Self Directed IRA Lawyers

The Prohibited Transaction Rules

The Internal Revenue Code & ERISA does not describe what a retirement plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of qualified retirement plans for accumulation of retirement savings and to prohibit those in control of retirement accounts qualified retirement plans from taking advantage of the tax benefits for their personal account.

Who is a “Disqualified Person”?

The IRS has restricted certain transactions between the retirement Plan and a “disqualified person”. The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed.

The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the retirement account holder, any ancestors or lineal descendants of the retirement account holder, and entities in which the retirement account holder holds a controlling equity or management interest. In essence, under Code Section 4975, a “Disqualified Person” means:

  • A fiduciary (e.g., the retirement account holder , or person having authority over making retirement account investments),
  • A person providing services to the retirement account (e.g., the trustee or custodian),
  • An employer, any of whose employees are covered by the plan (this generally is not applicable to retirement plan but does include the owner of a business that establishes a qualified retirement plan),
  • An employee organization any of whose members are covered by the retirement plan,
  • A 50 percent owner of C or D above,
  • A family member of A, B, C, or D above (family members include the fiduciary’s spouse, parents, grandparents, children, grandchildren, spouses of the fiduciary’s children and grandchildren (but not parents-in-law),
  • An entity (corporation, partnership, trust or estate) owned or controlled more than 50 percent by A, B, C, D, or E. Whether an entity is a disqualified person is determined by considering the indirect stockholdings/interest which would be taken into account under Code Sec. 267(c), except that members of a fiduciary's family are the family members under Code Sec. 4975(e)(6) (lineal descendants) for purposes of determining disqualified persons.
  • A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G,
  • A 10 percent or more partner or joint venturer of a person described in C, D, E, or G.

Note: brothers, sisters, aunts, uncles, cousins, step-brothers, step-sisters, and friends are NOT treated as “Disqualified Persons”.

Prohibited Transactions

Pursuant to Internal Revenue Code Section 4975, a retirement account holder is prohibited from engaging in certain types of transactions. The types of prohibited transactions can be best understood by dividing them into three categories: Direct Prohibited Transactions, Self-Dealing Prohibited Transactions, and Conflict of Interest Prohibited Transactions.

Direct Prohibited Transactions

Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Direct Prohibited Transaction” generally involves one of the following:

4975(c)(1)(A): The direct or indirect Sale, exchange, or leasing of property between a retirement account and a “disqualified person”

Example 1: Joe sells an interest in a piece of property owned by his retirement account to his son.

Example 2: Beth leases real estate owned by her retirement account to her daughter.

Example 3: Mark uses his retirement account funds to purchase an LLC interest owned by his mother.

4975(c)(1)(B): The direct or indirect lending of money or other extension of credit between a retirement account and a “disqualified person”

Example 1: Ted lends his wife $70,000 from his retirement account.

Example 2: Mary personally guarantees a bank loan to her retirement account to purchase real estate.

Example 3: Dan uses his retirement account funds to lend an entity owned and controlled by his father $18,000.

4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between a retirement account and a “disqualified person”

Example 1: Andrew buys a piece of property with his retirement account funds and hires his father to work on the property.

Example 2: Rachel buys a condo with her retirement account funds and personally fixes it up.

Example 3: Betty owns an apartment building with her retirement account and hires her mother to manage the property.

4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of a retirement account

Example 1: Ken is in a financial jam and takes $32,000 from his retirement account to pay a personal debt.

Example 2: John uses his retirement account to purchase a rental property and hires his friend to manage the property. The friend then enters into a contract with John and transfers those funds back to John.

Example 3: Melissa invests her retirement account funds in a real estate fund and then receives a salary for managing the fund.

Self-Dealing Prohibited Transactions

Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Self-Dealing Prohibited Transaction” generally involves one of the following:

4975(c)(1)(E): The direct or indirect act by a “Disqualified Person” who is a fiduciary whereby he/she deals with income or assets of the retirement account in his/her own interest or for his/her own account

Example 1: Debra who is a real estate agent uses her retirement account funds to buy a piece of property and earns a commission from the sale.

Example 2: Ben wants to buy a piece of property for $120,000 and would like to own the property personally but does not have sufficient funds. As a result, Ben uses $110,000 from in his retirement account and $10,000 personally to make the investment.

Example 3: Nancy uses her retirement account funds to invest in a real estate fund managed by her son. Heidi’s father receives a bonus for securing Nancy’s investment.

Conflict of Interest Prohibited Transactions

Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Conflict of Interest Prohibited Transaction” generally involves one of the following:

4975(c)(i)(F): Receipt of any consideration by a “Disqualified Person” who is a fiduciary for his/her own account from any party dealing with the Plan in connection with a transaction involving income or assets of the Plan.

Example 1: Jason uses his retirement account funds to loan money to a company in which he manages and controls but owns a small ownership interest in.

Example 2: Cathy uses her Solo 401k Plan to lend money to a business that she works for in order to secure a promotion.

Example 3: Eric uses his retirement account funds to invest in a fund that he manages and where his management fee is based on the total value of the fund’s assets.

