Prohibited Transactions in a Self Directed IRA
A prohibited transaction is any action involving your IRA that is expressly prohibited by the IRS. Some common examples include:
- Borrowing money from or lending money to your IRA
- Allowing your IRA to buy from or sell to any "disqualified person", including yourself and most of your family
- Purchase of prohibited assets (life insurance or collectibles)
- Using your IRA as collateral for a loan or other obligation
- Taking any action that directly or indirectly benefits you or any disqualified person rather than the IRA itself
Prohibited transactions are a serious problem when committed in an IRA and can have life-altering consequences. Let's take a moment to look into this a bit deeper:
A very good generalization to help identify a prohibited transaction is: A prohibited transaction is anything that benefits the IRA Owner or his/her loved ones - even if only very indirectly - rather than benefiting the IRA itself.
Prohibited transactions can be very, very subtle. For example:
- If your IRA owns real estate, allowing your granddaughter's girl scout troop to sell cookies on that land is prohibited
- If your IRA owns shares of a corporation, and you have more than a certain amount of ownership and/or influence over that corporation, that is prohibited
- If your IRA purchases real estate (or any asset) from you - even if at fair market value with no special consideration - that is prohibited
In just a moment, I'll tell you just how serious it is to commit a prohibited transaction in your IRA.
But first, if you'd like a more formal description of prohibited transactions, take a look at these resources:
Prohibited Transaction defined in 26 USC § 4975
Prohibited Transactions are defined under law at 26 USC § 4975, shown in relevant part below:
(c) Prohibited transaction
(1) General rule For purposes of this section, the term “prohibited transaction” means any direct or indirect—
(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
(B) lending of money or other extension of credit between a plan and a disqualified person;
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
Prohibited Transactions as described by the IRS
Generally, a prohibited transaction in an IRA is any improper use of an IRA account or annuity by the IRA owner, his or her beneficiary or any disqualified person.
Disqualified persons include the IRA owner’s fiduciary and members of his or her family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).
The following are examples of possible prohibited transactions with an IRA.
Borrowing money from it
Selling property to it
Using it as security for a loan
Buying property for personal use (present or future) with IRA funds
Who is a fiduciary?
An IRA fiduciary includes anyone who does any of the following:
Exercises any discretionary authority or discretionary control in managing the IRA or exercises any authority or control in managing or disposing of its assets.
Provides investment advice to the IRA for a fee, or has any authority or responsibility to do so.
Has any discretionary authority or discretionary responsibility in administering the IRA.
Effect on an IRA account
Generally, if an IRA owner or his or her beneficiaries engage in a prohibited transaction in connection with an IRA account at any time during the year, the account stops being an IRA as of the first day of that year. The effect of this is the account is treated as distributing all its assets to the IRA owner at their fair market values on the first day of the year. If the total of those values is more than the basis in the IRA, the IRA owner will have a taxable gain that is includible in his or her income.
What Are The Ramifications of a Prohibited Transaction in your IRA?
Committing a prohibited transaction in your IRA is the financial equivalent of a nuclear explosion.
It is not unusual for an IRA to be wholly obliterated as a result of a prohibited transaction.
Attorney John Hyre does a large amount of IRA audit defense, and what he told me about the IRS' presumption in these cases is astounding. In essence, the IRS assumes that a prohibited transaction has been committed in every self-directed IRA they encounter. (Listen to the interview with John Hyre here.)
This is confirmed by our own legal counsel, Tim Berry, who says: "The IRS loves to identify prohibited transactions. For them, it's a very black-and-white issue. You either did it, or you didn't. And if you did, they're not inclined to show any mercy. For an IRS agent, identifying a prohibited transaction is like Christmas morning, because it lets them tax a lifetime of savings and profits that were previously unreached by the government." (Tim Berry is a frequent guest on Self Directed Investor Talk and America's top self-directed IRA attorney.)
It is a very serious matter to commit a prohibited transaction in your IRA.
Furthermore, it's also quite simple to commit a prohibited transaction, as illustrated here:
When your IRA is guilty of committing a prohibited transaction, the IRS considers your IRA to be "fully distributed" as of January 1 of the year when the prohibited transaction took place.
To clarify this, let's break this down into these questions:
- What is a distribution?
- What is the meaning of "fully distributed"?
What Is A Distribution?
From the vantage point of the IRS, a "distribution" from your IRA means that a certain dollar-value in assets has been transitioned from being "in" your IRA (and subject to the IRA's tax benefits) to being "out" of your IRA. The rules for distributions are (generally) pretty simple:
- Traditional IRA: Pay income tax on the amount of your distribution. If you're under age 59 1/2, add 10% to that as an early withdrawal penalty
- Roth IRA: If you're under age 59 1/2, pay income taxes (plus a 10% early withdrawal penalty) on the amount of your distribution that's in excess of your total principal contributions. After age 59 1/2, no taxes are due on distributions.
