Shedco, Inc. v. Commissioner

T.C. Memo. 1998-295

UNITED STATES TAX COURT

SHEDCO, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 17268-95R. Filed August 12. 1998.

John F. Daniels III and Neil H. Hiller, for petitioner.

Ann W. Durning and J. Robert Cuatto, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PARR, Judge: This case is before the Court upon a petition

for declaratory judgment under section 7476 and Rule 211. All

section references are to the Internal Revenue Code in effect for

the years in issue, and all Rule references are to the Tax Court

Rules of Practice and Procedure, unless otherwise indicated. The

issue to be decided is whether petitioner's defined benefit plan
 - 2 -

and trust qualify under sections 401 and 501 for plan year ended

September 19, 1987, and for subsequent years.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulated facts and accompanying exhibits are incorporated

into our findings by this reference.

Background

Petitioner was incorporated in Arizona on December 16, 1976.

When it filed the petition, petitioner's principal place of

business was in Sedona, Arizona.

All of petitioner's stock is, and always has been, owned by

James N. Shedd (Mr. Shedd) and Jean Phelps Shedd (Mrs. Shedd)

(hereinafter collectively referred to as the Shedds). Mr. Shedd

is, and at all relevant time has been, vice president and

secretary of petitioner. Mrs. Shedd is, and at all relevant

times has been, president of petitioner.

Mr. Shedd

Mr. Shedd received a bachelor of arts degree from Park

College in Missouri during 1943. During 1952, he began a career

in banking as a loan officer trainee for First National Bank of

Arizona (First National). From 1958 through 1962, Mr. Shedd took

courses in banking through night classes offered by the American

Institute of Banking. Additionally, he attended a 2-week course

each year during 1961 through 1963 offered by Pacific Coast Bank

School in Seattle, Washington.
 - 3 -

Mr. Shedd served as a loan officer, specializing in real

estate financing, for First National from 1952 until 1963.

During 1963, he left First National to become president of

Mission Mortgage Co. (Mission), a subsidiary of Lusk Corp.

(Lusk), a publicly held home building company with headquarters

in Tucson, Arizona. Mr. Shedd's responsibilities for Mission

included obtaining construction and permanent financing for large

cooperative housing projects in which Lusk was involved.

Sometime later, he briefly served as corporate treasurer of Lusk.

He left Lusk in January 1966 when the company went bankrupt.

Mr. Shedd then took a position with Arizona Trust Co.

(Arizona Trust), a mortgage company. His responsibilities for

Arizona Trust included originating loans to individuals and

packaging the loans for resale to investors.

During spring 1968, Mr. Shedd was hired by Estes Bros.

Construction Co. (Estes Bros.), an Arizona corporation. Estes

Bros. built homes in the Tucson, Arizona, area. Mr. Shedd's

primary responsibility for Estes Bros. was to obtain favorable

financing at known discount rates so that Estes Bros. could

provide favorable financing for its customers and maintain a

reasonable cost structure for itself. During 1971, Mr. Shedd

acquired 5 percent of the shares of Estes Bros. The remaining

shares of Estes Bros. were owned by William Estes, Sr. (80

percent), and William Estes, Jr. (Mr. Estes) (15 percent).
 - 4 -

During his career in real estate lending, Mr. Shedd became

proficient at reading and analyzing financial statements of real

estate developers and in evaluating their creditworthiness.

Formation of Petitioner, Estes Co., and Estes Homes

Singer Housing Co. (Singer Housing), a subsidiary of the

Singer Sewing Machine Co., purchased all of the shares of Estes

Bros. during August 1972 and renamed it the Estes Division of

Singer Housing (Estes Division). Shortly thereafter, Estes

Division purchased Staggs Built Homes, a large builder located in

Phoenix, Arizona, and renamed it the Singer Housing Co. in

Phoenix (Phoenix Division).

Mr. Shedd and Mr. Estes entered into 5-year employment

agreements with Estes Division, commencing in 1972. Mr. Shedd

served as manager of Estes Division's Tucson business (Tucson

Division). In that capacity he was responsible for all phases of

Estes Division's activities in Tucson, but he concentrated on

financial matters related to marketing homes that Estes Division

built in Tucson.

During 1976, Mr. Shedd and Mr. Estes decided to purchase

Estes Division. To effectuate the purchase, the Shedds formed

petitioner, and Mr. Estes and members of his family formed WE 7,

Inc. (WE 7), an Arizona corporation. During January 1977,

petitioner and WE 7 formed a partnership known as Estes Co., of
 - 5 -

which petitioner and WE 7 were the general partners.1 When

formed, petitioner owned an equity interest in Estes Co. of

approximately 23.3 percent.

Also during January 1977, Estes Co. and Severn Corp.

(Severn), a wholly owned subsidiary of Singer Housing, formed

Estes Homes, a partnership which operated as a commercial and

residential real estate developer based in Tucson, Arizona.2 As

consideration for the transaction, petitioner and WE 7 in the

aggregate surrendered $200,000 in Singer Co. stock and assumed an

obligation of approximately $29 million, one-half of which was

owed to Singer Housing and the balance to local commercial banks.

Under the partnership agreement forming Estes Homes, the

partnership agreed to repay Severn's capital account plus an 8-

percent return on that account in semiannual distributions

through February 1987. Severn did not participate in the

management of Estes Homes.

The Management Contract

1
Before Jan. 5, 1981, Guardian Construction Co., a general
partnership of which WE 7 and Guardian Development, Inc., an
Arizona corporation, were the general partners, also became a
partner of Estes Co. Guardian Construction Co. was the managing
partner of Estes Co. sometime after Sept. 20, 1980, but at least
by Jan. 5, 1981.
2
During December 1986, WJL Resources, Inc. (WJL) acquired
Severn's interest in Estes Homes. WJL was an affiliate of WE 7.
At some time, Estes Homes became known as RCP Investments and
Estes Co. became known as GWS. For convenience, hereinafter we
use the names Estes Homes and Estes Co. throughout this opinion
to refer to those entities regardless of the names by which they
were known at the time.
 - 6 -

After the formation of Estes Homes, Mr. Shedd continued as

manager of the Tucson Division of Estes Co. During September

1980, a decision was made to transfer key management personnel

from Estes Co. to petitioner in order to provide certain fringe

benefits to those individuals. In furtherance of that decision,

petitioner and Estes Co. entered into a management contract on

September 20, 1980, in which petitioner agreed to employ certain

management employees of Estes Co., including Mr. Shedd, Mr.

Estes, and Jon Grove (Mr. Grove), among others, and through them

to provide management services to Estes Co. Mr. Estes was

designated president of Estes Co., Mr. Shedd was designated its

executive vice president, and Mr. Grove was designated it vice

president--finance. The management contract was amended on

January 5, 1981, to state specifically that the provision of

management services by petitioner was not to be construed as

creating a partnership between petitioner and Estes Co.

