Prohibition on loans from 403(b) plan participant’s account to church-related employer applies to indirect loans

The rule prohibiting loans from a Code Sec. 403(b)(9) retirement account of a participant to the participant’s employer, a church-related organization, under the exclusive benefit requirement of IRS Reg. Sec. 1.403(b)-9(2)(i)(C), applies not only to loans made directly to the employer, but also to indirect loans made to the employer, according to an IRS Chief Counsel advice memorandum.
The IRS presented two situations, under which the IRS assumed that the employer is a church and that the plan meets Code Sec. 403(b) requirements for separate accounting, investment performance, and a written plan document. In the first, one of the plan’s investment options was an investment in limited liability company (LLC) shares where the LLC’s primary function was to offer loans to the employer. The investment return to the participant was the interest on the loan paid by the employer. The LLC was not controlled directly or indirectly by the church. In the second, one of the plan’s investment options was an investment in an LLC controlled either directly or indirectly by the employer, but offering loans to the employer was not the LLC’s primary function.
A direct loan from the plan to the employer results in a loan or other extension of credit from assets in a participant’s retirement income account to the employer. In the case of an indirect loan, such as is described in the situations, an arrangement was structured so that the employer received a substantially similar loan or other extension of credit using the assets of the retirement income account as it would have under a direct loan. Accordingly, for purposes of Reg. §1.403(b)-9(a)(2)(i)(C), both direct and indirect loans are loans or other extensions of credit from assets in a participant’s retirement income account to the employer, which cause assets in the retirement income account to be treated as diverted to the employer, violating the exclusive benefit requirement of Reg. § 1.403(b)-9(a)(2)(i)(C).
In contrast, the IRS noted that if the assets of a participant’s account were invested in the publicly traded stock of a financial institution and the employer received a loan from that financial institution, there would not be an indirect loan from the account to the employer. In that case, the arrangement was not structured to provide the employer a loan using the assets of the account that was substantially similar to a direct loan.
The IRS concluded that, in both cases, the investment violated the rule prohibiting plan loans to employers under Code Sec. 403(b)(9). In addition, in both cases the loans violated the exclusive benefit requirement of Reg. §1.403(b)-9(a)(2)(i)(C) because it was an indirect loan from the plan to the employer. Thus, the plan failed to meet the requirements for being a Code Sec. 403(b)(9) retirement income account plan.
In the first case, the participant’s investment in shares in the LLC would be an indirect loan because the LLC’s primary function was to make loans to the employer. In addition, the LLC was funded, in part, by the plan participant’s investments. The arrangement was structured so that the church received a substantially similar loan using the assets of the account as it would have under a direct loan. In the second case, a plan participant’s investment in the LLC followed by a loan by the LLC to the employer would be an indirect loan because the LLC was controlled by the employer. The result was the same even if the LLC made loans to other entities not related to the employer. Accordingly, in both situations, the indirect loans would violate the exclusive benefit requirement of Reg. §1.403(b)-9(a)(2)(i), and cause the plan to no longer be treated as a retirement income account plan.

Source: IRS Letter Ruling (Chief Counsel Advice Memorandum) 201742022.
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