The Internal Revenue Code does not describe what a Self Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of IRAs for accumulation of retirement savings and to prohibit those in control of IRAs from taking advantage of the tax benefits for their personal account.
The foundation of the prohibited transaction rules are based on the premise that investments involving IRA and related parties are handled in a way that benefits the retirement account and not the IRA owner. The rules prohibit transactions between the IRA and certain individuals known as “disqualified persons”. The outline for these rules can be found in Internal Revenue Code Section 4975.
Who is a “Disqualified Person”?
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.
Direct Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Direct Prohibited Transaction” generally involves one of the following:
4975(c)(1)(A): The direct or indirect Sale, exchange, or leasing of property between an IRA and a “disqualified person”
Example 1: Jack sells an interest in a piece of property owned by his IRA to his son.
Example 2: Judy leases real estate owned by her IRA to her father.
Example 3: Brian uses his IRA funds to purchase an LLC interest owned by 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”
Example 1: Keith lends his wife $10,000 from his IRA.
Example 2: Amy personally guarantees a bank loan to her IRA.
Example 3: Peter uses IRA funds to lend an entity owned and controlled by his mother $60,000.
4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between an IRA and a “disqualified person”
Example 1: Eric buys a piece of property with his IRA funds and hires his father to work on the property.
Example 2: Marilyn buys a home with her IRA funds and personally fixes it up.
Example 3: Sara owns an apartment building with her IRA and hires her father to manage the property.
4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of an IRA
Example 1: Dan is in a financial jam and takes $12,000 from his IRA to pay his mortgage and credit card bill.
Example 2: Steve uses his IRA to purchase a rental property and hires his friend to manage the property. The friend then enters into a contract with Steve and transfers those funds back to Steve.
Example 3: Victoria invests her IRA funds in a real estate fund and then receives a salary for managing the fund.
Self-Dealing Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Self-Dealing Prohibited Transaction” generally involves one of the following:
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
Example 1: Jessica who is a real estate agent uses her IRA funds to buy a home and earns a commission from the sale.
Example 2: James wants to buy a piece of property for $110,000 and would like to own the property personally but does not have sufficient funds. As a result, James uses $90,000 from in his IRA and $20,000 personally to make the investment.
Example 3: Dana uses her IRA to funds to invest in a real estate fund managed by her Son. Dana’s son receives a bonus for securing Dana’s investment.
Conflict of Interest Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Conflict of Interest Prohibited Transaction” generally involves one of the following:
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
Example 1: Joe uses his IRA funds to loan money to a company in which he manages and controls but owns a small ownership interest in.
Example 2: Michelle uses her IRA to lend money to a business that she works for in order to secure a promotion.
Example 3: Brandon uses his IRA funds to invest in a hedge fund that he manages and where his management fee is based on the total value of the fund’s assets.
Under Internal Revenue Code Section 4975(d), Congress created certain statutory exemptions from the prohibited transaction rules outlined under Internal Revenue Code Section 4975(c). For these certain transaction, Congress believed there is a legitimate reason to permit them. For these transactions, Congress has issued a blanket statutory exemptions permitting these transactions assuming that certain requirements specified are satisfied. Below is a list of some of the statutory exemptions found in Internal Revenue Code Section 4975(d) that apply to IRAs:
- Any contract with a disqualified person for office space, legal, accounting or other services necessary for the operation of the IRA as long as reasonable compensation is paid.Note – this exemption does not apply to an IRA fiduciary (the IRA holder) as per Treasury Regulation Section 54.4975-6(a)(5).
- The provision of ancillary services to an IRA by a bank trustee
- Receipt by a disqualified person of any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries;
Life Insurance and Certain Collectibles
In general, a Self-Directed IRA LLC cannot Invest in life insurance contracts or collectibles defined below:
- Any work of art
- Any metal or gem
- Any alcoholic beverage
- Any rug or antique
- Any stamp
- Most coins
Types of Collectibles That may be Purchased Using IRA Funds
- one, one-half, one-quarter or one-tenth ounce U.S. gold coins (American Gold Eagle coins are the only gold coins specifically approved for IRAs. Other gold coins, to be eligible as IRA investments, must be at least .995 fine (99.5% pure);
- one ounce silver coins minted by the Treasury Department;
- any coin issued under the laws of any state;
- a platinum coin described in 31 USCS 5112(k) ; and
- gold, silver, platinum or palladium bullion (other than bullion that is made into a coin) of a certain fineness that is in the physical possession of a trustee that meets the requirements for IRA trustees under Code Sec. 408(a).
