Keystone Consolidated Industries: Supreme Court holds property contributions to pension plans for funding obligations to be prohibited transactions

The prolonged economic downswing has made it increasingly difficult for some employers to satisfy their obligations to fund their benefit plans. Some employers have sought to reduce transaction costs or improve cash flow by contributing property rather than cash to their benefit plan obligations. The problem with such action is that the Department of Labor and the Internal Revenue Service have taken a position limiting the availability of this funding technique to discretionary profit-sharing techniques.

Until recently, the courts did not agree on this issue. The Tax Court and Fifth Circuit agreed that contributions of property to discretionary profit-sharing plans are permissible, but disagreed on the possible use of this technique to fund pension plans. In contrast, the Fourth Circuit held that the assignment of third-party promissory notes to a qualified plan to satisfy a minimum funding obligation constitutes a prohibited transaction. The conflict among the circuits provided employers with a basis to aggressively pursue property contributions. The IRS estimates that in 1989 alone, $243 million in property was contributed by employers to more than 400 separate pension plans.

To resolve the conflict between the Fifth and Fourth Circuits, the Supreme Court granted a writ of certiorari in Commissioner v. Keystone Consolidated Industries, Inc. (Doc. No. 91-1677). In an 8-to-1 decision, the Court in May 1993 ruled in favor of the government, restricting the ability of employers to make contributions of unencumbered property to a defined benefit plan. This article explores the lower court decisions, including their differing interpretations of section 4975 of the Internal Revenue Code, and then analyzes the Supreme Court's decision.

I. Background

The prohibited transaction rules of section 4975 of the Internal Revenue Code were signed into law nearly two decades ago. Basic questions regarding these rules, however, remained unresolved until the Supreme Court's decision in Keystone Consolidated Industries. In Keystone Consolidated Industries, Inc. v. Commissioner, 952 F.2d 76 (5th Cir. 1992), the Fifth Circuit held that the contribution of unencumbered, non-cash property by an employer to its defined benefit retirement plan in satisfaction of its required contribution obligation was not a prohibited transaction. Fourteen days later, in Wood v. Commissioner, 955 F.2d 908 (4th Cir. 1992), the Fourth Circuit decided that it was.

Prior to the Keystone and Wood cases, the IRS had issued two revenue rulings. In Rev. Rul. 77-379, 1977-2 C.B. 887, the IRS concluded that a private foundation's transfer of stock to a disqualified person in repayment of an interest-free loan was an act of self-dealing because it was tantamount to a sale or exchange of property between a private foundation and a disqualified person. In Rev. Rul. 81-40, 1981 C.B. 508, the IRS ruled that the transfer of real estate by a disqualified person to a private foundation to correct an indebtedness constituted a new act of self-dealing.

The IRS had also promulgated a regulation relating to the maximum amount that may be allocated in a qualified defined contribution plan. Treas. Reg. [section] 1.415-6(b)(4) provides that a contribution by an employer of property other than cash will be considered a contribution in an amount equal to the fair market value of the property on the date of contribution, cautioning that the contribution "may, however, constitute a prohibited transaction within the meaning of section 4975(c)(1)."

Prior to Keystone and Wood, the Department of Labor had issued an advisory opinion regarding sections 406(a)(1)(A) and 406(c) of the Employee Retirement Income Security Act of 1974, which are basically identical to the Code provisions at issue in Keystone and Wood. Department of Labor Advisory Opinion 81-69A states that a contribution of an option to purchase a residential condominium unit by an employer to its qualified defined benefit plan in discharge of its contribution obligation would be a prohibited transaction.

