Although it may not always be true that sound corporate risk-management practices coincide with tax deductions, there are times when they clearly do. In a letter ruling issued by the Internal Revenue Service on February 19, for example, a company’s action to insure itself against liability risks in the wake of a fraud ended up being tax-deductible.
Let’s call the company in question Prudent Corp. The case in question involved Prudent’s management of the profit-sharing component of its defined-contribution pension plan. As many plan sponsors do, Prudent assigned the investment management of a portion of the profit-sharing plan assets of the profit-sharing component to a registered broker-dealer we’ll call In Firm.
Some time later, the president and founder of In Firm was charged with engaging in a scheme that resulted in “widespread depletion of assets” that had been placed under his firm’s management for investment, according to the letter ruling (LTR 201007077). Three days later, the broker-dealer filed for protection under Chapter 11 of the Bankruptcy Act.
Prudent “became concerned” that participants in the
profit-sharing plan would sue it. As a result, the company planned to make a “restorative payment” to the profit-sharing plan that would put the plan in the financial position it would have been in had employer contributions been invested other than with In Firm during the same period. Later, as an interim remedial measure, Prudent made its first payment in support of the plan, and the company plans to make more such payments. The IRS ruled that the payments would not jeopardize the plan’s tax-qualified status and that the payments would be deductible in computing Prudent’s taxable income.
Prudent was able to hold on to the tax-qualified status of the plan because the IRS didn’t think the payments were made to boost benefits to plan participants. Under Section 415(a) of the Internal Revenue Code, payments made to a pension, profit-sharing, or stock bonus plan can disqualify the plan from special benefit-plan tax status if they cause it to exceed certain benefit limits.
The code, however, also states that a restorative payment allocated to a participant’s account doesn’t add to the limited amount. To be sure, payments made merely to replenish a participant’s account against investment losses are treated as contributions for purposes toward those limits.
By contrast, however, payments made to restore losses stemming from an action (or failure to act) that creates a “reasonable risk of liability” (for breach of fiduciary duty) are restorative payments. To qualify as a restorative payment, the payment doesn’t have to result from legal action, according to the ruling; it only needs to be made as a result of a “reasonable determination” that there is a reasonable risk of liability. Moreover, the amount of a restorative payment cannot exceed the initial amount of the investment.
The IRS concluded that Prudent had made a reasonable determination that there was a reasonable risk of liability for breach of fiduciary duty as a result of the losses sustained by the plan because of In Firm’s fraud. The service thus reasoned that the payment could be characterized as restorative rather than as a contribution aimed at increasing benefits. Accordingly, the restorative payments should not change the plan’s qualified status.
Further, the service observed that “the situation in which [Prudent] finds itself arose in the ordinary course of its trade or business.” There is “no serious question of its business origin.” Precedent holds that such payments are ordinary and necessary, and therefore deductible as business expenses. And they’re also good risk management.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.