A distribution isn't a bad thing. The point of your IRA is to provide you with distributions during retirement. Of course, as you see, distributions taken prior to retirement may be subject to taxes and penalties.
What is a "Full Distribution"?
A "full distribution" simply means that 100% of the value of the IRA has been distributed. In that case, the IRA has a zero balance and for all practical purposes, no longer exists.
So What's The Big Deal?
The problem with prohibited transactions is that you're quite likely not aware that you've committed the error. Most people don't learn about prohibited transactions until they're discovered many years later during an audit. As a result, it's common for a prohibited transaction to establish a tax liability that was payable many years ago. This leads to a tax bill that includes a potentially huge amount of interest on what's likely already a substantial bill for taxes and penalties.
To further compound the situation, prohibited transactions cause a full distribution of your IRA (except for purchase of prohibited assets, which result in a distribution equal to the amount of the investment). This means that the distribution is not limited to the value of the specific asset on which you committed the transaction. A prohibited transaction means your entire IRA is zeroed out, and your tax liability will be based on a combination of income taxes, penalties and interest on your entire IRA value as of January 1 in the year when the prohibited transaction was committed.
Prohibited Transaction Consequences per the IRS
A prohibited transaction with respect to an IRA occurs if the owner or beneficiary of the IRA engages in certain transactions. However, in this case, with an individual retirement account, instead of imposing an excise tax on the parties to the transaction, the Code provides that the account is no longer an individual retirement account, and it is treated as if the assets were distributed on the first day of the taxable year in which the prohibited transaction occurred. (IRC Section 408(e)(2))
A prohibited transaction can also occur between an IRA and a disqualified person other than the IRA owner or beneficiary, such as a relative of the owner or beneficiary or a fiduciary. If a prohibited transaction with respect to an IRA involves a disqualified person other than the IRA owner or beneficiary, then that other person is subject to the prohibited transactions excise tax.
Common Examples of Perfectly Innocent Prohibited Transactions
The following common occurrences are both "perfectly innocent" (in that no harm was intended by you), but are nevertheless totally prohibited transactions:
- Payment of real estate hazard insurance for IRA-owned property with non-IRA funds
- Allowing an IRA to be placed as collateral for other accounts (very common with banks and brokerages, who frequently include stipulations that any of your accounts can be used to secure any of your other accounts)
- Getting a loan in your IRA that appears to be non-recourse, but has hidden carve-outs which re-establish lender recourse
- Reimbursing yourself (even if precisely dollar-for-dollar) for expenses incurred by your IRA property that you paid with personal (not IRA) funds
No matter how innocent these prohibited transactions are, you should not expect that the IRS will show leniency should they identify such a transaction.
Preventing Prohibited Transactions
The IRS has not provided an exhaustive listing of all transactions that are prohibited, so there's no foolproof plan for avoiding prohibited transactions. But there are steps you can take to protect yourself:
Get Good Legal Advice Before The Transaction
But there are questions you can ask yourself to safeguard your self-directed IRA. Before each transaction, ask yourself these questions:
- Am I personally benefiting (rather than or in addition to my IRA) from this transaction in any way... even indirectly?
- Are any of my relatives benefiting directly or indirectly from this transaction?
- Are any business entities that I have any ownership of, or substantial influence over, benefiting directly or indirectly from this transaction?
- Is any money landing in my pocket, or my family's pockets, as a result of this transaction even if I'm owed the money?
- Is anyone who may be considered a disqualified person involved in this transaction?
"Disqualified Persons" described by the IRS
A disqualified person is any of the following:
(1) a fiduciary of the plan;
(2) a person providing services to the plan;
(3) an employer, any of whose employees are covered by the plan;
(4) an employee organization, any of whose members are covered by
(5) any direct or indirect owner of 50% or more of any of the following:
- the combined voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of a corporation that is an employer or employee organization described in (3) or (4);
- the capital interest or profits interest of a partnership that is an employer or employee organization described in (3) or (4); or
- the beneficial interest of a trust or unincorporated enterprise that is an employer or an employee organization described in (3) or (4);
(6) a member of the family of any individual described in (1), (2), (3), or
(4) (i.e., the individual’s spouse, ancestor, lineal descendant, or any
spouse of a lineal descendant);
(7) a corporation, partnership, trust, or estate of which (or in which) any
direct or indirect owner described in (1) through (5) holds 50% or
more of any of the following:
- the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation;
- the capital interest or profits interest of a partnership; or
- the beneficial interest of a trust or estate;
(8) an officer, director (or an individual having powers or responsibilities
similar to those of officers or directors), a 10% or more shareholder,
or highly compensated employee (earning 10% or more of the yearly
wages of an employer) of a person described in (3), (4), (5), or (7);
(9) a 10% or more (in capital or profits) partner or joint venture of a
person described in (3), (4), (5), or (7); or
(10) any disqualified person, as described in (1) through (9) above, who
is a disqualified person with respect to any plan to which a
multiemployer plan trust is permitted to make payments under
section 4223 of ERISA.
