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.
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.