Prohibited Transaction Basics April 24, 2008
Posted by Jeff Nabers in Self Directed IRA/401k.Tags: 401k, 4975, account, department of labor, disqualified person, dol, investing, investor, ira, irs, plan, plan asset, prohibited transaction, retirement, self directed
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The most notable difference between endeavors down the path of using a self directed IRA versus traditional investing is the unique rules that apply to the former. The extremely simple rule is that an IRA (specifically) cannot buy life insurance or collectibles (such as rugs, works of art, alcohol, bullion).
The more involved rule is known as “no self dealing” and is described in Internal Revenue Code section 4975. This rule basically says that for each retirement plan/account, there is a list of “disqualified persons” with whom that plan cannot do business. These DQPs include:
- The accountholder/participant and any other fiduciary (person who makes investment decisions for the plan)
- Companies who provide services
- A member of the family of #1 or #2 above (family defined as spouse [husband/wife], ancestor [parents, grandparents, etc], lineal descendants [children, grandchildren, etc], and spouses of lineal descents)
- A corporation (or other entity) that is 50% or more owned (directly or indirectly) by #1, #2, or #3 above
- An officer, director, 10% or more owner, or highly compensated employee of #4 above.
- A 10% or more (in capital of profits) partner or joint venturer of #4 above
Every self directed IRA/401(k) investor should make this DQP list before making any investments.
Too many people seem to think of the list as only “the accountholder and his family”. As you can see it is a bit more involved than that. This doesn’t require calculus, but you should actually write out the list step by step to ensure that it is complete. This list can actually get quite extensive if you, your family member, or anyone who provides services to your plan has ownership in several companies.
So, what is a prohibited transaction?
In a nutshell, when a DQP transacts with a plan it is a prohibited transaction (abbr “PT”). The trick here is what is considered to be a “transaction”. This is generally defined in IRC 4975 as when one of the following happens between a plan and DQP directly or indirectly:
- sale, exchange or lease of property
- lending of money or extension of credit
- furnishing of goods, services, or facilities
So I consider that to be the general rule. There are a couple of special rules and they consider a PT to also include:
- When plan assets are transferred to, used by or creating benefit to a DQP
- When the accountholder/participant directs his plan in his own interests (to benefit him now instead of through a proper distribution)
- When the accountholder/participant receives compensation from anybody in connection with plan income or assets
The reason I call these last three items “special rules” is because they transcend the 50% rule in determining when corporations are DQPs. In other words, if XYZ Corp is owned 49% by the accountholder’s mother then XYZ Corp isn’t techinically a DQP. Buuuuuut, if the plan then transacts with XYZ Corp it is obvious that the transaction might violate one of these special rules simply because you can’t ignore that the mother’s position in XYZ Corp was probably considered in the decision to direct the plan into that transaction.
All in all, a little common sense goes a long way. The intent of IRC 4975 is to obviously keep the plan out of transactions connected to people that the #1 & #2 DQPs might be able to control or use as a strawperson. So, clever concoctions that aim to evade prohibited transactions rules by a technicality often times still violate the last 3 special rules. It all comes down to intent, and this is something that DOL (the Department of Labor - the government agency that solely bears the responsibility and authority to interpret prohibited transaction expemtions) concludes based on assembling a fact pattern.
So the “directly or indirectly” part of the rule allows them to let some common sense override the technical rules. It also means that if a plan invests into an entity (Corp, LLC, etc) and that entity invests with disqualified person, it may still be a PT. More on that (plan asset rule) in a later post.
In summary, every self directed IRA/401(k) investor should make a disqualified person list before doing any transactions that involve the plan. Overlooking this is on par with a teenager not making and reviewing a budget because he thinks he can learn from and apply the concepts without actually doing the budget. Once this list is made, prohibited transactions can easily be avoided as long as the plan is never involved in any deals connected to anyone on the DQP list.
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Under current Federal Law do you think a domestic partner could be considered a DQP?
For example do you think a domestic partner could peform active labor in a property flipping investment? If so could they be paid prevailing wages? Could they work for free?
Would it make a difference if the person is the beneficiary for the IRA?
I don’t think a domestic partner could be considered a DQP. The list of DQPs in the Internal Revenue Code is very simple and straightforward.
The definition of DQP is definitely intended to include most people who the accountholder could easily use as a conduit. For a domestic partner to not be on the DQP list may seem to be a loophole, but no more than the fact that siblings are not considered DQPs.
I think any non-DQP performing labor on an IRA/401k owned property is fine. But before pursuing such a thing, I recommend you read the “bigger picture” near the bottom of my post about landlording.
What if an ira company is wholly owned by a private bank. Let’s say one of the directors/shareholders of the bank has an IRA account with the ira company (which is owned by the bank). Could the IRA invest into the bank’s money market account, when that bank is partially directed and/or owned by the accountholder? Would that constitute a prohibited transaction, and would the bank be a DQP?
Could an IRA, LLC, who invests in first deeds of trust, invest in a loan with the individual who ownes the IRA.
Do you have any private letter rulings to reference, or any case law concerning an IRA that invests into an LLC which is managed by the IRA AccountHolder, who also has checkbook control for the LLC. This sounds very attractive, but I would like to see some type of official ruling on this. Thanks!
I have a prospective client who has an existing 401K0. The client is a commercial bank. The bank has an inhouse investment adviser. The bank via their investment adviser is haring in commissions of their plan. Is this a prohibited transaction?
@Mike - I focus mostly on self directed individual plans (not employee benefit plans).
To move yourself towards the answer,
- See IRC 4975(e)(2) to determine who is a disqualified person in the situation. Make a list.
- See IRC 4975(c)(1) [specifically (A) through (D)] to determine if any disqualified person “transacted” with the plan
- See IRC 4975(e)(3) to determine who is a fiduciary
- See IRC 4975(c) to determine if any fiduciary violates [specifically (E) and (F)]
If you need further assistance, contact me at 877-903-2220.
@Dee - No.
@Angela - Re: Bank Money Market account… I always recommend erring on the side of caution; in this case it means open a MMA at a different bank. Typically one bank’s MMA interest rates aren’t going to beat the pants off another’s… so there’s no real incentive to not err on the side of caution.
@Angela - Re: Legitimacy of IRA LLC strategy - There is a fairly straightforward summary of this issue here and also here.
I have a client who has a self directed IRA and inadvertently invested in some silver coins that I have determined to be a prohibited investment. It appears that this investment will be taxable and subject to a 10% penalty in 2007. Can this transaction be unwound to avoid the taxes and penalty?
Mike,
Did the silver coins hold collectors value?
IRS & DOL both have voluntary correction programs for prohibited transactions, but I have little experience with either.
This is in regards to Mike’s question. Yes this would be a prohibited transaction and, actually, could disqualify the plans triggering full distribution and tax penalties. This has been addressed on point in PLRs but I don’t have it around handy. Hope this helps.
I sold a piece of real estate that I personally owned to by brother.
I now want to buy it back in my IRA. Is this a prohibited transaction?
@Mike & John - Technically IRA investment into collectibles/metals is not a prohibited transaction. Firstly, if the metals meet definitions in IRC 408(m)(3), there should be no problem. If they do not, then, according to IRC 408(m)(1), it will be treated as a distribution in an amount equal to the cost of the “collectible” purchased.
@Phllip - If this ultimate result was never conceived or intended, buying the property back in your IRA might not be a prohibited transaction. However, that may be a difficult case to argue. If the ultimate result of getting it into your IRA plan was conceived or intended at the point at which you decided to sell the property to your brother, then directing your IRA to now buy the property from your brother would likely be a prohibited transaction.