ERISA Fidelity Bond and Family Employees: Relatives Not Exempt

A retirement plan that covers family members who are employees of the business almost always requires an ERISA fidelity bond. The only plans that escape the bonding requirement of ERISA section 412 by reason of their participant census are plans that cover no employees at all, which the Department of Labor defines as plans covering only a sole owner (or the owner and the owner’s spouse) of a wholly owned business, or only partners (and their spouses) of a partnership. A child, parent, sibling, cousin, or in-law who draws wages and participates in the plan is an employee. Once such a person is a participant, the plan is subject to Title I of ERISA, and every person who handles plan funds must be bonded. There is no exemption for family employees as a class.

The Email That Prompted This Essay

A plan sponsor recently declined to renew his ERISA fidelity bond with the following explanation: he had “just learned” that no bond was required “because there are no non-familial employees at this time,” and he would return for a bond when that changed.

The sponsor’s reasoning contains a real legal concept wrapped around an incorrect premise. The real concept is the owner-only plan carve-out under the Department of Labor’s coverage regulation. The incorrect premise is that the carve-out turns on whether employees are related to the owner. It does not. It turns on whether the plan covers any employees at all, and the regulation is explicit that only two categories of people are disregarded for that purpose: the owner and the owner’s spouse, or a partner and the partner’s spouse. Everyone else who works for the business and participates in the plan counts.

Because this misunderstanding is common among family businesses, closely held professional corporations, and small plan sponsors who have absorbed the folklore surrounding “solo” plans, it warrants a full treatment. What follows is the statutory architecture of the bonding requirement, the coverage regulation that creates the owner-only exemption, the Supreme Court authority that confirms how narrowly it operates, the entity form distinctions that matter, and the practical consequences of getting it wrong. The ERISA fidelity bond family employees question is not a close one once the authorities are laid side by side.

The Bonding Requirement: ERISA Section 412 and 29 CFR Part 2580

Section 412(a) of the Employee Retirement Income Security Act of 1974 provides that “every fiduciary of an employee benefit plan and every person who handles funds or other property of such a plan” shall be bonded.[1] The statute fixes the amount at not less than ten percent of the funds handled, subject to a floor of $1,000 and a ceiling of $500,000 per plan, with the ceiling raised to $1,000,000 for plans that hold employer securities.[2] The bond must protect the plan against loss by reason of acts of fraud or dishonesty on the part of the bonded person, whether acting alone or in connivance with others.[3]

Section 412(b) makes it unlawful for any plan official to permit another plan official to receive, handle, disburse, or otherwise exercise custody or control over plan funds without first being properly bonded, and extends that prohibition to “any other person having authority to direct the performance of such functions.”[4] The compliance burden is therefore layered: the person who handles funds must be bonded, and the persons who allow that handling to occur are independently responsible for ensuring the bond exists.[5]

The Department of Labor’s implementing regulations at 29 CFR Part 2580 define the operative terms. “Funds or other property” reaches all plan assets used or usable as a source of benefit payments, including contributions, cash, securities, real property, and interests in closely held entities.[6] “Handling” carries a broader meaning than physical contact and includes disbursement authority, check signing authority, power to transfer plan assets, and final decision-making authority over investments or benefit payments.[7] The Department has confirmed in Field Assistance Bulletin 2008-04 that the bond may not carry a deductible,[8] that the plan itself must be the named insured,[9] that the surety must appear on Treasury Department Circular 570,[10] and that the bond must afford a one year discovery period following termination.[11]

None of these provisions contains a family exemption. The word “family” does not appear in section 412 or in Part 2580. The exemptions that do exist are for certain banks, trust companies, insurance carriers, and registered broker-dealers,[12] for plans that are completely unfunded,[13] and, critically for present purposes, for plans that are not subject to Title I of ERISA at all.[14] It is this last category that sponsors of family businesses invoke, and it is this last category that must be examined with care.

The Threshold Question: Is the Plan Subject to Title I?