Mr. Shedd served as executive vice president of Estes Co.

until his retirement from that company during 1981. To

effectuate his retirement, petitioner and WE 7 amended their

partnership agreement to provide, in effect, for the buyout of

petitioner's interest in Estes Co. Under the terms of the

amended partnership agreement, dated January 5, 1981, WE 7 agreed

to distribute petitioner's capital account over a 10-year period

commencing August 31, 1981, as well as to pay interest on the

outstanding balance at a rate of 9 percent until the capital
 - 7 -

account was fully liquidated. Petitioner did not receive

Schedules K-1, Partner's Share of Income, Credits, Deductions,

Etc., from Estes Co. from 1981 through 1989 or 1990.

Petitioner employed Mr. Estes under the management contract

from September 1980 through September 1985. He did not serve as

an officer or director of petitioner during those years.

On September 30, 1986, petitioner's board of directors voted

to terminate the management contract effective December 31, 1986.

Formal notice of termination provided to Estes Co. was dated

November 1, 1986. At the time the management contract was

terminated, all of the employees originally listed in the

contract had retired from or otherwise terminated their

employment with petitioner except for Mr. Shedd, and he was

preparing to retire from petitioner.

The Pension Plan

On September 18, 1980, petitioner adopted a defined benefit

pension plan (the plan), effective September 20, 1979.

Petitioner amended and restated the plan on December 5, 1985,

effective for plan year ending September 19, 1985, and respondent

issued a favorable determination letter as to the qualification

of the plan and its related trust as restated (hereinafter

collectively referred to as plan) on July 8, 1987. The

determination letter cautioned: "Continued qualification of the

plan will depend on its effect in operation under its present

form."
 - 8 -

Petitioner adopted the plan originally to provide pension

benefits for employees covered under the management contract.

By the end of 1985, the Shedds were the only active participants

in the plan. Mr. Estes received the final distribution of his

vested accrued benefit from the plan no later than December 31,

1986. Mr. Shedd began receiving distributions from the plan when

he retired from petitioner during 1986. Mrs. Shedd retired from

petitioner during 1990, and she began receiving distributions

from the plan at that time. At various times from plan years

ended September 19, 1987 through 1993, the Shedds' children and

their spouses participated in the plan, and they have received

any vested benefit to which they were entitled.

After his retirement from Estes Co., Mr. Shedd was not

consulted about Estes Co.'s new loans, new projects, or ongoing

projects. However, he was invited to, and often attended,

quarterly meetings of the executives of Estes Co., and he was

privy to their plans as well as to Estes Co.'s financial

condition. On request, he was provided copies of Estes Co.'s

financial statements.

Mr. Shedd has been a trustee of the plan since its

inception, and he was its sole trustee after the plan was amended

and restated. Mr. Estes and Mr. Grove served as trustees of the

plan from its inception until 1985.

Section 8.3 of the plan agreement states as follows:

8.3 LIMITATION ON TRUSTEE'S POWERS. The Trustee's
powers under the foregoing provisions of this section
 - 9 -

may be exercised only in a fiduciary capacity. The
Trustee shall discharge such powers and its duties
solely in the interest of the Participants and
Beneficiaries for the exclusive purpose of providing
benefits to them, defraying reasonable expenses of
administering the Plan, and with the care, skill,
prudence and diligence under the circumstances then
prevailing that a prudent man 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 aim.
The Trustee shall diversify 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.
The Trustee shall not make any investments outside of
the jurisdiction of the United States of America and
shall not engage in any prohibited transactions as
defined in the Code.

Petitioner made the following contributions to the plan for

the years listed:

Year Ended Contribution

9/30/87 $219,000
9/30/88 -0-
9/30/89 226,769
9/30/90 44,044
9/30/91 -0-
9/30/92 127,844
9/30/93 122,665

Loans to Estes Co. From the Plan Before 1986

The plan made loans to Estes Co. sometime before July 29,

1985. During 1985, respondent began an examination of

petitioner's Forms 1120, U.S. Corporation Income Tax Returns, for

years ended September 30, 1980 through 1983. At the same time,

respondent examined the plan for plan years ended September 19,

1982 and 1983. Respondent determined that loans made to Estes

Co. by the plan constituted prohibited transactions because Estes

Co. was a disqualified person. Respondent determined Estes Co.
 - 10 -

was a disqualified person because Mr. Estes had an indirect

ownership interest in Estes Co. through his interest in WE 7 and

its interest in Guardian Construction Co., and he also served as

a trustee of the plan. Estes Co. agreed to file Forms 5330,

Return of Excise Taxes Related to Employee Benefit Plans, pay the

excise taxes under section 4975 applicable to the prohibited

transactions, and repay the loans.

The Loan to Estes Co. From the Plan During 1986

Sometime during 1986, Mr. Shedd approached Mr. Grove, who at

the time was executive vice president of Estes Co., and suggested

that Estes Co. borrow money from the plan. Subsequently, on

December 25, 1986, the plan lent $2,250,000 to Estes Co. (the

loan).

On behalf of Estes Co., Mr. Grove signed a promissory note

relating to the loan dated December 25, 1986 (the note), and

payable to Mr. Shedd as trustee of the plan. The note was

payable on demand and bore interest on the unpaid balance,

payable monthly commencing January 25, 1987, at the rate of

seven-eights of 1 percent above the prime rate charged by the

Wells Fargo Bank of California (Wells Fargo). The interest rate

on the loan on its face was somewhat higher than Estes Co. was

paying commercial banks, but the rate nonetheless was slightly

advantageous to Estes Co. on an overall basis because the banks

charged Estes Co. additional fees which the plan did not charge.

The combined effect of the loan's rate of interest and lack of
 - 11 -

fees was better than the plan could have received from another

source. Estes Co. pledged no collateral to secure the loan.

The proceeds from the loan were used by Estes Co. for

general working capital needs. When the loan was made, Estes Co.

could have obtained funds from several other sources.

As of December 31, 1986, Estes Co. and Estes Homes had a

revolving line of credit with Wells Fargo that expired during May

1987, and which was under negotiation for renewal on December 31,

1986. The revolving credit agreement granted Wells Fargo a first

deed of trust on essentially all real estate properties not

pledged as security for other borrowing and an assignment of

Estes Co.'s and Estes Homes' interests in all other assets except

for the investment in affiliates. The agreement imposed certain

restrictions on Estes Co. and Estes Homes, including limitations

on partner distributions and other borrowing, maximum debt-to-

equity ratios, and restrictions on various real estate inventory

levels. Mr. Shedd was not involved in negotiating Estes Co.'s

line of credit, and he had no control over the terms of the line

of credit.

