Prohibiited Transactions

Prohibited Transaction Consequences

Question:  What are the consequences of participating in a prohibited transaction?

A disqualified person who takes part in a prohibited transaction must correct the transaction and must pay an excise tax based on the amount involved in the transaction. The initial tax on a prohibited transaction is 15% of the amount involved for each year (or part of a year) in the taxable period. If the transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved is imposed. Both taxes are payable by any disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax.

The amount involved in a prohibited transaction is the greater of the following amounts:

  • the money and fair market value of any property given; and
  • the money and fair market value of any property received.

If services are performed, the amount involved is any excess compensation given or received.

The taxable period starts on the transaction date and ends on the earliest of the following days:

  • the day the IRS mails a notice of deficiency for the tax;
  • the day the IRS assesses the tax; and
  • the day the correction of the transaction is completed.

The tax is paid with Form 5330.

For additional information, see Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).

Prohibited Transaction Consequences2018-05-13T13:58:52-07:00

IRA Owners’ Guaranties of Corporate Debt Were Prohibited Transactions

In May of 2013, the U.S. Tax Court ruled that two IRAs engaged in prohibited transactions under Internal Revenue Code Section 4975(c)(1)(B) and were disqualified because the IRA owners guaranteed a debt of a corporation owned by the two IRAs.  See Peek vs. Commissioner, 140 T.C. No. 12, (2013).  Why did the IRA owners guaranty the debt of the corporation owned by their IRAs?  The rule against IRA owners guarantying loans to the LLC or corporation owned by the IRA is well know, at least among advisers who understand IRA LLCs.

The taxpayers in Peek apparently did everything wrong that they possibly could have done.  Even if the IRA owners had not guaranteed the corporation’s debt the IRS could have disqualified the two IRAs for several other prohibited transactions.  The Tax Court said:

“Because we hold that the loan guaranties were prohibited transactions, we need not and do not reach the additional questions of whether prohibited transactions occurred (i) when FP Company made payments of wages to Mr. Fleck and Mr. Peek (which the IRS contends were prohibited transactions under section4975(c)(1)(D)), or (ii) when FP Company made payments of rent to an entity owned by Mrs. Fleck and Mrs. Peek (which the IRS contends were prohibited transactions under section 4975(c)(1)(E)).”

IRA Owners’ Guaranties of Corporate Debt Were Prohibited Transactions2017-09-10T15:27:36-07:00

Can the IRA Owner Pay the Costs of Forming an IRA LLC?

Question:  I want to form an IRA LLC to be owned by my IRA.  Can I pay the costs and expenses to be incurred to form the LLC?

No:  The owner of an IRA may not pay any amounts incurred to form an IRA LLC.  If the IRA owner pays any debt or obligation of the IRA LLC, it is a prohibited transaction.  It is the equivalent of a loan from the IRA owner to the plan, which is prohibited under Internal Revenue Code Section 4975(c)(1)(B).  The IRS deems any payment by the IRA owner of the IRA LLC’s debts or expenses as a disguised contribution of money to the IRA.

Notice the net result to the IRA in the following two examples and you will see why it is a prohibited transaction for the IRA owner to pay expenses of the IRA LLC:

Example 1 IRA Owner Pays LLC Formation Expenses

$50,000 = total in IRA account
$  1,000  = IRA LLC  formation expenses paid by the IRA owner from his/her bank account
$50,000 = total capital in the IRA account after paying formation expenses

Example 2Custodian Pays LLC Formation Expenses

$50,000 = total in IRA account
$  1,000  = IRA LLC  formation expenses paid by the IRA custodian
$49,000 = total capital in the IRA account after paying formation expenses

The proper way to pay the IRA LLC’s formation expenses is to:

  • Cause the IRA custodian to write a check payable to lawyer / document preparer who is hired to form the IRA LLC.
  • If your current custodian will not allow self directed investments, open  an account with an IRA custodian that will allow it.  Transfer funds from the current custodian to the new custodian.  Cause the new IRA custodian to write a check payable to lawyer / document preparer who is hired to form the IRA LLC.
Can the IRA Owner Pay the Costs of Forming an IRA LLC?2017-09-10T15:33:14-07:00

Can My IRA Invest More Money into an LLC Partially Owned by My IRA?

Question:  Two years ago my spouse and I caused our IRAs to make self-directed investments into an LLC that purchased a rental home.  Each IRA is a 50% member of the LLC.  The property needs repairs that will cost more money than the LLC has available.  Can we cause our IRAs to make additional capital contributions to the LLC to fund the repairs?

Answer:  No.  If either IRA were to make an additional capital contribution to the LLC, it would create a prohibited transaction under Internal Revenue Code Section 4975(c), which provides that a:

“prohibited transaction” means any direct or indirect— . . . transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan”

Because the two IRAs each own 50% of the LLC, the LLC is a disqualified person under Section 4975(e)(2)(G).  This provision says that a disqualified person is an entity 50% or more of which is owned by a fiduciary.  Each IRA custodian is a fiduciary with respect to its IRA account and because the custodian owns 50% of the LLC, the LLC is a disqualified person.  Therefor a transfer of money from the custodian to the disqualified person (the LLC) to fund the repairs is a prohibited transaction.