Section 4(a) of ERISA extends Title I to “any employee benefit plan” established or maintained by an employer engaged in commerce.[15] Section 3(3) defines an employee benefit plan as an employee welfare benefit plan or an employee pension benefit plan.[16] The Department’s regulation at 29 CFR § 2510.3-3 then narrows the field by providing that the term “employee benefit plan” does not include “any plan, fund or program, other than an apprenticeship or other training program, under which no employees are participants covered under the plan.”[17]

The regulation supplies its own definition of who is not an employee for this purpose. Paragraph (c) provides:

(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 or her spouse, and

(2) A partner in a partnership and his or her spouse shall not be deemed to be employees with respect to the partnership.[18]

The regulation offers its own illustration. A Keogh plan “under which only partners or only a sole proprietor are participants covered under the plan will not be covered under title I.” But “a Keogh plan under which one or more common law employees, in addition to the self-employed individuals, are participants covered under the plan, will be covered under title I.”[19]

This is the entire legal basis for the so-called solo 401(k) exemption. The regulation does not create a category of exempt plans by reference to plan design, contribution level, participant count, or the relationship among participants. It asks one question: does the plan cover any person who is an employee within the meaning of paragraph (c)? If the answer is yes, the plan is an employee benefit plan, Title I applies, and section 412 bonding follows. If the answer is no, the plan is outside Title I and the bonding requirement, along with the fiduciary duties of Part 4, the reporting obligations of Part 1, and the civil enforcement machinery of section 502, never attaches.

Why “Family” Is Not the Test

The regulation’s language is exclusive rather than illustrative. It disregards two, and only two, kinds of people: the owner of a wholly owned business and that owner’s spouse, or a partner and that partner’s spouse. The spouse is specifically named. Children are not. Parents are not. Siblings are not. In-laws are not. Had the Department intended a broader family exclusion, the text would have said so, and the Department has had five decades in which to expand it. It has not done so.

The consequence is that an adult child who works for the family corporation, receives a Form W-2, and participates in the corporation’s profit-sharing plan is a common law employee participant. The plan covers an employee. Title I applies. The ERISA fidelity bond family employees analysis ends there, because the sponsor’s belief that only “non-familial” employees trigger coverage has no footing in the regulation.

The point deserves emphasis because the sponsor’s error is not idiosyncratic. It reflects a conflation of two distinct bodies of law. The Internal Revenue Code contains extensive attribution rules under sections 318 and 1563 that treat family members as constructive owners for purposes of controlled group analysis, highly compensated employee determinations, and related party transactions. Those attribution rules cause many practitioners to assume that family relationship is relevant to every question in the retirement plan universe. It is not relevant here. The Department’s coverage regulation does not incorporate Code attribution. It looks at actual ownership of the trade or business and at actual marital status, nothing more.

The common law test for employee status under ERISA, articulated by the Supreme Court in Nationwide Mutual Insurance Co. v. Darden, asks whether the hiring party controls the manner and means by which work is accomplished, taking into account the skill required, the source of tools, the location of work, the duration of the relationship, the method of payment, the provision of employee benefits, and the tax treatment of the worker.[20] A family member who is on payroll, subject to the owner’s direction, and covered by the plan will satisfy that test in virtually every case. Blood relation is not among the Darden factors.

Yates v. Hendon and the Working Owner

The Supreme Court addressed the interaction between working owners and Title I coverage in Raymond B. Yates, M.D., P.C. Profit Sharing Plan v. Hendon.[21] Dr. Yates was the sole shareholder and president of his professional corporation. He was also a participant in the corporation’s profit sharing plan, which covered several other employees. When Yates entered bankruptcy, the trustee argued that Yates could not be a “participant” under ERISA because he was an employer rather than an employee, and that his plan account therefore lacked ERISA’s anti-alienation protection.