II. Source of Controversy: Interpretation

of Statutory Provisions

The Department of Labor's position is relevant because the prohibited transaction provisions under section 406 of ERISA are nearly identical to the prohibited transaction provisions in the Code. Section 4975(c) of the Code imposes two excise taxes on any disqualified person who participates in a prohibited transaction. It expressly prohibits the direct or indirect -

* sale, exchange, or leasing of any property between a plan and a disqualified person;

* lending of money or other extension of credit between a plan and a disqualified person;

* furnishing of goods, services, or facilities between a plan and a disqualified person;

* transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;

* act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or

* receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

Under section 4975(e)(2), an employer is considered a disqualified person with respect to a tax-qualified retirement plan if that person is -

* a fiduciary;

* 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 by the plan;

* an owner, direct or indirect, of 50 percent or more of (1) the combined voting power of all classes entitled to vote or the total value of all classes of stock, (2) the capital or profits interests of a partnership, or (3) the beneficial interest of a trust or unincorporated enterprise;

* a member of the family;

* a corporation, partnership, or trust of which 50 percent or more of (1) the combined voting power of all classes of stock entitled to vote or the total value of all classes of stock, (2) the capital or profits interests of a partnership, or (3) the beneficial interest of a trust or estate;

* an officer, director, a 10-percent or more shareholder, or a highly compensated employee; or

* a 10-percent or more partner or joint venturer.

A. Fifth Circuit Provides a Taxpayer Victory

Keystone Consolidated Industries, Inc. maintained several qualified defined benefit plans that were subject to minimum funding requirements. In 1983, it contributed five truck terminals to the trust funding the plans and credited their fair market value against its minimum funding obligations for its taxable years ending June 30, 1982, and June 30, 1983. In 1984, it contributed real property and credited its fair market value against its minimum funding obligations for its taxable year ending June 30, 1984. The terminals and real property contributed to the trust were neither encumbered nor subject to any mortgage at the time of transfer and were not leased back to Keystone or any affiliate of Keystone.

Keystone claimed deductions equal to the fair market value of the terminals and real property and reported the difference between this amount and its cost to acquire the properties as capital gain. The IRS sought to impose excise taxes on Keystone on the ground that the contributions of the terminals and real property were prohibited under section 4975.

The IRS argued in Keystone that section 4975(f)(3) - relating to the treatment of a transfer of property subject to a mortgage or lien or sales or exchange and, hence, a prohibited transaction - was not the exclusive definition of what constitutes a "sale or exchange" for purposes of section 4975(c)(1)(A). The IRS reasoned that if section 4975(f)(3) were the exclusive definition of "sales or exchanges," the statutory provision would have expressly provided and, further, that for many tax purposes the phrase "sale or exchange" includes a transfer of property in satisfaction of a debt or bequest. Finally, the IRS claimed that section 4975(f)(3) is not vitiated by such an interpretation because it is a special rule that applies to voluntary transfers of encumbered property. In this regard, the IRS said section 4975 was intended to supplement the rules of prior law that permitted arm's-length transactions between the employer and its tax-qualified retirement plan to ensure that the value of these types of transactions (which have a great potential for abuse) would not have to be reviewed.

After a trial, the Tax Court ruled in favor of Keystone. 60 T.C.M. 1423 (1990). The Fifth Circuit affirmed, explaining that, in accordance with section 4975(f)(3), only the transfer of property subject to a mortgage or lien is to be treated as a sale or exchange. The Fifth Circuit found no statutory support for the IRS's theory that Congress intended that voluntary and involuntary transfers be treated differently. It said that the proffered distinction made no economic sense: if an employer made a contribution of unencumbered, noncash property in a year prior to the year in which its minimum funding obligation arose, it would not run afoul of the prohibited transaction rules, whereas a violation would occur if the employer made the identical contribution a year later. According to the Fifth Circuit, the potential for abuse was the same in both situations. The court did not, however, discuss the IRS's argument that, if its position were rejected, an employer that could not sell non-cash property to a plan in a noncontribution context could effect the same result by contributing the property to the plan.

The Fifth Circuit held that no deference need be accorded to Department of Labor Advisory Opinion 91-69A because a Labor Department advisory opinion is binding only on the party requesting the opinion. As for deference arguably owing to the IRS's interpretation, the court noted that the IRS had never promulgated a regulation declaring a transfer of property to be a sale or exchange. Moreover, the IRS's revenue rulings under section 4941 were inapposite because that section contains no definition of a sale or exchange; the only definition in the pertinent Code provisions is found in section 4975(f)(3) - and it only encompasses transfers subject to mortgages or liens.

Lastly, the Fifth Circuit rejected the IRS's position that section 4975 was not a penalty tax and, consequently, should be construed broadly in accordance with ERISA's remedial purposes. The court explicitly did not rule on whether the section 4975 was a penalty tax, but did conclude that the Code could not be construed to include transfers of unencumbered property.