When the loan was made, Estes Co.'s line of credit from

Wells Fargo had an available balance equal to or greater than the

amount of the loan. At that time, the plan would have had to

obtain a waiver from Wells Fargo in order to secure the loan.

Mr. Shedd thought that it was not necessary to seek a waiver from

Wells Fargo in order to secure the loan, because he believed that
 - 12 -

the unused portion of Estes Co.'s line of credit with Wells Fargo

and the general conservative attitude of Estes Co.'s management

provided sufficient protection for repayment of the loan.

Mr. Shedd understood the difference between secured and

unsecured loans. He knew that real estate loans often are

secured loans. While Mr. Shedd worked for First National and for

Arizona Trust, neither company had lent 80 percent or more of its

assets to one borrower on an unsecured basis. Mr. Shedd was

aware that Mission Mortgage had lent more than 80 percent of its

assets to Lusk, and that Lusk subsequently became bankrupt.

Before making the loan, Mr. Shedd did not perform written

calculations or prepare notes in which he recorded an analysis of

Estes Co.'s financial statements. Mr. Shedd thought the loan

offered a good rate of return from a sound company with good

management.

When the loan was made, the Shedds were the only active

participants in the plan. At that time, Mr. Estes was not a

shareholder, director, officer, or employee of petitioner or a

trustee of the plan. Mr. Shedd suggested that Estes Co. borrow

money from the plan, because the plan had money it could invest,

and he believed that a loan with Estes Co. would be the best use

of that money.

Mr. Shedd's decision to have the plan extend the loan to

Estes Co. was influenced by the good track record of Estes Co.

and the individuals who were managing that company, by his belief
 - 13 -

that Estes Co. was in a strong financial condition, and by the

previous loan history between Estes Co. and the plan. He felt

comfortable about the plan's making the loan because of the

demand feature in the note and the Wells Fargo line of credit.

When the loan was authorized, Mr. Shedd believed Estes Co.

maintained a proper ratio of land held as inventory to land held

for investment, a proper ratio of assets to liabilities, and a

proper ratio of current assets to current liabilities. He

believed that the demand feature provided sufficient liquidity

for the loan.

Mr. Shedd did not consult with counsel or with the plan's

actuarial firm about making the loan before the plan lent the

money to Estes Co. He would not have suggested the loan to Estes

Co. had he suspected that it would not be repaid. When the loan

was made, Mr. Shedd believed that Estes Co. was creditworthy.

Mrs. Shedd concurred with Mr. Shedd's opinion that the loan would

be a good investment for the plan. There was no connection with

termination of petitioner's management contract with Estes Co.

and the extension of the loan by the plan to Estes Co.

During 1987, after speaking with the retirement portfolio

department of Merrill Lynch & Co., Inc., Mr. Shedd asked Estes

Co. to make periodic installment payments of principal on the

loan so that the plan could diversify into other investments.

Estes Co. orally agreed to make semiannual principal payments on

the note in the amount of $250,000, commencing March 1988 and
 - 14 -

continuing through February 1992. The note remained subject to

full repayment of principal and interest upon demand

notwithstanding the oral agreement to amortize principal over 5

years.

Estes Co. made monthly payments of interest in accordance

with the terms of the note through January 1989. On March 8 and

August 28, 1988, Estes Co. made payments of $250,000 each toward

principal, thereby reducing the principal balance to $1,750,000.

Problems in the real estate economy in Arizona during the

late 1980's resulted in declining real estate values in that

State. Mr. Estes advised the Shedds during December 1988 that

Estes Co. was facing financial difficulties. Estes Co. defaulted

on the loan when it failed to make the monthly interest payment

due February 25, 1989. At the time of the default, the

outstanding principal balance represented 58 percent of the

plan's assets. Following the default, Mr. Shedd concluded that

collection of the outstanding principal balance was in jeopardy

and that the note was worthless. Consequently, for plan year

ended September 19, 1989, the plan wrote off on its books as a

worthless debt the principal balance remaining on the loan.

During July 1990, partly on the basis of Mr. Shedd's

efforts, Estes Co. identified a pool of assets from which

payments could be made to a limited group of creditors, including

the plan. Therefore, various entities in which Mr. Estes was

involved (the Estes companies), including Estes Co. and Estes
 - 15 -

Homes, executed the Collateral Pool Agreement, wherein the Estes

companies agreed to make payments toward specified fixed amounts

owed those creditors relating to defaulted loans. The amount

specified for the plan was $1,878,026, representing the remaining

principal balance of $1,750,000 plus accrued interest through

September 30, 1989. In furtherance of the Collateral Pool

Agreement, on July 30, 1990, Mr. Estes executed a nonnegotiable

promissory note (new note), on behalf of Estes Homes, payable to

the plan in the amount of $1,878,026. The new note was payable

on demand, but no later than December 31, 1998, and bore interest

on the unpaid principal at a rate of 18 percent.

For plan year ended September 19, 1990, the plan recognized

as an asset on its balance sheet the new note, at a value of

$809,000. As of the time of trial, the plan had received

payments pursuant to the Collateral Pool Agreement in an amount

somewhat in excess of $200,000. As of the time of trial,

approximately $1.8 million, including principal and accrued

interest, remained unpaid on the loan.

Estes Co. filed for protection under the Bankruptcy Code

during late 1994 or 1995. The bankruptcy court ultimately

awarded petitioner $1 for its interest in Estes Co.

Revocation of Qualified Status of the Plan

During 1991, respondent began an audit of the plan for plan

year ended September 19, 1989. The examination subsequently was

expanded to cover plan years ended September 19, 1985 through
 - 16 -

1992. As a result of that examination, respondent determined

that the plan was not operated exclusively for the benefit of

petitioner's employees pursuant to the requirements of section

401(a)(2). Respondent based that determination on the conclusion

that the loan was not a prudent investment and caused the plan to

lack diversity of assets. Accordingly, on June 9, 1995,

respondent issued a final revocation letter revoking the

favorable determination letter dated July 8, 1987, on the ground

that the plan did not meet the requirements of section 401(a) for

the plan year ended September 19, 1987, and all subsequent years,

with the consequence that its related trust was not exempt from

income tax under section 501(a).

