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Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
Investing Retirement Plan Assets: What Are The Limits?
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Investing Retirement Plan Assets: What Are The Limits?

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The Internal Revenue Code and the Title I of ERISA (administered by the U.S. Department of Labor) have restrictions on how retirement plan assets can be invested. For example, certain investments …

The Internal Revenue Code and the Title I of ERISA (administered by the U.S. Department of Labor) have restrictions on how retirement plan assets can be invested. For example, certain investments will cause UBTI (unrelated business taxable income) to what is otherwise a tax-exempt trust. Certain investments may cause prohibited transactions with the resulting excise tax under IRC Section 4975. There are also the general fiduciary rules governing trustees generally, e.g., the duty to diversify. This handout is designed to advise the trustee and the plan sponsor on how to avoid the pitfalls.

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  • 1. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION SUITE 445 12100 WILSHIRE BOULEVARD LOS ANGELES, CALIFORNIA 90025 www.GivnerKaye.com www.MajorTaxProblems.com This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. BRUCE GIVNER (bruce@GivnerKaye.com) OWEN D. KAYE (owen@GivnerKaye.com) KATHLEEN GIVNER (kathy@GivnerKaye.com) NEDA BARKHORDAR (neda@GivnerKaye.com) PHONE (310) 207-8008 (818) 785-7579 FAX (310) 207-8708 (818) 785-3027 August 24, 2013 Investing Retirement Plan Assets: What Are The Limits? TABLE OF CONTENTS 1.  Definitions. ............................................................................................................ 1  2.  Rules Governing Retirement Plan Investments. ..................................................... 2  3.  General Suggestions. ............................................................................................ 2  4.  Who Is A Disqualified Person?............................................................................... 3  5.  What Are The PT Rules?....................................................................................... 4  6.  What Is The Penalty For A PT? ............................................................................. 4  7.  Who Pays The PT Excise Tax? ............................................................................. 5  8.  What Is Required To "Correct" A PT? .................................................................... 5  9.  How Soon Must PT Be "Corrected" To Avoid 100% Excise Tax?............................ 5  10.  What Is The "Amount Involved" In A PT?............................................................... 5  11.  Is Contribution Of Mortgaged Property A PT? ........................................................ 5  12.  Is Contribution Of Unmortgaged Property A PT?.................................................... 6  13.  Is A Joint Investment A Prohibited Transaction?..................................................... 6  14.  What Is The PT Exemption For Participant Loans? ................................................ 6  15.  Employer Securities And Real Property Restrictions............................................... 7  16.  What Is A "Qualifying Employer Security"?............................................................. 7  17.  Limits On Holding Such Securities & Real Property................................................ 8  18.  What Plans Are Exempt From These Restrictions?................................................ 8  19.  What Is UBIT?....................................................................................................... 8  20.  What Is The Tax On UBIT?.................................................................................... 8  21.  What Is The Theory Behind UBIT? ........................................................................ 9  22.  What Types Of Leveraged Property Are Exempt From UBIT?................................ 9  23.  What Are The General Fiduciary Duties? ............................................................... 9  24.  When Is Failure To Appraise A Defined Contribution Plan A Fiduciary Violation?. 10  25.  How Much Invested In One Asset Violates The Diversification Rule?.................... 10  26.  Who Is A Fiduciary? ............................................................................................ 10  27.  Are There Ways To Limit Fiduciary Liability?........................................................ 11  28.  What Is The Liability For A Fiduciary Breach? ...................................................... 11 