The Court, in an opinion by Justice Ginsburg, held that a working owner may qualify as a participant in an ERISA plan, provided the plan covers one or more employees other than the owner and the owner’s spouse.[22] The Court relied expressly on the Department’s coverage regulation and on Advisory Opinion 99-04A, in which the Department had concluded that ERISA and the Code “reveal a clear Congressional design to include ‘working owners’ within the definition of ‘participant.'”[23]

Two features of Yates matter for the family employee question. First, the Court’s formulation of the condition, “one or more employees other than the business owner and his or her spouse,” mirrors the regulation precisely and confirms that the spouse is the only relative disregarded.[24] Second, the Court treated the presence of any such employee as the trigger. The Yates plan happened to cover unrelated staff, but nothing in the opinion suggests the result would differ if the other participants had been the doctor’s children. The regulation and the Court both ask whether an employee other than the owner or spouse is covered. They do not ask whether that employee is a stranger.

Entity Form Matters

Because the regulation turns on ownership rather than relationship, the form of the business entity determines the outcome in several family scenarios that sponsors frequently misjudge.

Sole Proprietorship or Single Member Entity Wholly Owned by One Individual

If the business is wholly owned by one individual (or by that individual and a spouse), and the plan covers only that individual (and spouse), the plan is outside Title I. No bond is required. This is the paradigm solo 401(k).

If the same business employs the owner’s son or daughter, and the child is a participant, the plan is inside Title I. A bond is required.

Partnership or LLC Taxed as a Partnership

Partners and their spouses are disregarded. A family LLC in which a father, mother, and two adult children are all members holding capital interests, and in which no one other than those members and their spouses participates in the plan, is outside Title I. Here, and only here, does a multigenerational family arrangement escape bonding, and it does so because the children are partners, not because they are children.

If the same LLC employs a nephew who is not a member, or a child who works for the firm but holds no partnership interest, that person is an employee, and coverage attaches.

Corporation With Multiple Family Shareholders

The regulation disregards an individual only with respect to a business “wholly owned” by that individual or by the individual and spouse. It does not contain a partner analogue for corporations. Two brothers who each hold fifty percent of a corporation’s stock do not wholly own the corporation, individually or as a married couple. Each brother is therefore an employee of the corporation for purposes of § 2510.3-3, and a plan covering both is a plan covering employees. Title I applies and a bond is required.

This result surprises many family business owners, who reason that “it is just the two of us.” The regulation does not care how many owners there are or how they are related. It cares whether the business is wholly owned by one individual or one married couple. A corporation held by siblings, by a parent and child, or by any combination other than one person and one spouse fails that test.

Corporation Wholly Owned by One Spouse With the Other Spouse on Payroll

Both spouses are disregarded, whether the second spouse holds stock or merely works for the company. A plan covering only the two of them is outside Title I.

The Employee Who Has Not Yet Enrolled

Paragraph (d) of the regulation defines when an individual becomes a “participant covered under the plan.” For a pension plan, that generally occurs on the earliest date on which the individual is eligible under the plan’s terms to have contributions made on his or her behalf, whether or not the individual has elected to defer.[25] An eligible family employee who has declined to participate may nonetheless be a participant covered under the plan for coverage purposes. Sponsors who rely on non-enrollment to preserve the owner-only exemption are relying on a distinction the regulation does not draw.

The Moment Coverage Attaches

The sponsor in the opening email offered to “reach back for a new bond” when non-family employees arrived. Even setting aside the family error, the timing premise is wrong. Coverage under Title I attaches on the date the first employee participant becomes covered, and section 412(b) makes it unlawful for any plan official to handle funds from that moment without a bond in place. There is no grace period, no cure window, and no provision for retroactive bonding. A plan that crosses from owner-only status to Title I coverage on a Tuesday must have a compliant bond on that Tuesday.

The Department has addressed the mechanics of bonding a plan that lacks a complete prior year of experience: the amount handled must be estimated under the procedures of 29 CFR § 2580.412-15,[26] and the bond amount must be fixed at the beginning of each plan year based on the highest amount handled in the preceding year.[27] A plan that has been operating without a bond in the mistaken belief that it was exempt has not merely a prospective problem but a retrospective one, because each year of unbonded operation while an employee participant was covered is a year of noncompliance.