Other Business Dealings Between Mr. Shedd and Mr. Estes or
Related Entities

Throughout the years, Mr. Shedd and Mr. Estes have entered

into a number of business ventures. For example, Mr. Shedd owns

a 25-percent interest and Mr. Estes owns a 75-percent interest in

Adam Development Co. (Adam Development), a land holding

partnership formed during 1977. Mr. Shedd owns a 25-percent

interest and Mr. Estes and other Estes employees own the

remaining interest in Brava, a partnership formed during 1977 or

1978 to purchase model homes from Estes Co. and then to lease

them back to Estes Co. During 1977 or 1978, Mr. Shedd owned a

24-percent interest and Mr. Estes and other Estes employees owned

the remaining interest in Caprice, a partnership formed to
 - 17 -

develop a business park in Phoenix, Arizona. During 1977 or

1978, Mr. Shedd, Mr. Estes, and others formed Dakota, a

partnership, to hold a piece of land on the south side of Tucson

for future development. Around 1977, Mr. Shedd, Mr. Estes, and

others formed EDC, a partnership. Mr. Shedd was a partner in EDC

until approximately 1982 or 1983. Additionally, from

approximately 1977 until 1981, Mr. Shedd and Mr. Estes were

coowners of Tucson Photo Engraving, a photo-developing

corporation in Tucson.

During 1980, petitioner and Estes Co. shared the same

address. During 1986 and 1987, petitioner had the same address

as did three entities related to Mr. Estes.3 At one time, Estes

Co. personnel kept petitioner's books and prepared petitioner's

income tax returns.

Mr. Shedd, as secretary of petitioner, identified petitioner

as a general partner of Estes Co. in a corporate resolution made

at a board of directors meeting held on February 26, 1985, as

well as in an acknowledgment dated March 8, 1985. The notes to

Estes Co. and Estes Homes Combined Financial Statements for years

ended December 31, 1986 and 1985, identify petitioner, WE 7, and

3
At trial we took under advisement petitioners's relevancy
objections to respondent's Exhibits BG, BH, and BI, upon which
the above findings of fact are based. We find those documents
relevant to the issue of whether the loan was made for a reason
other than for the exclusive benefit of the plan participants and
their beneficiaries and, accordingly, find the disputed exhibits
admissible. Fed. R. Evid. 401, 402.
 - 18 -

the Guardian Construction Co., Inc., as corporate partners of

Estes Co. Petitioner was identified as a partner of Estes Co. in

a settlement agreement with an unrelated party executed on

September 21, 1990. The Superior Court of the State of Arizona,

in and for the County of Pima, in a final judgment dated

September 30, 1996, relating to a complaint filed on October 18,

1993, by Walter McBee and Triple L Distributing Co., against

Estes Homes and other entities, found that petitioner's

partnership interest in Estes Homes was terminated before the

subject matter in that case arose.4

OPINION

This Court may exercise jurisdiction over a declaratory

judgment action if there is an actual controversy involving a

determination by the Secretary with respect to the initial or

continuing qualification of a retirement plan. Sec. 7476(a);

Loftus v. Commissioner, 90 T.C. 845, 855 (1988), affd. without

published opinion 872 F.2d 1021 (2d Cir. 1989).

Petitioner contends that the plan did not violate the

exclusive benefit rule and therefore should remain qualified.

Respondent contends that the plan is not a qualified plan within

the meaning of section 401(a) for plan year ended September 19,

1987, and for subsequent years because its investments and

4
The complaint filed in the Superior Court indicates that
the subject matter of the case involved a contract to purchase a
portion of a shopping center entered into on Aug. 3, 1987.
 - 19 -

administration violated the exclusive benefit rule of section

401(a)(2). Specifically, respondent contends that the plan

failed to satisfy the exclusive benefit rule when it lent 90

percent of its assets on an unsecured basis to Estes Co., with

whom both Mr. Shedd and petitioner had significant and longtime

financial relationships.5 When the loan was made, Mr. Shedd had

retired from both petitioner and Estes Co., he was receiving

benefits from the plan, and petitioner's equity interest in Estes

Co. was being liquidated over a 10-year period which had begun in

1981.

Section 404(a)(1)(A) provides that contributions to a

pension trust are deductible by the employer if the trust is

exempt from tax under section 501(a). In order for the trust to

be entitled to tax-exempt status under section 501(a), a

retirement plan must be established by an employer and meet all

the requirements of section 401(a). Professional & Executive

Leasing, Inc. v. Commissioner, 89 T.C. 225, 230 (1987), affd. 862

F.2d 751 (9th Cir. 1988). If a trust qualifies under section

401(a), contributions to the trust on behalf of employees are not

includable in the employees' income until the year money is

actually distributed to the employees. Sec. 402(a)(1); Ludden v.

Commissioner, 68 T.C. 826, 829-830 (1977), affd. 620 F.2d 700

(9th Cir. 1980). However, if the trust fails to qualify under

5
At time of default in February 1989 the loan represented
58 percent of the plan's assets.
 - 20 -

section 401(a), whether employer contributions are to be included

in the employees' incomes is determined in accordance with

section 83. Sec. 402(b); Ludden v. Commissioner, supra at 830.

In determining whether a plan is qualified under section 401(a),

the operation of the trust is relevant as are its terms.

Winger's Dept. Store, Inc. v. Commissioner, 82 T.C. 869, 876

(1984); Quality Brands, Inc. v. Commissioner, 67 T.C. 167, 174

(1976); sec. 1.401-1(b)(3), Income Tax Regs.

Section 401(a)(2)6 provides that for a trust forming part of

an employer's pension plan to be exempt, it must be impossible,

at any time prior to the satisfaction of all liabilities with

respect to the employer's employees and their beneficiaries under

the trust, for any part of the corpus or income to be used for,

or diverted to, purposes other than for the exclusive benefit of

6
Sec. 401(a) provides, in pertinent part, as follows:

SEC. 401(a). Requirements for Qualification.--A trust
created or organized in the United States and forming part of
a stock bonus, pension, or profit-sharing plan of an employer
for the exclusive benefit of his employees or their
beneficiaries shall constitute a qualified trust under this
section--

* * * * * * *

(2) if under the trust instrument it is impossible, at
any time prior to the satisfaction of all liabilities
with respect to employees and their beneficiaries under
the trust, for any part of the corpus or income to be
* * * used for, or diverted to, purposes other than for the
exclusive benefit of his employees or their beneficiaries
* * *
 - 21 -

those employees or beneficiaries. "[T]he phrase 'purposes other

than for the exclusive benefit of his employees or their

beneficiaries' includes all objects or aims not solely designed

for the satisfaction of all liabilities to employees or their

beneficiaries covered by the trust." Sec. 1.401-2(a)(3), Income

Tax Regs. However, the requirement that the trust be

administered for the exclusive benefit of the employees is not to

be construed literally. Time Oil Co. v. Commissioner, 258 F.2d

237 (9th Cir. 1958), revg. and remanding 26 T.C. 1061 (1956);

Bing Management Co. v. Commissioner, T.C. Memo. 1977-403. To

that effect, the Commissioner has indicated that the exclusive

benefit test of section 401(a)(2) does not prohibit others from

benefiting from a transaction as long as the primary purpose of

the investment is to benefit employees or their beneficiaries.

