Denial of Owner-Employee' Participation in ERISA Sheltered Plan Overturned

Small business owners have won an important victory in the U.S. Supreme Court. Reversing the U.S. Court of Appeals for the Sixth Circuit, the High Court ruled that some small business owners may be considered to be employees, as well as employers, for ERISA retirement plan purposes (R. B. Yates v. Hendon, 541 U.S. 1). In wearing both hats, owner-employees are able to fully participate in employer-sponsored plans and are entitled to all rights and protections of ERISA, including protecting benefits from reach of creditors.

Impact. The decision significantly helps to protect plan assets from the reach of creditors when the owner-participant is in bankruptcy. The decision is also a victory for non-owner employees at a time when small businesses are hesitant to sponsor employees-benefit plans.

Background. The taxpayer was the president and sole shareholder of a professional corporation. He served as administrator and trustee of the corporations profit sharing plan. The corporation also maintained a money purchase pension plan, which later merged into the profit sharing plan.

In 1989, the taxpayer borrowed $20,000 from the money purchase plan. He made no repayments until 1996, when he paid the loan in full. Three weeks later, his creditors filed an involuntary bankruptcy petition against him.

The bankruptcy trustee moved the court to set aside the loan repayment and it did. The bankruptcy court determined that the taxpayer, as a self-employed owner of a professional corporation, could not participate in the profit sharing plan as an employee. The money he repaid to the plan was not protected by ERISA, and the creditors could get it, the bankruptcy court found. The bankruptcy court's decision went all the way to the Sixth Circuit, which affirmed that the taxpayer did not qualify as a participant.

Supreme Court Reverses. According to the High Court, the Sixth Circuit erred when it applied an isolated definition of employee in an ERISA regulation. The regulation, 29 CFR 2510.3-3, provides that an owner shall not be deemed an employee. However, the court found the definition of employee was very limited in scope. It is not a generally applicable definition of employee, and it does not govern whether an individual is a participant in a plan.

The court further found that ERISA's anti-inurement protection was not offended. A fundamental requirement of any ERISA plan is that its assets never inure to the benefit of any employer. Assets must benefit plan participants.

An owner-employee's participation does not automatically indicate self-dealing, the court observed. The court did not address the issue of whether the taxpayer's handling of his loan repayments was conduct inconsistent with the anti-inurement rule. Back reference: 04FTG 11,202. (Source: CCH Federal Tax Guide Report Vol. 87, Issue No. 12)