Consequences of Operating Without a Required Bond

Form 5500 disclosure. Plans subject to Title I file Form 5500 or Form 5500-SF rather than the one-participant Form 5500-EZ. The Form 5500-SF at line 10e, and Schedules H and I at line 4e, ask whether the plan was covered by a fidelity bond and, if so, in what amount.[28] A “no” answer on a plan that is required to be bonded is a documented admission of a section 412 violation, and the Employee Benefits Security Administration uses these responses to select investigation targets.

Fiduciary liability. Section 409 imposes personal liability on a fiduciary for losses to the plan resulting from a breach of fiduciary duty.[29] The Department has characterized the selection of an appropriate bonding arrangement as a fiduciary responsibility.[30] A fiduciary who permits unbonded handling in violation of section 412(b) and whose plan then suffers a dishonesty loss has exposed personal assets to a claim that the bond would otherwise have covered. There is fiduciary liability insurance available to address this specifically.

Loss of the small plan audit waiver. Small plans that hold more than five percent of their assets in non-qualifying assets may avoid the independent audit requirement only if the persons handling those assets are bonded for at least one hundred percent of their value.[31] A plan that has no bond at all cannot claim the waiver and must engage an independent qualified public accountant, an expense that dwarfs the cost of the bond many times over.

Uninsured dishonesty loss. The most direct consequence is the one the statute was written to prevent. A family member who handles plan funds is no less capable of misappropriation than a stranger, and intrafamily embezzlement from retirement plans is a recurring fact pattern in EBSA enforcement releases. Without a bond, the plan and its participants absorb the loss.

What the Bond Must Provide

For a plan that has crossed into Title I, the required bond is straightforward, and any underwriter accustomed to ERISA placements will produce a compliant instrument on request. The bond must name the plan as insured,[32] must be written by a Circular 570 surety,[33] must provide first dollar coverage without deductible,[34] must cover every person who handles plan funds including the owner,[35] and must be in an amount equal to at least ten percent of funds handled, with a $1,000 minimum and a $500,000 maximum per plan (or $1,000,000 where the plan holds employer securities other than through a broadly diversified pooled fund).[36] The bond must afford a one year discovery period following termination,[37] and may include an inflation guard provision that automatically adjusts the penalty to the statutory amount at the time of loss discovery.[38]

A sponsor’s existing commercial crime policy may satisfy section 412 if the plan is added as a named insured by ERISA rider, but the Department has warned that a crime policy which excludes the company owner does not protect the plan if the owner handles plan funds.[39] In a family business, the owner almost always handles plan funds. A stand-alone ERISA fidelity bond, or a crime policy with an ERISA rider that expressly extends to owners, is the appropriate solution.

The Prudent Practice for Owner-Only Plans

Even a plan that is presently outside Title I benefits from carrying an ERISA fidelity bond. The reasons are practical rather than legal. The cost is nominal relative to the exposure. ERISA bonds are among the least expensive surety instruments in the market, and the underwriting for a small plan is minimal.

The plan’s status is fragile. The day a child joins the payroll and satisfies the plan’s eligibility conditions, the day a second shareholder is admitted, or the day a spouse’s ownership interest is transferred to a trust, the plan may cross into Title I without anyone noticing. A bond already in force eliminates the gap.

Financial institutions, third-party administrators, and plan document providers frequently require evidence of bonding regardless of Title I status, because their own compliance protocols do not distinguish between owner-only plans and small covered plans.

The bond protects against the same risk whether or not the statute requires it. A sole owner who has delegated check-signing authority to a bookkeeper, an adult child, or a family office has created a handling risk that a fidelity bond addresses at trivial cost.

From the underwriter’s chair, the request to cancel a bond because “there are no non-familial employees” is a signal to ask for the participant census, not to process the cancellation. The correct response is to identify every person who is a participant covered under the plan, determine whether each falls within § 2510.3-3(c), and confirm the plan’s Title I status in writing. If the census reveals any participant other than the owner and spouse (or partners and spouses), the bond stays in force, and the sponsor is told why.