E.g., Rev. Rul. 73-532, 1973-2 C.B. 128; Rev. Rul. 69-494, 1969-2

C.B. 88.7

7
A revenue ruling represents the Commissioner's position
on the application of tax law to specific facts. See Intel Corp.
& Consol. Subs. v. Commissioner, 100 T.C. 616, 621 (1993), affd.
67 F.3d 1445 (9th Cir. 1995), amended and superseded on denial of
rehearing 76 F.3d 976 (9th Cir. 1995); see also Brook, Inc. v.
Commissioner, 799 F.2d 833, 836 n.4 (2d Cir. 1986), affg. T.C.
Memo. 1985-462, supplemented by T.C. Memo. 1985-614. Revenue
rulings do not constitute binding authority on this Court. Stark
v. Commissioner, 86 T.C. 243, 251 (1986); Neuhoff v.
Commissioner, 75 T.C. 36, 46 (1980), affd. per curiam 669 F.2d
291 (5th Cir. 1982); see also Threlkeld v. Commissioner, 848 F.2d
81, 84 (6th Cir. 1988), affg. 87 T.C. 1294 (1986); Propstra v.
United States, 680 F.2d 1248, 1256-1257 (9th Cir. 1982).
(continued...)
 - 22 -

Petitioner contends that, when made, the loan was a prudent

investment. In support of its contention, petitioner asserts

that the primary purpose of the loan--to obtain an above-market

return on the investment, with minimal risk--was a proper purpose

and that in making the loan there was no incidental benefit to

petitioner or Mr. Shedd. Petitioner contends further that Mr.

Shedd was qualified to evaluate the loan and that, for that

purpose, he used criteria he had used as a commercial real estate

loan officer. Accordingly, petitioner asserts, before the plan

made the loan to Estes Co., Mr. Shedd considered alternative

investments, the relative safety of the loan, the prior loan

history of Estes Co. and the plan, and the demand feature of the

note. Petitioner contends further that, in determining that the

loan was an imprudent investment, respondent focused solely on

the ultimate result of the investment and not on Mr. Shedd's

conduct in deciding to have the plan lend money to Estes Co.

Petitioner also maintains that the loan satisfied the factors set

7
(...continued)
Nonetheless, where appropriate, we may adopt the reasoning on
which the revenue ruling is based. Estate of Lang v.
Commissioner, 64 T.C. 404, 406-407 (1975), affd. in part and
revd. in part 613 F.2d 770 (9th Cir. 1980). Moreover, the Court
of Appeals for the Ninth Circuit, to which an appeal in the
instant case would lie, has indicated that it would "give added
weight to an established revenue ruling that fell 'within
* * *[the Commissioner's] authority to implement the
congressional mandate in some reasonable manner.'" Estate of
Lang v. Commissioner, 613 F.2d at 776 (quoting Gino v.
Commissioner, 538 F.2d 833, 835 (9th Cir. 1976)); see also
Propstra v. United States, supra.
 - 23 -

forth in Rev. Rul. 69-494, supra,8 and therefore the plan met the

exclusive benefit rule.

In further support of its contention that the loan did not

violate the exclusive benefit rule, petitioner asserts that the

loan was not a violation of fiduciary standards--it provided a

fair return, left the plan sufficiently liquid to permit

distributions, and embodied safeguards which a prudent investor

would expect. Thus, petitioner contends, Mr. Shedd met the

fiduciary standards of section 404(a)(1),9 of title I of the

8
In Rev. Rul. 69-494, 1969-2 C.B. 88, the Commissioner set
forth the following four general requirements that must be met
before an investment of funds from a qualified plan in employer
stock or securities will satisfy the exclusive benefit rule of
sec. 401(a): (1) The cost must not exceed fair market value at
the time of purchase; (2) a fair return commensurate with the
prevailing rate must be provided; (3) sufficient liquidity must
be maintained to permit distributions in accordance with the
terms of the plan; and (4) the safeguards and diversity that a
prudent investor would adhere to must be present. Rev. Rul. 73-
532, 1973-2 C.B. 128, extended the reasoning of Rev. Rul. 69-494,
supra, to investments not involving employer securities.
9
Sec. 404(a)(1) of the Employee Retirement Income Security
Act of 1974 (ERISA), Pub. L. 93-406, 88 Stat. 877, provides as
follows:

Sec. 404.(a)(1) Subject to sections 403(c) and (d),
4042, and 4044, 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
(continued...)
 - 24 -

Employee Retirement Income Security Act of 1974 (ERISA), Pub. L.

93-406, 88 Stat. 877.

Petitioner contends further that violation of the prudent

investor rule is not necessarily a violation of the exclusive

benefit rule. Petitioner asserts that, even if the loan was not

prudent, the lack of prudence may be evidence of an exclusive

benefit rule violation, but it is not conclusive.

Additionally, petitioner contends that when the loan was

made, the plan was not subject to title I of ERISA, because the

Shedds were the plan's sole participants and that under

Department of Labor (DOL) regulations, 29 C.F.R. sec. 2510.3-3(b)

and (c)(1) (1997),10 no "employee" was a participant in the plan

9
(...continued)
man 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 provisions of this
title.
10
29 C.F.R. sec. 2510.3-3(b) and (c)(1) (1997), provides
in pertinent part as follows:

(b) Plans without employees. For purposes of Title I of the
Act and this chapter, the term "employee benefit plan" shall
not include any plan, * * * under which no employees are
participants covered under the plan, * * *.

(c) Employees. For purposes of this section:

(continued...)
 - 25 -

because the Shedds, who were the sole shareholders of petitioner,

were also its only employees. Petitioner asserts that the

failure to diversify is irrelevant to a determination of prudence

with respect to plans not subject to title I of ERISA.

Petitioner maintains further that under ERISA, even when

title I applies to a pension plan, a fiduciary cannot breach the

prudent investor rule by failing to diversify where the asserted

failure to diversify is because of a beneficiary-directed

investment. Accordingly, petitioner contends, a failure to

diversify is not a violation of the prudent investor rule where,

as in the instant case, title I does not apply and the sole

participants of the plan, in effect, make investment decisions in

their capacity as the ultimate beneficiaries, and not as

fiduciaries of the plan.

Citing H. Conf. Rept. 93-1280, at 302 (1974), 1974-3 C.B.