  • 2. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION SUITE 445 12100 WILSHIRE BOULEVARD LOS ANGELES, CALIFORNIA 90025 www.GivnerKaye.com www.MajorTaxProblems.com This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. BRUCE GIVNER (bruce@GivnerKaye.com) OWEN D. KAYE (owen@GivnerKaye.com) KATHLEEN GIVNER (kathy@GivnerKaye.com) NEDA BARKHORDAR (neda@GivnerKaye.com) PHONE (310) 207-8008 (818) 785-7579 FAX (310) 207-8708 (818) 785-3027 August 24, 2013 Investing Retirement Plan Assets: What Are The Limits? Introduction 1. Definitions. 1.1. Tax Qualified Plans. The retirement plans discussed in this handout are “tax qualified” employee retirement plans. They are “qualified” for certain tax benefits, principally the fact that the contributions are deductible by the employer and the earnings inside the employee retirement trust are not currently subject to tax. 1.2. Plan vs. Trust. The plans are contracts between the plan sponsor – the employer – and the trustee of the retirement trust which determine how the employer will contribute to the trust. So the plans are not “persons” – they are simply contracts. By contrast, the trustee of the retirement trust is a legal person. 1.3. Defined Contribution Plans vs. Defined Benefit Plans. There are two types of tax qualified employee retirement plans. Defined contribution plans measure how much goes in to the trust each year. These include profit sharing plans; 401(k) plans; ESOPs; money purchase pension plans; target benefit plans; and cash balance plans. Defined benefit plans measure how much is distributed from the trust. There are different ways of measuring how must gets distributed, but they in the world of closely held businesses they are targeting a specific percentage of monthly or annual compensation. 1.4. Pension Plans. For purposes of applying the fiduciary duties imposed on retirement plans by ERISA,1 all tax qualified employee retirement plans are treated as “pension plans. 1.5. IRAs. For purposes of this discussion, individual retirement accounts (“IRAs”) are generally treated the same as pension plans. The differences will be specially noted. 1 The Employee Retirement Security Act of 1974, Title I of which provides for reporting and fiduciary duty rules, Title II of which amended the Internal Revenue Code.
  • 3. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION Investing Retirement Plan Assets August 24, 2013 Page 2 This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. 2. Rules Governing Retirement Plan Investments. Three (3) sets of rules limit pension investments: 2.1. Prohibited transaction (“PT”) rules appearing in both the Internal Revenue Code (“IRC”)2 and the Employee Retirement Income Security Act of 1974 (“ERISA”)3 (which is enforced by the U.S. Department Of Labor (“DOL”)); 2.2. IRC's unrelated business income tax ("UBIT") rules; and 2.3. ERISA's fiduciary duties.4 3. General Suggestions. 3.1. Taxpayer I.D. Numbers. Each retirement trust must have its own taxpayer I.D. number, and should use that for all plan brokerage accounts and investments which issue a Form 1099.5 The trust will be issued an I.D. number if it submits a Form SS-4 to the IRS. Properly using the plan's I.D. number prevents accidental reporting of trust investment income under your individual or the corporation's taxpayer I.D. number, which might trigger an unnecessary audit. 3.2. FDIC Coverage. Employee retirement trust deposits that qualify for "pass-through coverage" are insured up to $250,000 for each participant's interest in the plan. For an employee retirement trust to receive pass-through insurance, the institution's deposit account records must specifically disclose the fact that the funds are owned by an employee retirement trust. Also, the details of the participants' beneficial interests in the account must be ascertainable from the institution's deposit account records or from the records that the plan administrator (or some other person or entity that has agreed to maintain records for the trust) maintains in good faith and in the regular course of business. Regulations now require that the trustee should determine the capital status of insured institutions each time a deposit is made. Failure to do so may result in personal liability in a default situation. 2 IRC §4975. 3 ERISA §406. 4 ERISA §404. 5 The plan’s third party administrator should secure the E.I.N. when the plan and trust are established.