Can My IRA Invest More Money into an LLC Partially Owned by My IRA?2018-05-13T13:58:53-07:00

IRS Publication 590 on Prohibited Transactions

IRS Publication 590 is entitled “Individual Retirement Arrangements.”  The following text is from page 43 of Publication 590:

What Acts Result in Penalties or Additional Taxes?

The tax advantages of using traditional lRAs for retirement savings can be offset by additional taxes and penalties if you do not follow the rules.  There are additions to the regular tax for using your IRA funds in prohibited transactions.  There are also additional taxes for the following activities.

  • Investing in collectibles.
  • Making excess contributions.
  • Taking early distributions.
  • Allowing excess amounts to accumulate (failing to take required distributions).

There are penalties for overstating the amount of nondeductible contributions and for failure to file Form 8606, if required.

This chapter discusses those acts that you should avoid and the additional taxes and other costs, including loss of IRA status, that apply if you do not avoid those acts.

Prohibited Transactions

Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.

Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).

The following are examples of prohibited transactions with a traditional IRA.

  • Borrowing money from it.
  • Selling property to it.
  • Receiving unreasonable compensation for managing it.
  • Using it as security for a loan.
  • Buying property for personal use (present or future) with IRA funds.

Fiduciary.  For these purposes, a fiduciary includes anyone who does any of the following.

  • Exercises any discretionary authority or discretionary control in managing your IRA or exercises any authority or control in managing or disposing of its assets.
  • Provides investment advice to your IRA for a fee, or has any authority or responsibility to do so.
  • Has any discretionary authority or discretionary responsibility in administering your IRA.

Effect on an IRA account.

Generally, if you or your beneficiary engages in a prohibited transaction in connection with your traditional IRA account at any time during the year, the account stops being an IRA as of the first day of that year.

Effect on you or your beneficiary.

If your account stops being an IRA because you or your beneficiary engaged in a prohibited transaction, the account is treated as distributing all its assets to you at their fair market values on the first day of the year. If the total of those values is more than your basis in the IRA, you will have a taxable gain that is includible in your income. For information on figuring your gain and reporting it in income, see Are Distributions Taxable, earlier. The distribution may be subject to additional taxes or penalties.

IRS Publication 590 on Prohibited Transactions2018-05-13T13:58:54-07:00

Definition of a Disqualified Person

Because the Internal Revenue Code prohibits an IRA LLC from engaging in transactions with a disqualified person, every member and manager of an IRA LLC must know the people and entities that are disqualified persons.  Internal Revenue Code Section 4975(e)(2) contains the definition of a disqualified person.  This section states that a disqualified person is:

(A) a fiduciary

[the IRA owner is a fiduciary];

(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 members are covered by the plan;

(E) an owner, direct or indirect, of 50 percent or more of—

(i) 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,

(ii) the capital interest or the profits interest of a partnership, or

(iii) the beneficial interest of a trust or unincorporated enterprise, which is an employer or an employee organization described in subparagraph (C) or (D);

(F) a member of the family (as defined in paragraph (6) [which states: the family of any individual shall include his spouse, ancestor, lineal descendant, and any spouse of a lineal descendant]) of any individual described in subparagraph (A), (B), (C), or (E);

(G) a corporation, partnership, or trust or estate of which (or in which) 50 percent or more of—

(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,

(ii) the capital interest or profits interest of such partnership, or

(iii) the beneficial interest of such trust or estate, is owned directly or indirectly, or held by persons described in subparagraph (A) [a fiduciary], (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 members are covered by the plan], or (E) [the IRA owner – this subsection (G)(iii) is what makes an entity a disqualified person if the IRA owner owns 50% or more of the entity];

(H) an officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person described in subparagraph (C), (D), (E), or (G); or

(I) a 10 percent or more (in capital or profits) partner or joint venturer of a person described in subparagraph (C) [an employer any of whose employees are covered by the plan], (D) [an employee organization any of whose members are covered by the plan], (E) [the IRA owner], or (G).

Definition of a Disqualified Person2018-05-13T13:58:54-07:00

Caution: An IRA LLC Transaction that Indirectly Benefits the IRA Owner Is a Prohibited Transaction

If your IRA is a member of an IRA LLC, you must know and follow the prohibited transaction rules set forth in Internal Revenue Code Section 4975.  Many prohibited transaction rules are obvious such as the IRA LLC cannot loan money to the IRA owner or buy, sell or lease property with the IRA owner.

The prohibited transaction rules also contain a general, but nebulous rule some times referred to as the “indirect benefits” rule.  If the IRA LLC engages in a transaction that creates an “indirect benefit” for the IRA owner, it is also a prohibited transaction that will disqualify the IRA, cause the IRA to lose its tax-exempt status and result in a deemed distribution of the all the assets to the IRA owner as of the first day of the tax year in which the prohibited transaction occurred.

The indirect benefit rule is codified in Internal Revenue Code Section 4975(c)(1) (E), which states that a:

prohibited transaction means any direct or indirect . . . 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;”

Before an IRA LLC engages in a transaction, its members and managers must be able to answer the following question with a clear NO!