415, 463, infra pp. 28-29, respondent contends that the ERISA

section 404(a) fiduciary requirements for investing trust funds

under the prudent investor rule--i.e., that (1) a fiduciary must

discharge his duties with respect to a plan solely in the

interest of the participants and their beneficiaries, and (2) he

10
(...continued)
(1) An individual and his or her spouse shall not be
deemed to be employees with respect to a trade or business,
whether incorporated or unincorporated, which is wholly
owned by the individual or by the individual and his spouse,
and * * *
 - 26 -

or she must act with the care, skill, prudence, and diligence

under the circumstances then prevailing that a prudent investor,

acting in like capacity and familiar with such matters, would use

in the conduct of an enterprise of a like character and with like

aims--were deemed to be coextensive with the exclusive benefit

requirements. Relying on Rev. Rul. 69-494, supra, respondent

contends that to satisfy the exclusive benefit rule a plan must

invest its funds in a manner which assures a fair return on the

investments, provides the plan with sufficient liquidity to meet

the needs of the plan, and provides the plan with sufficient

diversification and security to guard against risk of loss.

Respondent contends that, in lending 90 percent of the plan's

assets to Estes Co., Mr. Shedd did not act prudently, because he

failed to diversify plan investments, to secure the loan, and to

consult with counsel about the propriety of making the loan.

Respondent also maintains that Mr. Shedd had sufficient

knowledge and skills to understand that the loan was imprudent

particularly in view of his substantial knowledge about lending

to real estate developers. Respondent contends that the loan did

not meet basic, commonsense standards for security and

diversification. Respondent contends further that the Shedds and

petitioner had significant financial dealings with Mr. Estes and

his related companies and that the relationship between them

motivated Mr. Shedd to make the loan.
 - 27 -

Additionally, respondent contends that the loan violated the

plan provision requiring the trustee to diversify the investments

of the plan so as to minimize the risk of large losses unless it

was clearly prudent not to do so. Respondent contends further

that Mr. Shedd failed to demonstrate that it was clearly prudent

not to diversify plan investments.

Whether a plan has been operated for the exclusive benefit

of employees and their beneficiaries is determined on the basis

of the facts and circumstances. See Feroleto Steel Co. v.

Commissioner, 69 T.C. 97, 107 (1977); sec. 1.401-1(b)(3), Income

Tax Regs.;11 see also Bernard McMenamy, Contractor, Inc. v.

Commissioner, 442 F.2d 359 (8th Cir. 1971), affg. 54 T.C. 1057

(1970); Time Oil Co. v. Commissioner, 258 F.2d at 238-239. If a

violation of the exclusive benefit rule is found, then we look to

the totality of the transgressions that occurred in assessing

whether it is an abuse of discretion for the Commissioner to

disqualify the plan. The discretion to disqualify a plan should

be exercised with restraint, however, because the DOL and the

Internal Revenue Service have a broad range of alternative

remedies available to ensure that a trust is properly

11
Sec. 1.401-1(b)(3), Income Tax Regs., states in
pertinent part as follows:

All of the surrounding and attendant circumstances and
the details of the plan will be indicative of whether
it is a bona fide stock bonus, pension, or profit-
sharing plan for the exclusive benefit of employees in
general. The law is concerned not only with the form
of a plan but also with its effects in operation. * * *
 - 28 -

administered. Winger's Dept. Store, Inc. v. Commissioner, 82

T.C. at 887-888.

Neither the Code nor the regulations provide specific rules

identifying the types of investments which are considered to

satisfy or violate the exclusive benefit rule. Id.

Notwithstanding the lack of statutory and regulatory guidance,

this Court and other courts have recognized that, in appropriate

situations, improper investment practices of the trust may

warrant disqualification of the related pension plan under the

exclusive benefit rule. E.g., id. at 878 and the cases cited

thereat.

ERISA section 404(a)(1) requires a plan fiduciary to

discharge his or her duties for the exclusive purpose of (1)

providing benefits to participants and their beneficiaries and

(2) defraying reasonable expenses of the plan. Additionally, the

fiduciary must (1) perform those duties with the care, skill,

prudence, and diligence that a prudent investor would exercise

under similar circumstances, (2) diversify investments to

minimize the risk of large losses, unless diversification clearly

is not prudent under the circumstances, and (3) discharge those

duties pursuant to the terms of the plan to the extent they are

consistent with the provisions of title I. Id. The legislative

history of ERISA section 404(a), however, cautions: "It is

expected that courts will interpret the prudent man rule and

other fiduciary standards bearing in mind the special nature and
 - 29 -

purposes of employee benefit plans intended to be effectuated by

the Act." H. Rept. 93-533, at 12 (1973), 1974-3 C.B. 210, 221.12

Thus, we must "recognize that a fiduciary's duties are

circumscribed by Congress' overriding goal of ensuring 'the

soundness and stability of plans with respect to adequate funds

to pay promised benefits.'" Acosta v. Pacific Enters., 950 F.2d

611, 618 (9th Cir. 1992) (quoting 29 U.S.C. sec. 1001 (1988)).

We conclude that the prudent investor principles of ERISA

section 404 apply to an exclusive benefit determination under

section 401(a)(2), regardless of whether title I of ERISA applies

to the plan. We find support for our conclusion in the following

excerpt from the conference report on ERISA:

Basic fiduciary rules

Prudent man standard.--The substitute requires that
each fiduciary of a plan act with the care, skill, prudence,
and diligence under the circumstances then prevailing that a
prudent man acting in a like capacity and familiar with such
matters would use in conducting an enterprise of like
character and with like aims. The conferees expect that the
courts will interpret this prudent man rule (and the other
fiduciary standards) bearing in mind the special nature and
purpose of employee benefit plans.

Under the Internal Revenue Code, qualified retirement
plans must be for the exclusive benefit of the employees and
their beneficiaries. Following this requirement, the
Internal Revenue Service has developed general rules that
govern the investment of plan assets, including a
requirement that cost must not exceed fair market value at
the time of purchase, there must be a fair return
commensurate with the prevailing rate, sufficient liquidity

12
The quoted material from H. Rept. 93-533, at 12 (1973),
1974-3 C.B. 210, 221, describes H.R. 2, 93d Cong., 2d Sess. sec.
111(b)(1) (1974) as reported by the House Committee on Education
and Labor, on Oct. 2, 1973, which became ERISA sec. 404(a)(1).
 - 30 -

must be maintained to permit distributions, and the
safeguards and diversity that a prudent investor would
adhere to must be present. The conferees intend that to the
extent that a fiduciary meets the prudent man rule of the
labor provisions, he will be deemed to meet these aspects of
the exclusive benefit requirements under the Internal
Revenue Code. [H. Conf. Rept. 93-1280, supra at 302, 1974-3
C.B. at 463; emphasis added.]

We understand the underscored language to indicate a

congressional intent that the factors applied in determining

whether an investment meets the prudent investor requirement of

ERISA section 404(a)(1) are relevant to whether that investment

satisfies the exclusive benefit rule requirement of section

401(a)(2). We find nothing in that legislative history which

suggests that the prudent investor provision should be considered

in an exclusive benefit determination only if the plan is subject

to title I of ERISA. In view of our conclusion that the prudent

investor principles of ERISA apply in the instant case, we do not

decide whether the plan was subject to title I of ERISA when the

loan was made.

