The prohibited transaction rules are the most important rules to understand when you self-direct your retirement account. These rules restrict not what investments your retirement plan may acquire but whom your plan may transact with.
How It Happens
A prohibited transaction occurs when a retirement plan (e.g. self directed IRA or 401k) transacts with a disqualified person. IRC § 4975. A transaction is pretty easy to identify and is defined in the code as a sale, lease, exchange, payment, or other transfer of money from a retirement plan. If that transaction is with a disqualified person then the retirement plan has engaged in a prohibited transaction. The consequence of a prohibited transaction for an IRA is distribution of entire IRA while the consequence to a 401(k) or other employer based plan is a 15% excise tax on the amount involved and an additional 100% penalty if the transaction is not corrected. Regardless of the type of retirement account you are self-directing, the consequences are significant. IRC § 4975 (c)(3), IRC § 408 (e)(2)(A). IRC § 4975 (a),(b).
Often times, a disqualified person is generically referred to as a family member. While that definition can be accurate, it really can cause problems when applied as some family members are disqualified (e.g. spouse of plan owner) while others are not (e.g. brother of plan owner). Also, it can be really confusing to determine when a company is disqualified to a retirement plan or when partners are disqualified. Because of the confusion, I’ve created a disqualified person diagram to help sort out the details. If a party is in red, that means they are a disqualified person and that your retirement plan cannot transact with them. If the party is green, that means they are NOT disqualified and your retirement plan may transact with them.
Keep in mind that a self-dealing prohibited transaction can also arise if any disqualified party personally benefits from a retirement plans investments. In summary, you should avoid all transactions with disqualified persons and should seek legal counsel whenever a disqualified person is involved in any retirement plan investment.
What is a Self-Directed IRA?
A self directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include; real estate, promissory notes, precious metals, and private company stock. The typical reaction I hear from investors is: “Why haven’t I ever heard of self directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is that the large financial institutions that administer most U.S. retirement accounts don’t find it administratively feasible to hold real estate or non-publicly traded assets in retirement plans.
What Can a Self-Directed IRA Invest Into?
Under current law, a retirement account is only restricted from investing in the following:
The most popular self directed retirement account investments include; rental real estate, secured loans to others for real estate, small business stock or LLC interest, and precious metals such as gold or silver. These investments are all allowed by law and can be great assets for investors with experience in these areas.
When self-directing your retirement account you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes the account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.
The rationale behind the prohibited transaction rules is that the federal government doesn’t want tax advantaged accounts conducting transactions between parties who are close enough to the account owner that there could be a transaction designed to avoid or un-fairly minimize tax by altering the true fair market value/price of the investment. The consequence of a prohibited transaction is disqualification of the retirement account as of January 1 of the year the prohibited transaction occurred. In a typical self directed IRA investment, your IRA cusotidan holds your investment in their company name for your IRAs benefit (e.g. property is owned as ABC Trust Company FBO John Smith IRA) and receives the income and pays the expenses for the investment at the account owner’s direction and instruction.
What is an IRA/LLC?
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner and the IRA owner then directs the LLC investments and the LLC takes title to the assets, pays the expenses to the investment, and receives the income from the investment. There are many restrictions to the IRA owner being manager (such as not receiving compensation or personal benefit) and many laws to consider so please ensure you consult an attorney before establishing an IRA/LLC. For more details on the IRA/LLC structure, the cases, and the structuring options, please refer to my prior blog post here.
Most self directed IRA owners know that their self directed IRA cannot conduct transactions with themselves or certain family members (e.g. spouse, kids, parents, etc.). Most self directed IRA owners also know that their self directed IRA cannot do business with a company they own or that their disqualified family members own 50% or more of. However, one of the most confusing areas of the prohibited transaction rules are the prohibited transaction rules which apply to business partners or officers, directors, and/or highly compensated employees of companies the IRA owner or family members are personally involved in. For example, what if I own a business with a partner? Can my IRA enter into a transaction with that business partner if we aren’t family? Well, it depends.
Disqualified Person Analysis
To analyze the rules you first need to determine whether the company in which the business partner (or officer, or director) is involved in is a company that is owned 50% or more by the IRA owner or their disqualified family members. IRC 4975 (e)(2)(E),(H), (I). So, for example, if my wife and I owned 60% of the business and our partner owned 40% of the business, then this company would be owned 50% or more by disqualified persons.