B. Fourth Circuit Finds for the IRS

Dallas Wood, a self-employed real estate broker, established a tax-qualified defined benefit plan effective as of January 1, 1984. Wood was the administrator, trustee, and sole participant of the plan. To meet his 1984 minimum funding obligation under the plan, in 1984 and 1985 he contributed three promissory notes without recourse. The notes were payable by third parties unrelated to Wood and their aggregate face value equaled Wood's minimum funding obligation. Wood had purchased two of the three notes at discounts.

Wood claimed a deduction for the notes'aggregate face value even though their fair market value at the time they were transferred to the plan was significantly less. (Face value equaled $114,000, whereas fair market value was $94,430.) Furthermore, he did not report capital gains on the difference between the face value of the notes and his bases in the notes. Although ruling in favor of Wood, the Tax Court stated that the case demonstrated the potential for abuse that the IRS had claimed. 95 T.C. 364 (1990). The Tax Court contended that Wood overstated the value of the property contributed without any apparent cause and was aware that the face value of the notes was not their fair market value.

The Fourth Circuit reversed the Tax Court, holding that Wood's contributions of the three promissory notes were prohibited transactions under section 4975. In reaching this decision, the Fourth Circuit did not distinguish the facts in Wood from those in Keystone. Instead the court took issue with the Fifth Circuit's reasoning in Keystone. The Fourth Circuit noted that Wood had conceded that if he had funded the plan with cash and then caused the plan to use the cash to purchase the notes from himself, the transaction would have been prohibited under section 4975. Wood argued that the prohibition applies only to the operation and management of a plan and not to contributions of property to fund the plan, observing that the Code does not even use the term contribution." He also argued that the Code limits "sale or exchange" to transfers of encumbered property and must be interpreted consistently with section 404, which permits tax deductions for non-cash contributions to a tax-qualified retirement plan.

The Fourth Circuit reasoned that section 4975 was enacted to proscribe outright certain transactions that under prior law were subject to arm's-length standards. Specifically, the court said section 4975 was intended to avoid the potential for overvaluations of property to the detriment of the plan, such as would have occurred had Wood succeeded in discharging a $114,000 funding obligation with notes having a value of only $94,430. The court responded to Wood's argument about the absence of the word "contribution" in the Code by stating the word is a blanket prohibition.

The Fourth Circuit held that section 4975(f)(3) embodies congressional intent to expand the prohibition to all transfers of encumbered property, whether or not in discharge of debt. It found that the term "sale or exchange" encompasses transfers of property in satisfaction of debt. The court also found that the interpretations of the IRS and the Department of Labor deserved deference. The court stated that section 4975 is part of a remedial scheme to prevent abuses and that the very language of the statute applies to both direct and indirect transactions.

III. Supreme Court Settles the Conflict

in the Government's Favor

Because of the conflict between the Fifth and Fourth Circuits on the applicable legal standard, it was unclear whether an employer could contribute unencumbered, noncash property to a tax-qualified retirement plan in satisfaction of an obligation imposed by plan terms. The Supreme Court granted a writ of certiorari in Keystone to resolve the controversy. It did so in the government's favor.

A. Scope of "Sale of Exchange"

In reversing the Fifth Circuit's decision, the Supreme Court stated that for income tax purposes the transfer of property in satisfaction of a monetary obligation is usually a "sale or exchange" of the property. See, e.g., Helvering v. Hammel, 311 U.S. 504 (1941). It concluded that the same logic should apply under section 4975(c)(1)(A), which makes any direct or indirect sale or exchange of property between a plan and a disqualified person a prohibited transaction. According to the Court, the term "sale or exchange" had acquired a settled judicial and administrative interpretation during the 50 years before Congress in section 4975 enacted the even broader statutory language of "any direct or indirect ... sale or exchange." When it enacted section 4975, Congress was presumptively aware that the phrase "sale or exchange" had consistently been construed to include the transfer of property in satisfaction of a monetary obligation. See, e.g., Albernez v. United States, 450 U.S. 333 (1981).