We previously have held that the standards for fiduciary

behavior set forth in ERISA section 404(a)(1) may be used to help

determine whether the exclusive benefit rule has been violated.

Ada Orthopedic, Inc. v. Commissioner, T.C. Memo. 1994-606; see

also Calfee, Halter & Griswold v. Commissioner, 88 T.C. 641, 652

(1987) ("the standards of Title I and Title II [of ERISA] were

closely coordinated by Congress specifically to develop a unified

set of rules").
 - 31 -

The DOL regulations state that a fiduciary will satisfy the

prudent investor requirements of ERISA section 404(a)(1)(B) if

the fiduciary (i) gives appropriate consideration to the relevant

facts and circumstances of the investment or investment course of

action and (ii) acts accordingly. 29 C.F.R. sec. 2550.404a-

1(b)(1) (1997). Pursuant to those regulations,

"appropriate consideration" shall include, but is not
necessarily limited to,

(i) A determination by the fiduciary that the
particular investment or investment course of action is
reasonably designed, as part of the portfolio * * * , to
further the purposes of the plan, taking into consideration
the risk of loss and the opportunity for gain (or other
return) associated with the investment or investment course
of action, and

(ii) Consideration of the following factors * * * :

(A) The composition of the portfolio with regard to
diversification;

(B) The liquidity and current return of the portfolio
relative to the anticipated cash flow requirements of the
plan; and

(C) The projected return of the portfolio relative to
the funding objectives of the plan. [29 C.F.R. 2550.404a-
1(b)(2).]

The DOL requirements appear consistent with criteria set

forth by the Commissioner in Rev. Rul. 69-494, 1969-2 C.B. 88,

for testing compliance with the exclusive benefit requirement of

section 401(a)(2). Those criteria are (1) cost must not exceed

fair market value at the time of purchase; (2) a fair return

commensurate with the prevailing rate must be provided; (3)

sufficient liquidity must be maintained to permit distributions
 - 32 -

in accordance with the terms of the plan; and (4) the safeguards

and diversity that a prudent investor would adhere to must be

present. We previously have indicated that the criteria listed

in Rev. Rul. 69-494, supra, although not binding on the Court,

are relevant to a determination as to whether the prudent

investor requirements have been satisfied. Winger's Dept. Store,

Inc. v. Commissioner, 82 T.C. 869 (1984); Feroleto Steel Co. v.

Commissioner, 69 T.C. 97 (1977); see also Ada Orthopedic, Inc. v.

Commissioner, supra.

Additionally, in applying the prudent investor rule, it has

been stated:

Under ERISA, as well as at common law, courts have focused
the inquiry under the "prudent man" rule on a review of the
fiduciary's independent investigation of the merits of a
particular investment, rather than on an evaluation of the
merits alone. As a leading commentator puts it, "the test
of prudence--the Prudent Man Rule--is one of conduct, and
not a test of the result of performance of the investment.
The focus of the inquiry is how the fiduciary acted in his
selection of the investment, and not whether his investments
succeeded or failed." In addition, the prudent man rule as
codified in ERISA is a flexible standard: the adequacy of a
fiduciary's investigation is to be evaluated in light of the
"character and aims" of the particular type of plan he
serves. [Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th
Cir. 1983); fn. ref. omitted; citations omitted.]

Thus, the ultimate outcome of an investment is not proof that the

investment failed to meet the prudent investor rule. DeBruyne v.

Equitable Life Assur. Socy. of U.S., 920 F.2d 457, 465 (7th Cir.

1990); see also Norton Bankruptcy Law and Practice 2d, sec. 156:9

(1997-98).
 - 33 -

Accordingly, in determining whether a plan has satisfied the

exclusive benefit rule, we must consider the risk of the loan to

the plan when the loan was made, taking into account its relative

safety, its effect on the diversity and liquidity of the plan's

assets, its profit potential, and the trustee's rationale for

making the loan. We also must consider whether the loan complies

with the terms of the plan.

In our view, the loan was not a prudent investment for the

plan. When made, the loan constituted approximately 90 percent

of the plan's assets. The promissory note evidencing the loan

was not secured. Estes Co. used the loan for working capital

needs, not to acquire assets. When the loan was made,

essentially all of Estes Co.'s and Estes Homes' property already

was pledged as collateral for loans those entities had received

from Wells Fargo or other creditors. Although Estes Co. had

available on its line of credit with Wells Fargo a balance equal

to or greater than the amount of the loan when the loan was made,

the plan extracted no commitment from Estes Co. and Estes Homes

that they would keep that balance available for the benefit of

the plan. Moreover, petitioner had no guaranty that Wells Fargo,

or any other creditor of Estes Co., would continue to extend

credit to Estes Co. in the future, especially should Estes Co. or

Estes Homes experience financial difficulties. Consequently, the

line of credit provided no security for the loan and the note was
 - 34 -

backed by nothing more than Estes Co.'s promise to repay the

loan.

Furthermore, the expected rate of return (seven-eights of 1

percent above the prime rate charged by Wells Fargo) does not

appear to be commensurate with the high degree of risk to which

the loan exposed the plan. The note was unsecured. The loan was

extended to a single borrower which was involved in developing

real estate, a business dependent on economic factors not within

its control. Additionally, Estes Co. and Estes Homes built and

sold property in a relatively small geographic area, making them

more vulnerable to fluctuations in the real estate market.

Although Mr. Shedd had extensive experience in real estate

financing and marketing, he went against normal practice in real

estate financing by not securing the note and by lending a

substantial portion of the plan's assets to one borrower on

nothing more than a promise to repay. In essence, Mr. Shedd was

gambling that the Tucson and Phoenix real estate markets would

remain healthy and that Estes Co. and Estes Homes would continue

to prosper. We believe that a prudent investor under similar

circumstances would not have extended a loan to Estes Co. under

similar terms.

Additionally, we believe that the loan does not comply with

section 8.3 of the plan agreement which, among other things,

requires the trustee to diversify investments so as to minimize

the risk of large losses. We are not persuaded that it was
 - 35 -

clearly prudent not to diversify. The loan entrusted 90 percent

of the plan's assets, over $2 million, on an unsecured basis to

one creditor that operated in a limited geographic area and in a

risky business. In our view, the trustee did not minimize the

risk of a large loss.

We do not agree with petitioner that diversification is not

relevant in the instant case. Whether plan assets are

sufficiently diversified as a result of an investment is one

factor in determining whether the prudent investor rule has been

satisfied. The exception for participant-directed investments

involves individual account plans, not defined benefit plans, as

is involved in the instant case. The participant-directed

exception, therefore, is not applicable here. See ERISA sec.

