Considerations for financial firms that waive investment fees for employees

Editor: Mary Van Leuven, J.D., LL.M.

Renaissance Technologies LLC (Renaissance) recently made news in The Wall Street Journal for a letter the New York-based investment management company reportedly sent to its current and former employees cautioning that the IRS could assess back taxes and penalties against them related to their investment in Renaissance hedge funds (Zuckerman and Rubin, “Renaissance Employees Could Face Clawbacks Over Hedge Fund’s Tax Maneuver,” The Wall Street Journal (Dec. 18, 2019)). The potential tax implications of their investment in the firm’s funds are complicated by the fact that employees were permitted to invest through the Renaissance 401(k) plan and individual retirement arrangements (IRAs) without paying the typically required investment, administrative, or other fees.

Publicity surrounding this employee investment opportunity is not the first time Renaissance has attracted attention for the investment benefits available to its employees. In 2010, Renaissance terminated its 401(k) plan for employees, which allowed employees to roll over their investments into a traditional IRA. Under existing tax rules, employees converted their traditional IRAs into Roth IRAs. In 2012, Renaissance received an exemption from the U.S. Department of Labor from certain prohibited-transaction rules, and Renaissance employees were allowed to invest in Renaissance-established funds, primarily the Medallion funds, through their IRAs. Renaissance employees were able to realize significant tax advantages as a result. By paying tax on the amount upfront and immediately converting the investment to a Roth IRA, the substantial gains on invested fund assets could grow in the account with no taxes ever imposed on the future earnings. Another advantage of Roth IRAs is that they generally do not have to follow the same required minimum distribution rules as traditional IRAs and qualified retirement plans, which often require that distributions begin during the individual’s lifetime.

Although the details of any potential IRS audit are not currently public, this story has renewed discussion of important considerations for investment firms offering similar benefits to their employees. This article discusses a few relevant questions that employers offering fee-free or reduced-fee investments should consider. (Of course, the tax implications to both the employer and its employees will depend on the specific design of the benefit being provided.)

First inquiry

When employees are permitted to invest in an employer-managed fund without paying fees, is there a benefit that should be included in the employee’s income as additional compensation?

This is a frequently asked, and often fundamental, question. As a general rule, the value of any benefit provided by an employer to its employees in exchange for performing services must be included in income as compensation. If a benefit is provided to employees that is not available on the same basis to other groups (e.g., to the general public), it is generally presumed to arise out of the employment relationship and be payment for services.

There are, of course, certain exceptions to this general rule. Some are well known and frequently used — for example, certain health and welfare benefits, as well as de minimis fringe benefits (e.g., coffee in the break room, personal phone calls) may typically be provided to employees tax-free.

Some other exceptions to income inclusion are less common, and some are more prevalent within specific industries. For example, the “no-additional-cost services” fringe benefit generally allows an employer to provide a benefit to its employees without including the value of that benefit in income, provided the employer is not incurring any costs to provide the benefit. The determination of whether a cost is incurred must include consideration of any forgone revenue.

A classic example of this fringe benefit is the opportunity for airline employees to fill available seats on a flight free of charge. Typically, this fringe benefit requires that the employee fly standby; if the airline holds a reserved seat for the employee, it may be forfeiting revenue, and the seat would not truly be provided on a no-additional-cost basis. In the investment fund context, employees may be permitted to participate in a fund without paying fees if there is truly no incremental cost to the employer for their participation. However, if the employer has to incur additional fees and/or expenses to establish or maintain a separate investment vehicle that is primarily used for employees, it is less likely this exception will apply. Similarly, if employees take up a limited number of spots for investors in the fund, there may be forgone revenue that could preclude application of the no-additional-cost service fringe benefit exception.

Second inquiry

Could investing through a qualified retirement plan or IRA run afoul of the qualified plan contribution limits?

Annual limitations apply to the amount that can be contributed to a tax-qualified plan such as a 401(k) or an IRA. For the 2020 tax year, for example, the annual contribution limit for employees who participate in a 401(k) plan is $19,500 (or up to $26,000 for participants age 50 or older), while the limit on annual contributions to an IRA is $6,000 (up to $7,000 for participants age 50 or older) (see Notice 2019-59). These limits are generally measured against the cash value contributed to the plan or arrangement by or on behalf of the employee. Once in the plan, the contributed funds are allocated to one or more specified investments. The investment options frequently carry various levels or types of fees.

In financial firms like Renaissance, when an employee is permitted to allocate contributed funds into an investment that traditionally imposes fees (e.g., for Renaissance, both management fees and performance-based fees) and receive the full benefit of that investment without any fees, an argument could be made that there is a greater value to the retirement plan contribution than its face value. If the amount of forgone fees is considered compensation to the employee, then it raises the question of whether that additional compensation should be counted as an effective contribution to the plan and toward the annual limitation, resulting in a potential excess contribution to the qualified plan or IRA. In some situations, an excess contribution may result in excise taxes.

Third inquiry

Does it raise any concerns to charge typical fees to employees (or the qualified plan/IRA) for investing in employer-managed funds?

As is the answer to many tax questions, it depends. Qualified retirement plans and IRAs are subject to a complex web of rules and requirements, and some might apply to charging typical fees. Sec. 4975 imposes an excise tax on any “disqualified person” who participates in a prohibited transaction with a qualified plan or IRA. For this purpose, a disqualified person includes, among others, any fiduciary of the plan and an employer with employees covered by the plan. Transactions penalized by this section include, e.g., the sale or exchange of any property between a plan and disqualified person as well as the transfer to, or use by or for the benefit of, a disqualified person of plan assets or income. The Employee Retirement Income Security Act of 1974 (ERISA) includes similar language prohibiting certain transactions between a fiduciary and qualified retirement plan. When an employer receives a monetary benefit from its employees’ investment in employer-managed funds through a qualified retirement plan or IRA, it may raise a question of whether the arrangement complies with the prohibited-transaction rules under Sec. 4975 and ERISA, as applicable.

Time for a checkup

Discussion of these issues provides an opportunity for investment and/or hedge fund employers, as well as similarly situated employers, to review benefits made available to employees involving investments. Particularly, the structure and design of such benefits provided exclusively to employees merit additional review. In performing a benefits checkup, renewed consideration may be given, e.g., to the tax implications of the benefits to both the employer and its employees, and whether the provided benefits raise any compliance concerns.

Of course, whatever actions an employer ultimately takes is an individualized determination that should be made in consultation with professional legal and tax advisers.

EditorNotes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.