities or employer-owned real property beyond limits established in ERISA Section 407, which generally caps such holdings at 10% of the fair market value of the plan’s assets.

Fiduciary Self-Dealing Prohibitions

Beyond transactions with parties in interest, ERISA Section 406(b) establishes prohibitions focused on the conduct of the plan fiduciary. These rules address self-dealing and scrutinize the fiduciary’s potential for personal gain.

The first prohibition prevents a fiduciary from dealing with plan assets in their own interest or for their own account. For instance, a plan trustee who is also a real estate developer cannot direct the plan to invest in a property development project that the trustee personally owns or is managing.

A second rule forbids a fiduciary from acting in a transaction on behalf of a party whose interests are adverse to the plan. An example of a violation would be a plan fiduciary, who is also an officer at a bank, approving a loan from the plan to a third party on terms that are highly favorable to the bank but risky for the plan.

The third prohibition prevents a fiduciary from receiving any personal consideration, or kickback, from any party dealing with the plan in connection with a transaction involving plan assets. For example, if an investment manager offers a plan fiduciary a vacation in exchange for the plan investing in a particular fund, the fiduciary would be violating this rule.

Consequences of a Prohibited Transaction

Engaging in a prohibited transaction carries significant financial penalties, enforced through excise taxes detailed in Section 4975 of the Internal Revenue Code. The responsibility for paying this tax falls on the “disqualified person,” the tax code’s equivalent of a “party in interest,” who participated in the transaction, not the plan itself.

The penalty structure is two-tiered. The first-tier tax is 15% of the “amount involved” in the transaction for each year it remains uncorrected. The “amount involved” is the greater of the fair market value of the asset given or received. This tax applies even if the transaction was unintentional or caused no harm.

If the transaction is not corrected within the “taxable period,” a second-tier tax of 100% of the amount involved is imposed. Correction involves undoing the transaction, restoring to the plan any lost profits, and putting the plan in a financial position no worse than it would have been otherwise. Fiduciaries who authorized the transaction can also be held personally liable for any plan losses.

Prohibited Transaction Exemptions

While the rules under Section 406 are strict, the law provides exemptions for certain arrangements that are beneficial to the plan, provided specific conditions are met. These Prohibited Transaction Exemptions (PTEs) fall into two main categories: statutory and administrative.

Statutory exemptions are written directly into ERISA. A common example allows a plan to pay reasonable compensation to a party in interest for office space or for legal, accounting, or other services necessary for the plan’s operation. The requirements are that the service is necessary and the compensation is reasonable, meaning it aligns with what would be paid in an arm’s-length transaction.

Administrative exemptions are granted by the Department of Labor (DOL) when it determines an exemption is in the best interest of the plan and its participants. These can be class exemptions, which apply to an entire category of transactions that the DOL has deemed permissible for any plan that meets the stated conditions. For example, PTE 2020-02 provides guidance for investment advice fiduciaries.

An individual exemption is granted to a specific plan for a particular transaction after a formal application process. The plan must demonstrate to the DOL that the transaction is protective of the plan’s rights and in the interest of its participants and beneficiaries.