404(c).13 Following the loan, the plan's assets were not

diversified. The note was not secured. Consequently, when made,

the loan was a risky investment for the plan. On the basis of

13
ERISA sec. 404(c) provides as follows:

(c) In the case of a pension plan which provides for
individual accounts and permits a participant or beneficiary
to exercise control over assets in his account, if a
participant or beneficiary exercises control over the assets
in his account(as determined under regulations of the
Secretary)--

(1) such participant or beneficiary shall not be
deemed to be a fiduciary by reason of such exercise, and

(2) no person who is otherwise a fiduciary shall be
liable under this part for any loss, or by reason of any
breach, which results from such participant's or
beneficiary's exercise of control.
 - 36 -

the foregoing, we conclude that, in extending the Loan to Estes

Co., the plan violated the prudent investor rule.

Nevertheless, an isolated violation of the prudent investor

rule, although a factor to be considered, does not, of itself,

require a finding that the plan was not operated for the

exclusive benefit of the employees or their beneficiaries. We

must look at the entire picture in assessing whether the plan

violated the exclusive benefit rule. See Feroleto Steel Co. v.

Commissioner, 69 T.C. at 107. Mr. Shedd made an error in

judgment in having the plan lend money to Estes Co. without

security. We are persuaded, however, that Mr. Shedd intended the

plan, and thereby the participants, to benefit from the loan.

Indeed, on the basis of the record, we believe that the plan

would have profited from the loan if the depression in the real

estate market had not occurred in Arizona during the late 1980's.

The loan proceeds did not flow back to petitioner, nor were they

diverted for the personal benefit of the Shedds or Mr. Estes.

Interest was stated on the note at market rate, and payments were

being made until Estes Co. and Estes Homes began to experience

financial difficulties. Viewing the total picture, we conclude

that the loan was an isolated violation of the prudent investor

rule, but that violation was not so serious as to constitute a

violation of the exclusive benefit requirement of section 401(a).

In Winger's Dept. Store, Inc. v. Commissioner, 82 T.C. 869

(1984), the trustees of an employer-sponsored defined benefit
 - 37 -

pension plan lent a major portion of the trust's assets to the

employer, through the employer's sole shareholder, to meet the

company's working capital needs. The loans were unsecured,

interest payments to the trust were delinquent, and most of the

principal was not repaid. The sole shareholder and his spouse

were cotrustees of the trust, and most of the benefits under the

plan accrued to the sole shareholder. We found under the

circumstances that the trust had not been operated for the

exclusive benefit of the employees and their beneficiaries, and

we upheld the Commissioner's determination that the related plan

was no longer qualified under section 401(a).

In Ada Orthopedic, Inc. v. Commissioner, T.C. Memo. 1997-

606, the trustees of an employer-sponsored defined benefit plan

lent a substantial portion of the plan's assets through unsecured

loans to participants, relatives, and friends of the trustees.

Some of the loans were made or extended without written

promissory notes, and principal and interest remained unpaid on

some of the loans. In addition, the trust acquired real property

by unrecorded quitclaim deeds without investigating title and

subsequently lost that property upon foreclosure of preexisting

mortgages; the trust invested in a tax-shelter partnership in

which one of the trustees and his relatives also held interests;

the trust acquired three loose diamonds, the largest of which

could not be located; and the plan disbursed plan assets to

nonparticipants without explanation. We found under those
 - 38 -

circumstances that the trust's investment practices violated the

exclusive benefit rule. Accordingly, we upheld the

Commissioner's determination that the plan was no longer

qualified.

The facts in Winger's Dept. Store, Inc. v. Commissioner,

supra, and Ada Orthopedic, Inc. v. Commissioner, supra, reveal

investment philosophies that were not aimed primarily at

providing benefits for the employees and their beneficiaries in

general but instead were aimed at benefiting the plan sponsors or

certain individuals. The investment practices in those cases

involved flagrant violations of the exclusive benefit rule.

As we stated previously, the record reveals that the loan

constituted an isolated violation of the prudent investor rule.

Mr. Shedd sought the loan because he believed it would be a good

investment for the plan, and not because he sought a benefit for

himself (other than as a beneficiary of the plan), petitioner,

Estes Co., or others. He recommended the loan because he had

extensive experience in the real estate financing area and

therefore he felt confident in his ability to evaluate the

investment. Mr. Shedd approached Estes Co. about the loan

because he believed that Estes Co. was strong financially, and he

trusted the abilities of its management personnel to maintain

that strong position. He assumed that Estes Co. would repay the

loan. Mr. Shedd made an error in judgment in having the plan
 - 39 -

lend most of the plan's assets to one borrower and in not

securing the note.

In the instant case, we do not find the indifference toward

the continued well-being of the plan that we found in Winger's

Dept. Store, Inc. v. Commissioner, supra and in Ada Orthopedic

Inc. v. Commissioner, supra. Interest on the loan was paid

timely until January 1989, when a depression in the real estate

market in Arizona resulted in financial problems for Estes Co.

and Estes Homes. Additionally, although the loan was extended on

a demand basis on December 25, 1986, in order to diversify the

plan's assets, during 1987 Mr. Shedd sought and obtained Estes

Co.'s agreement to amortize payment of the loan over a 5-year

period, commencing in March 1988. Two payments of $250,000 each

were made during 1988, and the plan used the payments to acquire

other, safer investments for the plan. Additionally, after Estes

Co. defaulted on payment of the note, Mr. Shedd took an active

role in attempting to locate assets of the Estes companies which

could be used toward payment of the loan. Estes Co.'s inability

to repay the loan resulted from a downturn in the real estate

market and not from impropriety on its part.

The longstanding business relationship between petitioner

and Estes Co., and among the Shedds, Mr. Estes, and the Estes

companies, requires that we give the loan closer scrutiny.

Nevertheless, even after that scrutiny, we do not find an attempt

to manipulate the plan's assets for the benefit of petitioner,
 - 40 -

the Shedds, Mr. Estes, or Estes Co. The loan did not hinder the

annual payment of benefits. Estes Co. received some benefit in

that, on an overall basis, the cost of borrowing the money from

the plan was slightly less than the cost of borrowing a similar

amount from another source. Nonetheless, we are persuaded that

the primary purpose of the loan was to benefit plan participants.

Consequently, although the loan failed to meet the prudent

investor test, we find that it did not violate the exclusive

benefit rule. Accordingly, we conclude that extension of the

loan to Estes Co. did not cause the plan to fail to satisfy the

requirements of sections 401(a) and 501 for plan years ended

September 19, 1987, and for subsequent years.

To reflect the foregoing,

Decision will be

entered for petitioner.