Prohibited Transactions Under the Internal Revenue Code
By Jeff Aga, QKA
What is a prohibited transaction under the Internal Revenue Code?
A prohibited transaction under the Internal Revenue Code (IRC) is a transaction prohibited by law between a retirement plan and a disqualified person. The purpose of these statutes is to prevent or correct conflicts of interest, wherein there is potential for a tax-qualified savings arrangement to suffer financial harm or disadvantage due to other interests or motives being given preference. It is not necessary for actual harm to occur for a transaction to be prohibited.
The prohibited transaction rules are found both in the IRC and the labor laws and regulations under ERISA. IRC Section 4975 (c) states that generally a prohibited transaction is any direct or indirect
sale, exchange, or leasing of property between a plan and a disqualified person
lending of money, or extending credit between a plan and a disqualified person
furnishing goods, services, or facilities between a plan and a disqualified person
a transfer of plan income or assets to use by or for the benefit of, a disqualified person
act by a plan fiduciary whereby plan assets or plan income are used for his or her own interest
receipt for consideration by a fiduciary for his or her own personal account from any party dealing with the plan in a transaction that involves plan income or assets
Who is a disqualified person?
A disqualified person is described in IRC Sec. 4975(e) and includes any of the following.
(A) a fiduciary of the plan
(B) a person providing services to the plan
(C) an employer, any of whose employees are covered by the plan
(D) an employee organization, any of whose employees are covered by the plan
(E) a 50 percent owner of items C or D above
(F) a family member of A, B, C, or D above (family members include spouse, ancestor, lineal descendant, and any spouse of lineal descendant, but not brother or sister)
(G) a 50 percent or more ownership (or control) in a corporation, partnership, trust or estate owned by A, B, C, D, or E
(H) an officer, director, or 10 percent or more shareholder, or highly compensated employee of C, D, E, or G
(I) a 10 percent or more partner or joint venture of a person described in C, D, E, or G
What are some examples of prohibited transactions?
EXAMPLE 1
Jeff has a parcel of land in his owner-only 401(k) plan. He is going to retire next year and has decided that he would like to build a retirement home on this property. Jeff submits an appraisal to the plan trustee showing that the appraised value is $150,000. He sends a cashier’s check to the trustee to purchase the property out of the plan. This is an example of a sale, exchange, or leasing of property between a plan and a disqualified person.
EXAMPLE 2
Lisa’s 401(k) plan holds $100,000 in cash. Her mother recently started a business and needs a short-term loan for her business start-up. Lisa offers her mother $50,000 in exchange for a promissory note paying 6% interest in 60 monthly installments. This is an example of lending of money or other extension of credit between a plan and a disqualified person.
What are the consequences of a prohibited transaction?
When a prohibited transaction takes place, the disqualified person or persons must correct the violation and pay a 15 percent excise tax on the dollar value that was involved in the prohibited transaction for each separate tax year. If a prohibited transaction is not corrected timely, an additional tax of 100 percent of the amount of the prohibited transaction may be assessed. Both taxes will be assessed against any disqualified person who participates in a prohibited transaction. If more than one, each person can be liable for the entire tax. If the prohibited transaction is corrected within 90 days of a notice of deficiency concerning the additional tax, the IRS may abate, credit, or refund the 100 percent tax.
How is a prohibited transaction corrected?
Correcting the prohibited transaction requires the undoing of the transaction to the extent possible and, in any case, to “make whole” the plan or affected account for any losses resulting from the transaction, by restoring to the plan or affected account any profits made through the prohibited use of the assets involved. The plan or affected account must be placed in a financial position no worse than if the disqualified person had complied with the highest fiduciary standards.
