ERISA 25% Plan Assets Test for a Real Estate Syndication

The ERISA 25% test asks whether benefit plan investors, a group that includes IRAs and 401(k)s, hold 25% or more of the value of any class of a syndication's equity. If they do, and no exception applies, the deal's underlying assets are treated as plan assets, and the people who manage them can become fiduciaries to every investing plan. Most single-property syndications avoid this by capping plan money below 25% per class in the operating agreement and checking the number at every closing.

This is general information for a first-time sponsor. The rules are technical, so have your securities attorney or an ERISA attorney read your documents.

What is the 25% test?

When a plan buys equity in a private entity, the general rule in the regulation is that the plan owns its interest and also an undivided interest in each of the entity's underlying assets. That is the "look-through" rule. The regulation lists ways out, and the one most syndications use is that equity participation by benefit plan investors is "not significant."

Participation is significant if, immediately after the most recent acquisition of any equity interest, benefit plan investors hold 25% or more of the value of any class of equity interests. ERISA section 3(42) puts the same line in the statute. Below 25% in every class, the deal's apartment building is not plan assets.

Who counts as a benefit plan investor?

Under section 3(42), a benefit plan investor is:

An employee benefit plan subject to Part 4 of Title I of ERISA, such as a company 401(k) or pension plan
Any plan to which Internal Revenue Code section 4975 applies, which includes IRAs and self-directed IRAs
Any entity whose underlying assets include plan assets because of plans' investment in it

The statute's wording, added in 2006, is narrower than the older text of the regulation. It leaves out plans not subject to those provisions, such as governmental and church plans, from the count. If a pension fund for a city or a church wants in, ask counsel how to treat it.

For investors, this is the same money we cover in investing with a self-directed IRA or solo 401(k). One investor's IRA is enough to start the count.

How do you calculate it?

Three details trip up sponsors.

Leave the sponsor out. The regulation says to disregard equity held by anyone (other than a benefit plan investor) with discretionary authority or control over the entity's assets, anyone paid to give investment advice about them, and their affiliates. The sponsor's co-investment drops out of both sides of the fraction.
Test each class. The line applies to "any class." If your deal has Class A and Class B units, each one is tested on its own. A class funded mostly by IRA money can cross the line even if the deal as a whole does not.
Test again after each purchase. The measure is taken immediately after the most recent acquisition of any equity interest. A second closing, a transfer or a redemption can change the answer.

A made-up example

This example is made up, with round numbers. A deal raises $2,000,000 of Class A units. The sponsor's own Class A units are $100,000. IRA money totals $460,000.

Step	Class A total	Sponsor units left out	Counted base	Plan money	Share
First closing, counted wrongly (sponsor not removed)	$2,000,000	$0	$2,000,000	$460,000	23.0%
First closing, counted correctly	$2,000,000	$100,000	$1,900,000	$460,000	24.2%
Second closing adds one $40,000 IRA	$2,040,000	$100,000	$1,940,000	$500,000	25.8%

The math: $460,000 / $1,900,000 is about 24.2%, under the line. After the second closing, $500,000 / $1,940,000 is about 25.8%, over it. The same deal looked safe at 23% when the sponsor's units were left in by mistake. A cap in the operating agreement would have stopped the last IRA subscription or limited its size.

What happens if a deal crosses 25%?

If benefit plan participation is significant and no other exception applies, the deal's underlying assets are plan assets. The regulation then says anyone who exercises authority or control over those assets, or gives paid investment advice about them, is a fiduciary of each investing plan.

That has real effects. Fiduciaries owe ERISA duties, and payments between the deal and related parties, such as fees to the sponsor, can become prohibited transactions under ERISA and section 4975 unless an exemption applies. The fix after the fact is hard and expensive. This is why the cap is written in before the first dollar comes in.

How do operating agreements keep a deal under 25%?

Most single-property deals use the same set of tools.

A representation in the subscription. Each investor states whether they are a benefit plan investor. See what a subscription agreement includes and the accredited investor questionnaire, where the question usually sits.
A cap. The operating agreement limits benefit plan investors to less than 25% of each class.
Rights to refuse. The sponsor may reject or cut back a subscription that would cross the line.
Transfer limits. A transfer to a plan, or a withdrawal that shrinks the base, needs the manager's consent.
A cure right. Some agreements let the manager require a sale or redemption of plan-held units if the line is crossed.

What about the REOC and VCOC exceptions?

The regulation also excludes "operating companies," which include a real estate operating company (REOC) and a venture capital operating company (VCOC). A REOC must, on set valuation dates, have at least 50% of its assets, valued at cost, in real estate that is managed or developed and in which it has the right to substantially participate directly in management or development, and must actually engage in that work in the ordinary course of business. Larger real estate funds sometimes structure for REOC status, which takes ongoing monitoring. A VCOC rarely fits real estate. For a single apartment deal, a 25% cap is the common and simpler approach.

How DoorRaise fits in

DoorRaise helps sponsors raise equity for apartment buildings with 5+ units from their friends and followers under Rule 506(b) or 506(c). DoorRaise prepares the standard offering documents, forms the LLC, files Form D and state notices, and verifies accredited investors for 506(c) deals. Escrow is at Enterprise Bank & Trust, an FDIC-insured bank, investors fund by wire only and distributions are quarterly by default. Fees are $1,500 at setup (non-refundable), $5,000 at closing (only if the deal closes) and $3,500 a year, with no percentage of the raise and no part of the promote. DoorRaise is not a law firm, broker-dealer, investment adviser, funding portal or bank, and it does not give ERISA advice.

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FAQ

Does a Roth IRA count toward the 25%?

Yes. A Roth IRA is an IRA covered by section 4975, so it is a benefit plan investor like a traditional IRA.

Does a solo 401(k) count?

A plan covered by section 4975 counts, and solo 401(k)s generally are. Treat the money as plan money unless counsel tells you otherwise.

Is the 25% measured on the whole raise or per investor?

Neither. It is measured per class of equity, as a share of that class's value, leaving out the sponsor's and its affiliates' interests.

Do we test only at the first closing?

No. The test applies immediately after the most recent acquisition of any equity interest, so check it at each closing and before approving a transfer or redemption.

Next step: read investing in syndications with a self-directed IRA or solo 401(k) to see the same rules from the investor's side, including UBTI.

Sources

This article is general information, not legal, tax or investment advice. Talk to a securities attorney or an ERISA attorney about your deal. DoorRaise is not a law firm, broker-dealer, investment adviser or funding portal.