If the IRA LLC engages in the proposed transaction, will the IRA owner receive an indirect benefit?

This rule does not apply if the only indirect benefit is that the IRA LLC will make a profit some or of all of which will ultimately be distributed to the IRA and then to the IRA owner.

Here are some examples of common situations that involve violations of the indirect benefit rule and that will result in the disqualification of the IRA from its tax-exempt status.  The IRA owner or a member of his or her family (defined in Internal Revenue Code Section 4975(e)(6) as a spouse, ancestor, lineal descendant, and any spouse of a lineal descendant) or any other disqualified person:

  1. lives in a home owned by the IRA LLC.
  2. uses a ski boat owned by the IRA LLC.
  3. is an employee of the IRA LLC and is paid a salary.
Caution: An IRA LLC Transaction that Indirectly Benefits the IRA Owner Is a Prohibited Transaction2018-05-13T13:58:54-07:00

What is the Plan Asset Rule?

All IRA owners who have made self-directed investments into an IRA LLC and anybody considering do so should read Jeff Nabers’ article called “What is the Plan Asset Rule?”  This rule turns assets owned by an entity into assets that are deemed to be assets of the IRA with the consequence that any transaction between a disqualified person and the entity is a prohibited transaction.

“The plan asset rule, among other things, is used to determine whether or not a retirement plan is involved in a prohibited transaction.”

See my post called “Department of Labor Regulation 29 CFR 2510.3-101 – the Plan Asset Rules.”

What is the Plan Asset Rule?2018-05-13T13:58:56-07:00

Department of Labor Advisory Opinion 2006-09A

[RK Summary:  The Department of Labor ruled that an IRA owner could not cause the IRA to invest in promissory notes issued by an entity that was controlled by the IRA owner’s son in law because it would be a prohibited transaction under Internal Revenue Code Section 4975.]

The text of  Department of Labor Advisory Opinion 2006-09A is below.

December 19, 2006
Edward A. Appelt
24 Winslow Drive
Pittsburg, PA 15229

Department of Labor Advisory Opinion 2006-09A
IRC Section 4975 (c)(1)(A) & (B)

Dear Mr. Appelt:

This is in response to your request for an advisory opinion under section 4975 of the Internal Revenue Code (Code). Specifically, you ask whether allowing the owner of an individual retirement account (IRA) to direct the IRA to invest in notes being offered by a corporation, in which a relative of the IRA owner is the majority owner and stockholder, would give rise to a prohibited transaction under Code section 4975.(1)

You represent that as the owner of an IRA for which you have retained investment discretion, you would like to direct the investment of these IRA funds into notes (Notes) that are being offered by STARR Life Sciences Corporation (STARR). STARR is currently owned by the founders of the Company who are: Eric (your son-in-law) – 87.5%; Erika (an unrelated party) – 7.5%; and Dr. Strolh (an unrelated party) – 5.0%. (more…)

Department of Labor Advisory Opinion 2006-09A2019-03-17T14:14:14-07:00

Department of Labor Advisory Opinion 2006-01A

RK Summary:  The Department of Labor ruled that an IRA owner could not cause the IRA to invest in a new limited liability company that would purchase real estate and lease it to an entity 68%  of which is owned by the IRA owner because it would be a prohibited transaction under Internal Revenue Code Section 4975.  The opinion contains a statement that IRA owners should always keep in mind before an IRA LLC makes an investment”  “the Department considers “a fiduciary who makes or retains an investment in a corporation or partnership for the purpose of avoiding the application of the fiduciary responsibility provisions of the Act to be in contravention of the provisions of section 404(a) of the Act.”

The text of Department of Labor Advisory Opinion 2006-01A is below.

January 6, 2006
Debra C. Buchanan, Esq.
Guidant Legal Group, PLLC
225 Commerce Street, Suite 450
Tacoma, WA 98402

Department of Labor Advisory Opinion 2006-01A
ERISA Sec. 29 CFR 2509.75-2

Dear Ms. Buchanan,

This is in response to your request for an advisory opinion as to whether the following proposed transaction would be prohibited under section 4975 of the Internal Revenue Code (the “Code”), 26 U.S.C. § 4975.(1)

You represent that Salon Services and Supplies, Inc. is a Washington state “S” Corporation (“S Company”) which is 68% owned by Miles and Sydney Berry, a marital community (M). The other 32% is owned by a third-party, George Learned (“G”). Miles Berry (Berry) proposes to create a limited liability corporation (“LLC”) that will purchase land, build a warehouse and lease the property to S Company. The investors in the LLC would be Berry’s individual retirement account (“IRA”) (49%), Robert Payne’s (“R”) IRA (31%) and G (20%). R is the comptroller of S Company. R and G will manage the LLC. You represent that S Company is a disqualified person with respect to Berry’s IRA under section 4975(e)(2) of the Code. You represent that R and G are independent of Berry. You also represent that the LLC does not contain plan assets because it is a “real estate operating company” (REOC) as defined by 29 C.F.R. § 2510.3-101(e). (more…)

Department of Labor Advisory Opinion 2006-01A2019-03-17T14:14:14-07:00