Thus, at a minimum the contribution of property in satisfaction of a funding obligation is an indirect type of sale and a form of exchange, since the property is exchanged for diminution of the employer's funding obligation. The Court determined that section 4975(f)(3) - which provides that a transfer of property by a disqualified person to a plan is to be treated as a sale or exchange "if the property is subject to a mortgage or similar lien" - extends the reach of the phrase "sale or exchange" in section 4975(c)(1)(a) to include contributions of encumbered property that do not satisfy funding obligations, rather than limiting its scope to transfers of encumbered property.

B. Congress's Response to Potential Abuses

The Supreme Court stated that a broad construction of section 4975 is necessary to accomplish Congress's goal to bar categorically a transaction that is likely to injure the pension plan. It explained that a property transfer poses various potential problems for the plan, including (1) a shortage of funds to pay promised benefits, (2) assumption of the primary obligation to pay any encumbrance, (3) overvaluation of the property by the employer, (4) the property's nonliquidity, (5) the burden and cost of disposing of the property, and (6) the employer's substitution of its own judgment about investment policy.

The Court stated that section 4975 operates to prevent such abuses regardless of whether the property is encumbered. In Keystone, even though the properties at issue were unencumbered and were not overvalued at the times of their respective transfers, the evidence established that it was neither easy nor inexpensive to dispose of them. The Court noted, for example, that one truck terminal was not sold until three-and-a-half years after being listed for sale by the pension trust and that the sales-listing agreements made with respect to the two other terminals called for the payment of sales commissions.

C. Keystone's Implications for the Future

The Supreme Court was not concerned with property contributions to pension plans when there is no outstanding funding obligations. In other words, the Court did not completely close the door for property contributions. A transfer of encumbered property, like the transfer of unencumbered property to satisfy an obligation, has the potential of burdening a plan, whereas a transfer of property that is neither encumbered nor satisfying a debt presents less potential for causing the plan to sustain a loss.

Example. An employer with no outstanding funding obligations wishes to contribute property to a pension fund to reward its employees for an especially productive year of service. The property contribution is permissible if the property is unencumbered, because it will not be "exchanged" for a diminution in funding obligations and therefore does not fall within the prohibition of section 4975(c)(1)(A). On the other hand, the property contribution is impermissible if the property is encumbered, because section 4975(f)(3) specifically prohibits all contributions of encumbered property.

IV. Conclusion

Although the Supreme Court in Keystone dealt employers a harsh blow in disallowing property contributions to pension plans for funding obligations, property contributions are still permitted for discretionary profit-sharing plans and for pension plans when they are not used for funding obligations. Voluntary contributions of property to defined benefit plans can be a useful tool to go beyond current funding obligations and thus reduce future funding obligations.

Conference on Professionalism

On October 18, the American College of Tax Counsel will sponsor a Conference on Professionalism in Tax Practice in Washington, D.C. The one-day conference is being organized in cooperation with Tax Executives Institute, the American Institute of Certified Public Accountants, and the American Bar Associations's Tax Section.

Participants in the conference will include IRS employees, the practitioner community (both in-house and outside representatives), and academia, who will contribute to the understanding of and dedication to professional standards by those involved in tax practice, whether on behalf of the government or taxpayers. TEI participants will include Larry Langdon of Hewlett-Packard Company, a past President of TEI, and Mike Murphy, TEI's Executive Director.

Attendance at the program will be limited. (A registration fee of $100 will be charged.) If you are interested in attending the conference or receiving additional information, please call Mike Murphy or Timothy McCormally at TEI Headquarters.

RAY A. KNIGHT is a professor of accounting at Middle Tennessee State University. He received a B.S. degree in accounting from the University of Houston, an M.A. degree in accounting from the University of Alabama, and a J.D. degree from Wake Forest University. He is a member of the American Institute of Certified Public Accountants, American Bar Association, American Taxation Association, and several other professional organizations. Mr. Knight has published articles in many professional journals, including The Tax Executive.

Lee G. Knight is a professor of accounting at Middle Tennessee State University. She received a B.S. degree in accounting from Western Kentucky University and M.A. and Ph.D. degrees from the University of Alabama. She is a member of the American Accounting Association and the American Taxation Association. Ms. Knight has published articles in many professional journals, including The Tax Executive.

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