Statutory Exemptions

Under Internal Revenue Code Section 4975(d), Congress created certain statutory exemptions from the prohibited transaction rules outlined under Internal Revenue Code Section 4975(c). For these certain transaction, Congress believed there is a legitimate reason to permit them. For these transactions, Congress has issued a blanket statutory exemptions permitting these transactions assuming that certain requirements specified are satisfied.

Below is a list of some of the statutory exemptions found in Internal Revenue Code Section 4975(d) that apply to retirement accounts:

  • Any contract with a disqualified person for office space, legal, accounting or other services necessary for the operation of the retirement account as long as reasonable compensation is paid. Note – this exemption does not apply to a retirement account fiduciary (i.e. Solo 401k Plan trustee) as per Treasury Regulation Section 54.4975-6(a)(5).
  • The provision of ancillary services to a retirement account by a bank trustee.
  • receipt by a disqualified person of any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries.

S Corporation Stock

Because of the shareholder restrictions imposed on “S” Corporations, a Solo 401k Plan cannot own stock in an S Corporation. Note – a Solo 401k Plan can own stock in a “C” Corporation.

What Type of Precious Metals and Coins are IRS Approved Investments?

Internal Revenue Code Section 408(m) lists the type of precious metals and coins that are permitted investments using retirement funds:

  • One, one-half, one-quarter or one-tenth ounce U.S. gold coins (American Gold Eagle coins are the only gold coins specifically approved for retirement accounts). Other gold coins, to be eligible as retirement account investments, must be at least .995 fine (99.5% pure) and be legal tender coins.
  • one ounce silver coins minted by the Treasury Department;
  • any coin issued under the laws of any state;
  • a platinum coin described in 31 USCS 5112(k); and
  • gold, silver, platinum or palladium bullion (other than bullion that is made into a coin) of a certain fineness that is in the physical possession of a trustee that meets the requirements for retirement account trustees under Code Sec. 408(a).

Life Insurance Contracts & Collectibles

In general, pursuant to Code Section 408, a self-directed IRA cannot Invest in life insurance contracts, whereas, a Solo 401(k) plan is able to purchase life insurance contracts. In the case of collectibles, a self-directed IRA and Solo 401(k) plan are both not permitted to purchase collectibles as defined below:

  • Any work of art
  • Any metal or gem
  • Any alcoholic beverage
  • Any rug or antique
  • Any stamp
  • Most coins

Types of Collectibles that may be Purchased Using retirement Funds

  • one, one-half, one-quarter or one-tenth ounce U.S. gold coins (American Gold Eagle coins are the only gold coins specifically approved for retirement accounts. Other gold coins, to be eligible as IRA investments, must be at least .995 fine (99.5% pure);

  • one ounce silver coins minted by the Treasury Department;
  • any coin issued under the laws of any state;

  • a platinum coin described in 31 USCS 5112(k) ; and
  • gold, silver, platinum or palladium bullion (other than bullion that is made into a coin) of a certain fineness that is in the physical possession of a trustee that meets the requirements for retirement account trustees under Code Sec. 408(a).

The Technical and Miscellaneous Revenue Act of 1998 allowed retirement account holders owners to invest their retirement assets in certain platinum coins as well as certain gold, silver, platinum, or palladium bullion provided the precious metals are held in the physical possession of the financial organization or depository. With respect to state minted coins, the coins must be held in the possession of a third-party other than the retirement account holder. The Technical and Miscellaneous Revenue Act of 1998 does not state that the third-party holding the state minted coins must be a bank, but the holder must not be the retirement account holder. Regarding American Eagle coins, there does not seem to be a "physical possession" requirement as precious metals or a restriction on possession by the retirement account as in the case of state minted coins, however, holding the IRS approved coins in your personal possession is not advisable.

Determining Whether a Specific Transaction is a Prohibited Transaction

Through an arrangement between the IRS and the Department of Labor (DOL), it is the DOL’s responsibility to determine whether a specific transaction is a prohibited transaction and to issue prohibited transaction exemptions. When the IRS discovers what appears to be a prohibited transaction in an individual’s retirement account, it turns the matter over to the DOL to make the determination. The DOL reviews the situation and responds to the IRS, which in turn responds to the taxpayer. If the retirement account grantor wants to apply for a prohibited transaction exemption, he or she must apply to the DOL. The DOL has the authority to issue prohibited transaction exemptions. Some, known as “prohibited transaction class exemptions” (PTCEs), are available for anyone’s reliance, while others, called “individual prohibited transaction exemptions” (PTEs), are issued only to the applicant.

Prohibited Transaction Penalties

The Bergman Law Group understands how important it is to protect your retirement funds from the IRS prohibited transaction rules because they can be so harsh. For example, in the case of a self-directed IRA, your entire IRA can be deemed terminated and subject to tax and penalty even if not all your IRA funds were involved. Section 4975 imposes excise taxes intended as penalties on a wide variety of prohibited transactions, embracing virtually every sale, loan, or transfer between a qualified plan and an employer, trustee, or other disqualified person, subject to a long list of intricately worded statutory exemptions and an administrative dispensing power in the Treasury. The tax is initially 15 percent of the amount involved in the transaction, but the 15 percent is reimposed annually until the transaction is corrected and is followed by an additional tax of 100 percent if the taxpayer is recalcitrant.

To learn more about the IRS prohibited transaction rules, please contact us at 800-472-0467.