In My View

The ERISA fidelity bond family employees question has a clear answer that is frequently misunderstood. The exemption from bonding for plans without employees is real, narrow, and textually precise. It disregards the owner of a wholly owned business and that owner’s spouse, or a partner and that partner’s spouse. It disregards no one else. A retirement plan that covers a working child, parent, sibling, or in-law who is not an owner or spouse covers an employee, is subject to Title I of ERISA, and must be bonded under section 412 from the first day of that coverage. Sponsors who believe otherwise have confused the Code’s family attribution rules with the Department’s coverage regulation, or have absorbed the solo 401(k) folklore without reading the regulation that creates it. Plan officials, their advisors, and the sureties who serve them should treat the phrase “family only” as the beginning of the coverage inquiry rather than its conclusion.

Key Takeaways”

• ERISA section 412 requires every person who handles plan funds to be bonded. There is no exemption for family employees.
  The only census-based exemption is for plans covering no employees, defined at 29 CFR § 2510.3-3(c) as plans covering only the owner and spouse of a wholly owned business, or only partners and their spouses.
• Children, parents, siblings, and in-laws who are on payroll and participate in the plan are employees. Their participation brings the plan within Title I.
• Yates v. Hendon confirms that the trigger is any employee “other than the business owner and his or her spouse.”
  A corporation owned by two siblings, or by a parent and child, is not wholly owned by one individual or married couple. Its plan is covered.
• A family LLC taxed as a partnership may be exempt if every participant is a partner or a partner’s spouse.
  Coverage attaches the day the first employee participant becomes eligible. Bonding must be in place that day.
  Operating without a required bond is disclosed on Form 5500, exposes fiduciaries to personal liability, forfeits the small plan audit waiver, and leaves dishonesty losses uninsured.
• Owner-only plans should carry the bond anyway. The cost is nominal and the status is fragile.

Frequently Asked Questions

• Does a family business retirement plan need an ERISA fidelity bond? Yes, if any participant is an employee other than the owner and the owner’s spouse (or, in a partnership, other than partners and their spouses). Relatives who work for the business and participate in the plan are employees for this purpose.
• What is the owner-only plan exemption? Under 29 CFR § 2510.3-3, a plan that covers no employees is not an employee benefit plan under Title I of ERISA. The regulation treats a sole owner and spouse, or partners and their spouses, as non employees. A plan covering only those people is outside Title I and outside section 412 bonding.
• Are my children employees for ERISA coverage purposes? If your children work for the business under your direction, receive wages, and participate in the plan, they are common law employees under the Darden test. The coverage regulation does not exclude children, only spouses.
• My brother and I each own half of our corporation. Do we need a bond? Yes. The regulation disregards an individual only with respect to a business wholly owned by that individual or by that individual and a spouse. Neither brother wholly owns the corporation, so both are employees and the plan is covered.
• When does the bonding requirement begin? On the date the first employee participant becomes covered under the plan, which is generally the date the employee first satisfies the plan’s eligibility conditions. Section 412(b) prohibits unbonded handling from that date forward.
• How much must the bond be? At least ten percent of funds handled, subject to a $1,000 minimum and a $500,000 maximum per plan. The maximum rises to $1,000,000 for plans holding employer securities.
• Can the bond have a deductible? No. The Department’s regulations and FAB 2008-04 prohibit deductibles or any other feature that shifts risk back to the plan.
• Does fiduciary liability insurance satisfy the bonding requirement? No. Fiduciary liability insurance covers breaches of fiduciary duty. The section 412 bond covers fraud and dishonesty by persons who handle plan funds. They are different instruments addressing different risks.
• Should a true solo 401(k) carry a bond? It is not required, but prudent sponsors carry one because the cost is nominal, the plan’s exempt status can change without warning, and many custodians and administrators require it regardless.