How do I hold Physical Gold in a Self-Directed IRA LLC?
Internal Revenue Code Section 408(m) identifies what types of coins and precious metals are permitted to be purchased using a Self-Directed IRA.
Internal Revenue Code Section 408(n) defines a bank as any bank (as defined in section 581) or an insured credit union (within the meaning of paragraph (6) or (7) of section 101 of the Federal Credit Union Act).
Section 541 defines a bank as a bank or trust company incorporated and doing business under the laws of the United States (including laws relating to the District of Columbia) or of any State, a substantial part of the business of which consists of receiving deposits and making loans and discounts, or of exercising fiduciary powers similar to those permitted to national banks under authority of the Comptroller of the Currency, and which is subject by law to supervision and examination by State, Territorial, or Federal authority having supervision over banking institutions. Such term also means a domestic building and loan association. The Code seems to suggest that metals cannot be held in a foreign bank account since it would not satisfy the definition of a bank. The question then becomes what does “physical possession” mean.
IRC Section 408(m) clearly states that gold, silver, or palladium bullion must be held in the physical possession of a U.S. trustee, otherwise known as a U.S. bank or financial institution.
Thus, the question then becomes, if a an IRA holder holds precious metals in a safety deposit box at a U.S. bank in the name of the Self-Directed IRA LLC is that in the “physical possession” of a U.S. trustee or bank. Well the argument goes that the precious metals are certainly not in the physical possession of the IRA holder since they will physically be held in a safety deposit box of the bank. Although, an argument can be made that the safety deposit box is constructively in the control of the IRA holder, since he or she has the keys for the box. However, the Internal Revenue Code under Section 408 clearly states “physical possession” and not “constructive control”. From a legal standpoint, possession is not defined to represent control, meaning one can be in possession of an item but not in control or ownership of. Hence, many tax practitioners take the position that holding precious metals in a safety deposit box in the name of the Self-Directed IRA LLC would satisfy the “physical possession” requirement under Internal Revenue Code Section 408(m).
The IRS has not offered any clear guidance on this issue, but what is clear, unlike IRS approved coins, is that precious metals should not be stored in the home or possession of the IRA holder or any person that does not satisfy the definition of a trustee pursuant to the Internal Revenue Code.
How do I hold IRS Approved Coins with a Self-Directed IRA LLC?
Now that you have a clear idea of the types of coins that the IRS allows to be purchased using retirement funds, the next questions becomes how can the coins be held without violating IRS rules.
Unlike precious metals, the Internal Revenue Code and the legislative history does not include a requirement that IRS approved coins be held in the “physical possession of a U.S. trustee.” If so, the requirement would have been so stated in the tax code. Accordingly, it appears that IRS approved coins can be purchased by a Self-Directed IRA LLC and not be held at a depository or U.S. Bank. However, based on conversations between IRA Financial Group tax counsel and representatives of the IRS and Department of Labor, we suggest that our clients try to hold IRS approved coins at a bank safety deposit box, depository, or some sort of third-party vault in the name of the IRA LLC. The reason for this is that it is another level of separation between the IRA holder - a disqualified person - and the IRA LLC assets (the coins), which the IRS plan asset rules will attribute to the IRA even though the coins will be owned by the LLC. Irrespective of the fact that it appears that IRS approved coins are not required to be held in the “physical possession of a U.S. trustee”, holding the coins in the physical possession of a disqualified person puts the onus on the IRS holder, as the disqualified person, to prove that no self-dealing or conflict of interest event occurred in the case of an IRS inquiry. For IRA Financial Group clients that wish to hold IRS approved coins in their physical possession, our retirement tax professionals suggest that an affidavit be drafted stating that the IRS approved coins are being held solely for the benefit of the IRA and not for any personal or other benefit. We also suggest that the affidavit be signed and notarized.