For additional information, see Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).
"Disqualified Persons" in clear language
Broadly speaking, "disqualified persons" include:
- You - the owner of the IRA
- Family - your ancestors, descendants and their spouses
- IRA Account Professionals - your account custodian or anyone providing services connected to the IRA
- Related Entities - any business or organization on which you or a family member have substantive ownership or influence
"Disqualified Persons" is a critically important consideration. By engaging in a transaction that directly (or even indirectly) benefits a disqualified person, your entire IRA will be categorized as "Fully Distributed", which is catastrophic to your IRA and nearly always irreparable.
Alas, there’s more… FAR MORE… than meets the eye, and it’s all legally uncharted waters.
In moving forward, keep this little tidbit in mind: The IRS lists 10 groups of people who are DISQUALIFIED from doing business with your IRA. What’s #1? That honor goes to anyone who can be described as a FIDUCIARY of the plan. And SDI Society Legal Counsel Tim Berry – the Great One, we call him – tells us that Section 4975 of the tax code defines Fiduciary as anyone who has discretionary authority over a retirement plan.
Do YOU have discretionary authority over your retirement plan? Yes, you do. Remember, it’s *SELF* directed.
But that only prohibits the IRA from doing business directly with you, right? You’d think so, but… no.
According to Tim, the examples in that regulation (26 CFR 54.4975-6 a(5)) make it arguable that the disqualification extends not just to the fiduciary, but to anyone in whom the fiduciary has an “interest” that could sway the judgment of the fiduciary. Notice the use of the vague word “interest”. It doesn’t say bloodline. It doesn’t say family relationship. It doesn’t even say “personal relationship”. It just says “interest”.
Is it arguable that you have an interest in your siblings, your aunts, your uncles, your nieces or nephews? Sure it is.
So the bad news is this: The law says YOU are a fiduciary of your plan, and that you – and anyone in whom you’ve got an interest – are disqualified from doing business with your IRA. That’s a sobering thought.
The good news: Tim says he’s never seen this authority asserted by the IRS, so maybe their operating definition is narrower than what appears to be stipulated in law.
In addition to asking yourself these question, you should enlist the assistance of experienced, qualified legal expertise, and seek their advice specifically on questions including:
- Does the asset I'm considering purchasing qualify as either life insurance or a collectible?
- Does it appear that there's involvement of any disqualified persons in this transaction?
- Do you see any indirect benefits that I'm receiving from this transaction?
- Is this transaction setting me up for any tax burden beyond that payable when I withdraw funds during retirement?
- Which parts of this transaction are most likely to be attacked by the IRS and need to be particularly well-documented?
Sequester Risky Assets
The thing that makes prohibited transactions so destructive is that any prohibited transaction, even if it involves a transaction of only $1, still results in full distribution of the IRA.
For that reason, if you're investing in assets that have a high proclivity towards prohibited transactions, such as real estate or LLC's, you would be wise to consider sequestering those assets into their own IRA accounts, like so:
- Determine the amount of capital necessary to perform the transaction in full
- Create a new self directed ira (a "sequestered account") and transfer that amount of capital into the sequestered account from the original IRA
- Never invest in any additional assets in the sequestered account
The advantage of this approach is that in the event a prohibited transaction takes place in the sequestered account, the assets in your original IRA will not be harmed. Additionally, you can create as many sequestered IRA's as you like.
Consider Using a Solo 401(k) Instead Of A Self-Directed IRA
The Solo 401(k) is another type of retirement account that provides the ability to fully self-direct its own investments, just like a self-directed IRA. However, the Solo 401(k) has several substantial advantages over the self-directed IRA, the most relevant of which for our purposes here is:
The Solo 401(k) makes it relatively simple and inexpensive to correct prohibited transactions. With Self-Directed IRA's, it's all but impossible to correct prohibited transactions.
The eligibility requirements for the Solo 401(k) are more demanding that the self-directed IRA. If you qualify, it is my advice that you seriously consider using the Solo 401(k) for your retirement investing rather than the Self-Directed IRA.
Prohibited Transactions are a Very Serious Matter
It is not an exaggeration to say that prohibited transactions can be cataclysmic for your self-directed IRA. Furthermore, the attitude of the IRS about these transactions during audit has recently been deeply inflexible, as they know that they "have you" and there's precious little you can do about it.
But don't let this particular risk scare you aware. Instead, do all you can to understand the risk of prohibited transactions. You'll go far in avoiding them simply by keeping excellent records and by seeking pre-emptive and on-going legal advice.