Understanding IRA Prohibited Transactions
By Ascensus
Because Congress has granted special tax benefits to encourage people to save for retirement, there's an expectation that individuals won't misuse these privileges or take unnecessary risks with their IRA assets. The prohibited transaction rules are in place to ensure that IRA transactions are managed in a way that benefits the IRA itself in the long run, rather than providing short-term gains to the IRA owner. As a result, decisions involving retirement savings should be made with a singular motive—to maximize the accumulation of assets for an individual’s retirement security, and potentially to benefit a spouse or other beneficiaries.
What are prohibited transactions?
The different situations in which prohibited transaction issues may arise are almost endless. One of the most common prohibited transactions involves using IRA assets to purchase property for personal use (present or future). Internal Revenue Code Section (IRC Sec.) 4975 lists the transactions that are considered to be prohibited. These include any direct or indirect
sale or exchange, or leasing, of any property between an IRA and a disqualified person;
lending of money or other extension of credit between an IRA and a disqualified person;
furnishing of goods, services, or facilities between an IRA and a disqualified person;
transfer to, or use by or for the benefit of, a disqualified person of the income or assets of an IRA;
act by a disqualified person who is a fiduciary whereby he deals with the income or assets of an IRA in his own interest or for his own account; or
receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the IRA in connection with a transaction involving the income or assets of the IRA.
Who is a disqualified person?
As previously mentioned, IRA owners and other disqualified persons may not use the IRA in a self-serving manner. Although the definition of what constitutes a disqualified person is detailed and complex, some entities will always be considered disqualified persons with respect to IRA transactions. In addition to IRA owners and beneficiaries, disqualified persons for IRAs include fiduciaries and certain relatives of the IRA owner (e.g., spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).
For IRA purposes, a fiduciary generally includes any individual who does the following.
Exercises discretionary authority or control in managing the IRA, administering the IRA, or in managing or disposing of its assets
Provides IRA investment advice for a fee, or has any authority or responsibility to do so (Prohibited Transaction Exemption 2020-02 may provide relief to eligible fiduciaries)
What are indirect prohibited transactions?
If a transaction directly violates the prohibited transaction rules, simply altering the transaction to remove the disqualified person from direct involvement does not resolve the issue; merely insulating that person from the transaction and enlisting a third party does not make a prohibited transaction permissible.
Under the prohibited transaction rules, a disqualified person must not do indirectly that which must not be done directly. Many times a transaction that appears permissible will violate the general self-dealing rule. An example may help illustrate this concept.
Example: Golf pro, Carter Jones, discovers that anyone who owns 1,000 or more shares of stock in Badlands Golf Courses, Inc ., receives a free lifetime country club membership . Carter decides to use his IRA to purchase 1,000 shares of Badlands stock . Carter’s investment of his IRA assets in Badlands stock will not, by itself, constitute a prohibited transaction . But because Carter will receive a benefit (lifetime membership) from the purchase by the IRA, a prohibited transaction occurs under IRC Sec . 4975(c)(1)(E) (“act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account”) . The basic premise behind this provision is the concept of self- dealing (i .e., Carter is investing his IRA assets for his own personal benefit (the golf membership) rather than for the benefit of the IRA) .
Examples of prohibited transactions
Following are examples that illustrate the various types of prohibited transactions, which are defined in IRC Sec. 4975(c)(1).
Sale or Exchange of Assets: Angie maintains a Traditional IRA, which holds $100,000 in cash. Her husband, Jeffrey, owns a salvage business. Angie directs the trustee of her IRA to purchase a $50,000 interest in the business.
Angie’s IRA purchased an interest in property already owned by her husband—who is a disqualified person—which is impermissible.
Lending of Money: Andrea maintains a Roth IRA that holds $500,000 in cash. Andrea wants the IRA to purchase a new business, but the IRA does not have enough cash to purchase the business outright. Andrea consults with a financial organization that can loan the difference to the IRA. Andrea personally guarantees the debt. Because a personal guarantee is an extension of credit, a prohibited transaction has occurred.
Furnishing of Goods, Services, or Facilities: Chad’s IRA purchases a piece of commercial real estate from an unrelated third party. Thereafter, the IRA permits Chad’s dental practice to operate out of the property for free. The furnishing of facilities between a plan and a disqualified person (Chad) is prohibited.