  • 4. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION Investing Retirement Plan Assets August 24, 2013 Page 3 This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. PART I: GENERAL PT RULES 4. Who Is A Disqualified Person? To have a Prohibited Transaction there must be a “Disqualified Person.” So first let us review those rules. “`Disqualified person' means a person who is - (A) a fiduciary [e.g., a trustee]; (B) a person providing services to the plan [e.g., the pension consultant]; (C) an employer any of whose employees are covered by the plan; (D) an employee organization any of whose members are covered by the plan; (E) an owner, direct or indirect, of 50% or more of - (i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation, (ii) the capital interest or the profits interest of a partnership, or (iii) the beneficial interest of a trust or unincorporated enterprise, which is an employer or an employee organization described in subparagraph (C) or (D); (F) a member of the family [spouse, ancestor, lineal descendant, and any spouse of a lineal descendant] of any individual described in (A), (B), (C), or (E); (G) a corporation, partnership, trust or estate [entity] of which (or in which) 50% or more of the: (i) combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock..., (ii) capital interest or profits interest of such partnership, or (iii) beneficial interest of the trust...is owned directly or indirectly, or held by persons described in...(A), (B), (C), (D), or (E); (H) an officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10% or more shareholder, or a highly compensated employee (earning 10% or more of the yearly wages of an employer) of a person described in...(C), (D), (E), or (G); or
  • 5. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION Investing Retirement Plan Assets August 24, 2013 Page 4 This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. (I) a 10% or more (in capital or profits) partner or joint venturer of a person described in...(C), (D), (E), or (G).”6 The comparable ERISA term is "party in interest".7 5. What Are The PT Rules? The IRC provides that a PT means any “direct or indirect - (A) sale or exchange, or leasing, of any property between a plan and a disqualified person (“DP”); (B) lending of money or other extension of credit between a plan and a DP; (C) furnishing of goods, services, or facilities between a plan and a DP; (D) transfer to, or use by or for the benefit of, a DP of plan income or assets; (E) act by a DP who is a fiduciary whereby he deals with plan income or assets in his own interest or for his own account; or (F) receipt of any consideration for his own…account by any DP who is a fiduciary from any party dealing with the plan in connection with a transaction involving the [the plan’s] income or assets….”8 ERISA has essentially the same PT rules.9 However, it adds a rule not found in the Internal Revenue Code: “acquisition, on behalf of the plan, of any employer security or employer real property....” PTs are not permitted even when the result would be fair or beneficial to the retirement plan. 6. What Is The Penalty For A PT? The initial excise tax is fifteen percent (15%) of the "amount involved" for each year in the "taxable period."10 6 IRC §4975(e)(2). 7 ERISA §3(14). 8 IRC §4975(c)(1). 9 §406. 10 IRC §4975(a).
  • 6. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION Investing Retirement Plan Assets August 24, 2013 Page 5 This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. If the PT is not "corrected" within the "taxable period" the 2d stage excise tax is one hundred percent (100%) of the "amount involved".11 7. Who Pays The PT Excise Tax? Any disqualified person who participated in the PT pays the excise tax.12 If more than one (1) person is liable, all such persons are jointly and severally liable.13 8. What Is Required To "Correct" A PT? Correcting a PT means "undoing the transaction to the extent possible, but in any case placing the plan in a financial position not worse than that in which it would be if the disqualified person were acting under the highest fiduciary standards."14 9. How Soon Must PT Be "Corrected" To Avoid 100% Excise Tax? The PT must be corrected by the earliest of the date - (A) of mailing a notice of deficiency ("90 day letter") for the 15% excise tax; (B) on which the 15% excise tax is assessed; or (C) on which correction of the PT is completed. 10. What Is The "Amount Involved" In A PT? "'Amount involved' means...the greater of the...money and the fair market value of the other property given or [that which is] received...."15 For example, if the PT was a loan, the amount involved is the greater of the interest actually paid or the then prevailing fair interest rate. 11. Is Contribution Of Mortgaged Property A PT? Generally, yes. "A transfer of real or personal property by a disqualified person to a plan shall be treated as a sale or exchange [and, therefore, a PT] if the property is subject to a mortgage or similar 11 IRC §4975(b). 12 IRC §4975(a) and (b). 13 IRC §4975(f)(1). 14 IRC §4975(f)(5). 15 IRC §4975(f)(4).
  • 7. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION Investing Retirement Plan Assets August 24, 2013 Page 6 This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. lien which the plan assumes or if it is subject to a mortgage or similar lien which a disqualified person placed on the property within the 10-year period ending on the date of the transfer."16 12. Is Contribution Of Unmortgaged Property A PT? You should assume that the answer is “yes.”17 Technically, the answer should be “no” in the case of a contribution to a profit sharing plan in which the employer’s contributions are strictly discretionary. However, even in that situation the contribution of property will still be subject to the fiduciary duty to ensure that it is an appropriate trust investment. 13. Is A Joint Investment A Prohibited Transaction? Certainly you can buy 100 shares of IBM and your pension plan can buy 100 shares of IBM without causing a PT.18 Can you be a 50% shareholder in a corporation in which your pension plan owns the other 50%? The DOL has informally indicated the conditions under which mere co-ownership of property or a joint investment is not a prohibited transaction: if the disqualified person would have been able to make the same investment in the absence of the plan also buying an interest. 14. What Is The PT Exemption For Participant Loans? "[A]ny loan made by the plan to a disqualified person who is a participant or beneficiary of the plan [is exempt] if such loan - (A) is available to all such participants or beneficiaries on a reasonably equivalent basis, (B) is not made available to highly compensated employees [as defined] in an amount greater than the amount made available to other employees, (C) is made in accordance with specific [loan] provisions...set forth in the plan, (D) bears a reasonable rate of interest, and (E) is adequately secured”.19 16 §4975(f)(3). 17 Keystone Consolidated (U.S. Supreme Court 5/93). 18 Compare ERISA Opinion Letter 200-10A (7/27/00), in which there was joint ownership of a partnership by an IRA and an IRA owner. The IRS indicated that the IRA owner may not rely upon, and cannot otherwise be dependent upon, participation in an IRA to undertake or continue a personal benefit. This has been interpreted to mean that “co-investment” is permissible as long as the IRA owned is able to establish that he had sufficient other personal assets to “carry” the investment were IRA assets not used. 19 IRC §4975(d)(1). See also ERISA §408(b)(1).