~ C. Constantin Poindexter, MA, JD, CPCU, AFSB, ASLI, ARe, AINS, AIS, CPLP

Notes

• [1] 29 U.S.C. § 1112(a) (ERISA § 412(a)).
• [2] Id.; Pension Protection Act of 2006, Pub. L. No. 109-280, § 622, 120 Stat. 780 (2006); 29 CFR §§ 2580.412-11 through 2580.412-13.
• [3] 29 U.S.C. § 1112(a); 29 CFR § 2580.412-9; U.S. Department of Labor, Employee Benefits Security Administration, Field Assistance Bulletin No. 2008-04 (Nov. 25, 2008) [hereinafter FAB 2008-04], Q1.
• [4] 29 U.S.C. § 1112(b).
• [5] FAB 2008-04, Q6.
• [6] 29 CFR §§ 2580.412-4, 2580.412-5; FAB 2008-04, Q17.
• [7] 29 CFR § 2580.412-6(b); FAB 2008-04, Q18 through Q21.
• [8] 29 CFR § 2580.412-11; FAB 2008-04, Q30.
• [9] 29 CFR § 2580.412-18; FAB 2008-04, Q31.
• [10] 29 CFR §§ 2580.412-21, 2580.412-23, 2580.412-24; FAB 2008-04, Q4.
• [11] 29 CFR § 2580.412-19(b); FAB 2008-04, Q26.
• [12] 29 U.S.C. § 1112(a)(2), (a)(3); 29 CFR §§ 2580.412-27 through 2580.412-32; FAB 2008-04, Q15.
• [13] 29 CFR §§ 2580.412-1, 2580.412-2; FAB 2008-04, Q13.
• [14] 29 U.S.C. § 1112(a)(1); FAB 2008-04, Q12 (“The bonding requirements under ERISA section 412 do not apply to employee benefit plans that are completely unfunded or that are not subject to Title I of ERISA.”).
• [15] 29 U.S.C. § 1003(a).
• [16] 29 U.S.C. § 1002(3).
• [17] 29 CFR § 2510.3-3(b).
• [18] 29 CFR § 2510.3-3(c).
• [19] 29 CFR § 2510.3-3(b).
• [20] Nationwide Mutual Insurance Co. v. Darden, 503 U.S. 318, 323 to 324 (1992).
• [21] Raymond B. Yates, M.D., P.C. Profit Sharing Plan v. Hendon, 541 U.S. 1 (2004).
• [22] Id. at 6.
• [23] Id. at 17 to 18 (citing U.S. Department of Labor, Advisory Opinion 99-04A (Feb. 4, 1999)).
• [24] Id. at 6, 21.
• [25] 29 CFR § 2510.3-3(d)(1).
• [26] 29 CFR § 2580.412-15; FAB 2008-04, Q42.
• [27] 29 CFR §§ 2580.412-11, 2580.412-14, 2580.412-19; FAB 2008-04, Q41.
• [28] Form 5500-SF, line 10e; Form 5500, Schedule H, line 4e, and Schedule I, line 4e. Practitioners should confirm line references against the instructions for the applicable plan year.
• [29] 29 U.S.C. § 1109(a).
• [30] 29 CFR §§ 2580.412-10, 2580.412-20; FAB 2008-04, Q22.
• [31] 29 CFR § 2520.104-46; FAB 2008-04, Q36.
• [32] 29 CFR § 2580.412-18; FAB 2008-04, Q31.
• [33] 29 CFR § 2580.412-21; FAB 2008-04, Q4.
• [34] 29 CFR § 2580.412-11; FAB 2008-04, Q30.
• [35] FAB 2008-04, Q29.
• [36] 29 U.S.C. § 1112(a); FAB 2008-04, Q35, Q38.
• [37] 29 CFR § 2580.412-19(b); FAB 2008-04, Q26.
• [38] FAB 2008-04, Q34.
• [39] FAB 2008-04, Q22, Q29.

C. Constantin Poindexter is the founder of Surety One, Inc., chief executive of Janus Assurance Re, and a partner at VSP Law, PLLC. He is the author of The Contractor’s Guide to Surety Bonds and has underwritten fidelity and surety risks for more than three decades. This essay is scholarly commentary and does not constitute legal advice. Plan sponsors should consult counsel regarding their specific circumstances.