Transfer to or Use of IRA Assets: Logan is a real estate agent. One of Logan’s clients is selling an apartment building in an up-and-coming neighborhood, and Logan represents the client as the listing agent. Logan uses his IRA assets to purchase the apartment building and earns a commission as the real estate agent on the sale.
The IRA assets are used for the benefit of a disqualified person (Logan), which is a prohibited transaction.
Fiduciary Dealing with Assets in His Own Interest: Warren uses $20,000 of his IRA assets to lend money to a limited liability company that he controls and manages.
Warren, as the IRA owner, is a disqualified person and a fiduciary. IRC Sec. 4975(c)(1)(E) prohibits Warren from dealing with the income or assets of the IRA for his own interest.
Receipt of Consideration for Personal Account: Stationary Plus, LLC, which is owned by Grace’s Traditional IRA, hires Grace as a saleswoman on the weekends. Grace makes a commission on any of her sales and receives an hourly wage paid by Stationary Plus, LLC. IRC Sec. 4975(c)(1)(F) prohibits Grace, who is a disqualified person, from receiving wages or commissions from Stationary Plus, LLC. As result, a prohibited transaction has occurred.
What happens after a prohibited transaction occurs?
When an IRA owner or beneficiary is involved in a transaction that is prohibited under IRC Sec. 4975, the IRA loses its tax-exempt status and the IRA owner (or beneficiary) is deemed to have received a distribution on the first day of the tax year in which the prohibited transaction occurred (IRC Sec. 408(e)). The distribution amount that the IRA owner is deemed to have received is equal to the IRA’s fair market value as of the first day of such tax year (January 1 for most taxpayers), and is considered taxable income to the IRA owner.
The financial organization must report this amount on Form 1099- R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., using code 5, Prohibited transaction, in Box 7.
If someone other than the IRA owner or beneficiary engages in a prohibited transaction, that person may be liable for certain taxes. In general, there is a 15 percent tax on the amount of the prohibited transaction and a 100 percent additional tax if the transaction is not corrected; Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, must be filed.
Are there ways to prevent prohibited transactions?
Because the correction for failing to avoid a prohibited transaction is usually unpleasant and not always possible, most financial organizations have found that preventing prohibited transactions is worth the effort. So how should a financial organization respond if it suspects that a client has conducted (or is considering) a prohibited transaction?
The financial organization generally should avoid making the ultimate determination of whether a proposed transaction is prohibited.
In situations where a proposed transaction is explicitly prohibited (e.g., selling IRA assets to a disqualified person), the financial organization generally should refuse to engage in the transaction.
If the potential for a prohibited transaction is not quite as clear, the course of action taken by the financial organization may differ.
The financial organization can inform the IRA owner that there is a possible prohibited transaction.
By giving the individual an opportunity to address the situation, the financial organization can help the individual to understand the nature of the possible prohibited transaction, seek additional counsel, and avoid a potential prohibited transaction.
If the individual still insists on completing the proposed transaction, the financial organization should consider the following options.
Refuse to permit the suspected prohibited transaction
Require that the individual sign a “hold harmless” agreement, releasing the financial organization from liability, before allowing the transaction
Resign as the trustee or custodian on the account by giving proper notice.
Alternatively, if an individual insists on engaging in a transaction that the financial organization believes could be prohibited, the financial organization can take steps to minimize the potential risk to the individual and to the organization.
If the prohibited transaction involves an IRA, establishing a separate IRA for the assets related to the transaction may be a safer course of action.
Because a prohibited transaction results in the disqualification of the entire IRA, segregation of the assets into a separate IRA that includes only the assets involved in the transaction in question will preserve the qualified status of the other assets if the transaction is later found to be prohibited.
NOTE: Any action that a financial organization takes in response to a potential prohibited transaction should be based on competent legal advice.
Key Takeaway
Financial organizations that offer a wide variety of investment options or offer self-directed IRAs may be at risk of inadvertently becoming involved in prohibited transactions. Because prohibited transactions can be complex and result in additional taxes, it’s important for IRA owners and financial organizations to consult with a competent attorney before engaging in any unusual transactions.