  • 8. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION Investing Retirement Plan Assets August 24, 2013 Page 7 This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. The DOL has issued extensive regulations governing participant loans. PART II: LIMITS ON EMPLOYER (a) SECURITIES & (b) REAL PROPERTY 15. Employer Securities And Real Property Restrictions. "A plan may not acquire or hold - (A) any employer security which is not a qualifying employer security, or (B) any employer real property which is not qualifying employer real property.”20 "'[E]mployer security' means a security issued by an employer of employees covered by the plan, or by an affiliate of such employer."21 "'[E]mployer real property' means real property (and related personal property) which is leased to an employer of employees covered by the plan, or to an affiliate of such employer."22 16. What Is A "Qualifying Employer Security"? "'[Q]ualifying employer security' means an employer security [defined in the preceding Q&A] which is - (A) stock, (B) a marketable obligation (as defined in subsection (3)), or (C) an interest in a publicly traded partnership...."23 Also: "(A) no more than 25% of the aggregate amount of stock of the same class issued and outstanding at the time of acquisition [can be] held by the plan, and (B) at least 50% of the aggregate amount referred to in subparagraph (A) is held by persons independent of the issuer."24 20 ERISA §407(a)(1). 21 ERISA §407(d)(1). 22 ERISA §407(d)(2). 23 ERISA §407(d)(5). 24 ERISA §407(f)(1).
  • 9. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION Investing Retirement Plan Assets August 24, 2013 Page 8 This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. 17. Limits On Holding Such Securities & Real Property. "A plan may not acquire any qualifying employer security or qualifying employer real property, if immediately after..., the aggregate fair market value of employer securities and employer real property held by the plan exceeds 10% of the fair market value of the [plan's assets]."25 18. What Plans Are Exempt From These Restrictions? The restrictions on qualifying employer securities and qualifying employer real property do not apply to "an eligible individual account plan." "Eligible individual account plan" means a: "(i) profit-sharing, stock bonus, thrift, or savings plan; (ii) an employee stock ownership plan (ESOP); or (iii) a money purchase plan [in existence in 1974, etc.]."26 The term does not include an IRA. PART III: UNRELATED BUSINESS INCOME TAX ("UBIT") 19. What Is UBIT? UBIT is "gross income [a tax-exempt entity] derives...from any unrelated trade or business...[it] regularly carrie[s] on...less [specified] deductions."27 It also includes a percentage of the gross income derived by the tax-exempt entity from debt-financed property. That percentage is determined by comparing the debt on the property to the tax-exempt entity's basis in the property.28 20. What Is The Tax On UBIT? The tax-exempt entity pays tax on its UBIT at the same rate as a corporation pays on its own income.29 25 ERISA §407(a)(2). 26 ERISA §407(d)(3)(A). 27 IRC §512(a)(1). 28 IRC §514(a). 29 IRC §511(a)(1).