Once we know that the company is owned 50% or more by disqualified persons, we need to identify all of the officers, directors, highly compensated employees, and 10 % or more owners of that company. In sum, all of these persons are disqualified to the IRAs of the 50% or more owners. In the example above, since my business partner owned 40% of the company, he is a 10% or more owner and as a result he is a disqualified person to my IRA (since my wife and I own 50% or more of the company).
Let’s look at another example. Say that I am a 35% owner of a business with a few other partners who are not disqualified family members to me. Since I do not own 50% or more of this company, it doesn’t matter who the other partners, officers, or directors, are, as they are not disqualified to my IRA as part of this rule since my ownership (and that of my disqualified family members) is below 50%.
As a final example, let’s say that I own 70% of a company and that I have a partner who owns 5%. Under the rule, my partner or fellow shareholder does not have 10% or greater ownership and as a result they are not disqualified to my IRA. However, if that 5% owner was the President of my company then they would be a disqualified person.
These rules can be tough to understand when you read the code, but if you take the two step analysis you can easily determine what partners, officer, directors, or highly compensated employees are disqualified to your IRA.
Here’s also a quick summary of the rule from my book where I took the text of the tax code and put it into plain language.
Key Persons in Company Owned 50% or More by Disqualified Persons
An officer, director, or 10% or more shareholder, or highly compensated employee (earns 10% or more of the company’s wages) of a company owned by the IRA owner or other disqualified persons. IRC § 4975 (e)(2)(H).
Before investing with someone who is an officer, director, highly compensated employee, or a shareholder/owner in a company you are involved in, please consult these rules and where you are un-clear, seek the advice of competent counsel.
When IRA-owned property is held for rent, the management of the rental property must be structured such that rental income is received by the IRA and expenses are paid by the IRA. The IRA owner and other disqualified persons (e.g. IRA owner, spouse, etc.) cannot personally be the “middle man” by paying expenses personally or by collecting the rent in their personal account and then forwarding the funds to the IRA. There are essentially three different methods whereby the IRA may be structured to properly collect rent and pay expenses.
Three Methods to Manage the Property
|1. Manage directly through the IRA. Money goes to the IRA custodian and expenses are paid by the custodian at the direction of the IRA owner.|
|2. Property Manager. The IRA hires a property manager who manages the property and receives the income and pays property expenses. Cash flow is returned to the IRA.|
|3. IRA/LLC. Under the IRA/LLC, the IRA owner is the manager of the IRA/LLC and receives income and pays expenses from an IRA/LLC checking account. The IRA/LLC structure is very common in IRA owned real estate investments.|
First, the IRA may be receiving the income directly and paying the expenses. This method involves a lease between the IRA and the tenant directly. Under this method, the tenant pays rental income to the IRA (e.g. ABC Trust Company FBO Sally Jones IRA) and sends the actual payment to the IRA custodian and the custodian then deposits that income into the respective IRA. If expenses are due, the IRA owner will need to direct the custodian to pay them by completing a written form (e.g. payment authorization letter) and instructing the IRA custodian as to the expenses to be paid from the IRA. There is usually a fee each time an instruction letter is issued to a self directed IRA custodian. This method can be tedious and can be fee intensive and as a result is not the most common way of managing a rental property held by an IRA.
Second, the IRA hires a property manager who receives the rental income to the property and pays the expenses to the property. The property manager cannot be a disqualified person to the IRA owner and the property manager will typically take a percent of the rental income collected as payment for their services. Under this method the IRA enters into an agreement with the property manager and the property manager then enters into leases with respective tenants. The IRA receives rental income minus property expenses and fees charged by the property manager.
Third, many IRA owners with rental property decide to use a structure known as an IRA/LLC. Under the IRA/LLC structure, the IRA invests into a newly created LLC and the IRA’s investment is then the ownership of the LLC. The IRA will invest an amount designated by the IRA owner into the LLC, and then funds are typically deposited into an LLC checking account at a bank selected by the IRA owner.
