The IRS has restricted certain transactions between the IRA and a “disqualified person”. The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed.
The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest. In essence, under Code Section 4975, a “Disqualified Person” means:
- IRC 4975(e)(2)(A): fiduciary (e.g., the IRA holder, participant, or person having authority over making IRA investments).
- IRC 4975(e)(2)(B): A person providing services to the plan (e.g., the trustee or custodian).
- IRC 4975(e)(2)(C): An employer, any of whose employees are covered by the plan (this generally is not applicable to IRAs).
- IRC 4975(e)(2)(D): An employee organization, any of whose members are covered by the Plan (this generally is not applicable to IRAs).
- IRC 4975(e)(2)(E): A 50 percent owner of C or D above.
- IRC 4975(e)(2)(F): A family member of A, B, C, or D above (family members include the fiduciary’s spouse, parents, grandparents, children, grandchildren, spouses of the fiduciary’s children and grandchildren, but not parents-in-law).
- IRC 4975(e)(2)(G): An entity (corporation, partnership, trust or estate) owned or controlled more than 50 percent by A, B, C, D, or E. [Whether an entity is a disqualified person is determined by considering the indirect stockholdings/interest which would be taken into account under Code Sec. 267(c), except that members of a fiduciary’s family are the family members under Code Sec. 4975(e)(6) (lineal descendants) for purposes of determining disqualified persons].
- IRC 4975(e)(2)(H): A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G.
- IRC 4975(e)(2)(I): A 10 percent or more partner or joint venturer of a person described in C, D, E, or G.
Note: brothers, sisters, aunts, uncles, cousins, step-brothers, step-sisters, and friends are NOT treated as “Disqualified Persons”.
Application of the Prohibited Transaction Rules
In order to determine whether a proposed transaction is a prohibited transaction and violates IRC 4975, it is important to examine all the parties engaged in the proposed transaction rather than on just the IRA owner.
Pursuant to Internal Revenue Code Section 4975, a Self-Directed IRA is prohibited from engaging in certain types of transactions. The types of prohibited transactions can be best understood by dividing them into three categories: Direct Prohibited Transactions, Self-Dealing Prohibited Transactions, and Conflict of Interest Prohibited Transactions.
The Best Way to Prevent a Prohibited Transaction
When making an investment with a Self-Directed IRA, it is advisable to not engage in any transaction with a disqualified person. There is an abundance of case law that clearly states that an IRA holder can not engage in a transaction that directly or indirectly benefits a disqualified person. Below are several examples of common prohibited transactions involving disqualified persons:
4975(c)(1)(A): The direct or indirect Sale, exchange, or leasing of property between an IRA and a “disqualified person”
Tom sells an interest in a piece of property owned by his IRA to his son.
4975(c)(1)(B): The direct or indirect lending of money or other extension of credit between an IRA and a “disqualified person”
Jen lends her husband $20,000 from her IRA.
4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between an IRA and a “disqualified person”
Joel buys a home with his IRA funds and personally fixes it up.
4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of an IRA
Tim is in a financial jam and takes $3,000 from his IRA to pay his mortgage and credit card bill.
4975(c)(1)(E): The direct or indirect act by a “Disqualified Person” who is a fiduciary whereby he/she deals with income or assets of the IRA in his/her own interest or for his/her own account
Tina who is a real estate agent uses her IRA funds to buy a home and earns a commission from the sale.
Carl and Judy, husband and wife, use their IRA funds to do a joint venture with an LLC they own personally to buy real estate.
4975(c)(i)(F): Receipt of any consideration by a “Disqualified Person” who is a fiduciary for his/her own account from any party dealing with the IRA in connection with a transaction involving income or assets of the IRA
Derrick uses his IRA funds to loan money to a company in which he manages and controls but owns a small ownership interest in.