  • 10. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION Investing Retirement Plan Assets August 24, 2013 Page 9 This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. 21. What Is The Theory Behind UBIT? Congress added the UBIT rules to the Internal Revenue Code to prevent the type of competitive disadvantage apparent in the following hypothetical: General Mills makes and sells cereal. Quaker Oats also makes and sells cereal. General Mills, a normal corporation, must pay income taxes on its profits. However, Quaker Oats, which is owned by a church, is exempt from paying income taxes. 22. What Types Of Leveraged Property Are Exempt From UBIT? A retirement plan can use normal mortgages to acquire real property without subjecting income from the property to the UBIT. IRC §514(c)(9). PART IV: FIDUCIARY DUTIES 23. What Are The General Fiduciary Duties? "[A] fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and - (A) for the exclusive purpose of: (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan; (B) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent [person] acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims; (C) by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so; and (D) in accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with [the law]."30 Also, "no fiduciary may maintain the indicia of ownership of any assets of a plan outside the jurisdiction of the district courts of the United States."31 30 ERISA §404(a)(1). 31 ERISA §404(a)(2).
  • 11. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION Investing Retirement Plan Assets August 24, 2013 Page 10 This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. 24. When Is Failure To Appraise A Defined Contribution Plan A Fiduciary Violation? ERISA has always required annual valuation of plan assets. Until recently, many plan sponsors determined an asset's value based upon Schedule K-1 or book value. Unfortunately, some plan sponsors made poor investments and then used improper values to determine account balances or contribution levels. In some cases, an investment carried at book value was nearly worthless. Defined contribution plans (DCPs) may have paid terminated participants more than their fair share and the remaining participants bore all the loss. Due to these problems, the IRS has targeted hard-to-value assets in their audit program. IRS added the following question to the annual reporting requirements:32 "Does the plan hold any assets that have a fair market value that is not readily determinable on an established market?" A red flag is raised if the assets have not been valued during the plan year. If you answer the question "yes" you must tell when the assets were last valued by an independent appraiser.33 IRS said a plan can be disqualified for failure to have an independent appraisal of an asset without a public market. That is logical because fiduciaries are responsible for making sure participants receive the correct benefits; they cannot receive the correct benefits from a defined contribution plan if the assets are improperly valued. 25. How Much Invested In One Asset Violates The Diversification Rule? There is no absolute safe harbor. In some cases the DOL has taken the position that 15% in a real estate project was too much. One case held that having 80% of the funds in government bonds breached the diversification requirement. In each situation consider discussing the investment with your professional advisors who are familiar with the fiduciary responsibility rules. 26. Who Is A Fiduciary? A "person is a fiduciary with respect to a plan to the extent he: (i) exercises any discretionary authority or discretionary control respecting management of the plan or exercises any authority or control respecting management or disposition of its assets, 32 Form 5500. 33 See 401(a)(28)(C) for the requirement of an independent appraiser for ESOPs.
  • 12. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION Investing Retirement Plan Assets August 24, 2013 Page 11 This Handout provides general information. It does not give legal advice. Each situation is different, and factual differences require different approaches. Do not rely on anything described in this Handout. Instead, consult your own lawyer and C.P.A. (ii) renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of the plan, or has any authority or responsibility to do so, or (iii) has any discretionary authority or discretionary responsibility in the administration of the plan."34 27. Are There Ways To Limit Fiduciary Liability? The plan document "may expressly provide procedures: (A) for allocating fiduciary responsibilities (other than trustee responsibilities) among named fiduciaries, and (B) for named fiduciaries to designate persons other than named fiduciaries to carry out fiduciary responsibilities (other than trustee responsibilities)...."35 Also, the plan should buy "insurance for its fiduciaries or for itself to cover liability or losses occurring [due to] the act or omission of a fiduciary...."36 28. What Is The Liability For A Fiduciary Breach? "Any person who is a fiduciary...who breaches any of the responsibilities...shall be personally liable to make good to such plan any losses...resulting from each such breach, and to restore to the plan any profits…which have been made through [the fiduciary’s] use of [of the plan] assets…and shall be subject to such other equitable or remedial relief as the court may deem appropriate, including removal…."37 There are also potential criminal penalties38 and: (i) fines of up to $100 per day39 ; (ii) fines of up to $1,000 per day40 ; (iii) attorneys' fees and costs41 ; and (iv) fine of 20% of the amount recovered.42 34 ERISA §3(21)(A). 35 ERISA §405(c)(1). 36 ERISA §410. See also §412 requiring the purchase of a bond. 37 ERISA §409(a). 38 §501. 39 §502(c)(1). 40 §502(c)(2). 41 §502(g)(1). 42 §502(l)(1).

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