IRA/LLC Structure for Real Estate
The IRA owner then, as manager of the LLC, signs the contract for the LLC to purchase the real estate. The property should close in the LLC name with funds from the LLC bank account and the LLC then in turn rents the property, receives the income and pays the expenses all from the LLC checking account. The LLC is entirely owned by the IRA and all funds in the LLC checking account must eventually be returned to the IRA when the IRA owner desires to take a distribution.
Regardless of the method used to own and manage the IRA owned rental property, the property cannot be leased to a disqualified person. So, for example, the IRA cannot purchase a property and allow the IRA owner’s son to lease the property as that lease would be a transaction with a disqualified person which results in a prohibited transaction.
In addition to prohibited transactions that are involved in leasing the property to family members, the IRA owner should closely analyze any leasing arrangement to a company where the IRA owner or other disqualified persons are owners of the IRA or company. For example, any lease to a company that is owned 50% or more by the IRA owner or other disqualified persons would constitute a prohibited transaction. IRC § 4975(e)(2)G).
In summary, there are many different ways to manage a rental property owned by your IRA. Make sure you are implementing one of these methods and that you are managing the IRA’s income, expenses, and properties properly.
This article is an excerpt from Mat Sorensen’s book, The Self Directed IRA Handbook.
The prohibited transaction rules applicable to self directed IRAs prohibit not what your IRA can invest into but WHO your IRA may engage in a transaction with. For example, the prohibited transaction rules restrict my IRA from buying a rental property from my father. This is not because rental properties are prohibited to my IRA but because my father is prohibited by law from transaction with my IRA. My self directed IRA could buy a rental property from a third party seller whom I have no family or other business relationship with since there is nothing wrong in buying the rental property the question is just who am I buying it from. Congress decided to restrict investments with certain persons who could potentially collude with the IRA owner to unfairly avoid taxes. As a result, transactions with certain family members and business partners of an IRA owner are prohibited. The consequence for engaging in a prohibited transaction can be drastic (e.g. no longer have an IRA, penalties and taxes on distribution) so IRA owners must avoid them in all situations.
The prohibited transaction rules therefore provide the greatest restriction on using self directed IRA funds and must be understood by self directed IRA investors. These rules are found in IRC 4975 and state that a prohibited transaction occurs when an IRA engages in a transaction (e.g. buy, sell) with a disqualified person. The question immediately arises, who is a disqualified person to my IRA?
Categories of Persons Disqualified to Your SDIRA
There are essentially four categories of disqualified persons to your IRA and they are as follows.
- IRA Owner. The IRA owner is disqualified to his/her own IRA as the fiduciary making decisions for the account. IRC 4975(e)(2)(A), Harris v. Commissioner, 76 T.C.M. 748 (U.S. Tax Ct. 1994).
- Certain Family Members. Disqualified family members include the IRA owner’s spouse, children, spouses of children, grandchildren and their spouses, and the IRA owner’s parents and grandparents. Family member who are NOT disqualified persons are siblings (e.g. brothers and sisters), aunts and uncles, cousins, nieces and nephews, and parent in-laws (e.g. spouses parents). IRC 4975 (e)(2)(F), IRC 4975 (e)(6).
- Company Owned 50% or More by IRA Owner or Certain Family Members. Any Company that is owned 50% or more by the IRA Owner or Certain Family Members outlined above are disqualified to the IRA. For example, an LLC owned 30% by the IRA owner, 30% by the IRA owner’s spouse, and 40% by an un-related partner is a disqualified company to the IRA (owned 50% or more by disqualified persons) and any transaction between the IRA and the company would be a prohibited transaction. IRC 4975 (e)(2)(G).
- Key Persons in Company Owned 50% or More by IRA Owner or Certain Family Members. Any person who is a 10% or more owner of a company owned 50% or more by disqualified persons (e.g. number 3 above) or any person who is an officer, director, or manager of a disqualified company (owned 50% or more by disqualified persons) is also disqualified. For example, if my wife and I own 60% of a company and if Julie is an officer of that company then Julies is a disqualified person to my IRA. Additionally, if Julie was a 15% or more owner of the company she would also be prohibited to my IRA.
When you are dealing with unrelated persons (not related as family or as business partners) the prohibited transaction rules do not need to be analyzed but once family members or business partners are involved in any part of the transaction, the IRA owner must ensure that the prohibited transaction rules are not being violated.