In summary, the "physical possession" threshold seems to only apply to IRS approved precious metals under Internal Revenue Code Section 408(m), although the tax code does not state anywhere that the coins could be held in the possession of a disqualified person.
S Corporation Stock
Because of the shareholder restrictions imposed on “S” Corporations, an IRA cannot own stock in an S Corporation. Note – an IRA can own stock in a “C” Corporation.
Plan Asset Rules
The Department of Labor’s (DOL) Plan Asset Rules essentially define when the assets of an entity are considered ‘Plan" assets. Under the rules, Self Directed IRAs are frequently viewed as pension plans subjecting them to the Plan Asset Rules. Under the Plan Asset Rules, if the aggregate Self Directed IRA or 401k Plan ownership of an entity is 25% or more of all the assets of the entity, then the equity interests and assets of the “investment entity” are viewed as assets of the investing Self Directed IRA/401(k) Plan for purposes of the prohibited transactions rules, unless an exception applies. Also, if a plan (i.e. IRA or 401(k)) or group of related plans owns 100% of an “operating company”, the operating company exception will not apply and the company's assets will still be treated as plan assets.
In summary, the Plan Asset Rules can be triggered if:
- 100% of an “operating company” is owned by one or more Self Directed IRAs/401(k) Plan and disqualified persons, in which case all the assets of the “operating company” are deemed Plan assets (assets of the Self Directed IRA/401(k)), or
- If 25% or more of an “investment company” is owned by Self Directed IRAs/401(k) and disqualified persons, in which case all the assets of the “investment company” are deemed Plan assets (assets of the IRA/401(k)). In determining whether the 25% threshold is met, all IRAs/401(k) owners are considered, even if they are owned by unrelated individuals.
Exceptions to the DOL Plan Asset Regulations
The Plan Asset look-through rules do not apply if the entity is an operating company or the partnership interests or membership interests are publicly offered or registered under the Investment Company Act of 1940 (e.g., REITs). They also do not apply if the entity is an “operating company,” which refers to a partnership or LLC that is primarily engaged in the real estate development , venture capital or companies making or providing goods and services, such as a gas station, unless the “operating company” is owned 100% by a Plan and/or disqualified persons. In other words, if a Self Directed IRA or 401k Plan owns less than 100% of an LLC that is engaged in an active trade or business, such as a restaurant or manufacturing plant, the Plan Asset Rules would not apply. However, the Self Directed IRA or 401k Plan investment may still be treated as a prohibited transaction under Internal Revenue Code Section 4975. In addition, the Unrelated Business Taxable Income may apply to subject to the IRA or 401k Plan to tax on the income or gains generated from the operating business.
Note: The fact that a transaction does not trigger the Plan Asset Rules does not mean that the transaction may not be deemed a prohibited transaction under Internal Revenue Code Section 4975. In other words, a transaction that does not fall under the Plan Asset Rules can still be treated as a prohibited transaction pursuant to Internal Revenue Code Section 4975.
The following are a number of examples that demonstrate the scope of the Plan Asset Rules.
Example 1: A general partner of a hedge fund wishes to invest his Self Directed IRA LLC in the hedge fund he manages. If the percentage of IRA ownership, including what it would be after the General Partner invests his IRA in the fund, equals or exceeds 25% of the equity interests, then the fund's assets are considered "plan asset." That means that a transaction between the general partner, as a disqualified person, and the fund, could be deemed a prohibited transaction because the assets of the fund are viewed as assets of his IRA, since a disqualified person cannot transact with the assets of his plan or IRA. Accordingly, the General Partner cannot receive benefits from his IRA investment into the fund. Thus the General Partner would not be permitted to receive any management fees associated with the IRA’s ownership interest in the fund because he would be receiving a personal benefit from his IRA. Note – the General Partner’s IRA investment in the fund may also be deemed a direct or indirect prohibited transaction under Internal Revenue Code Section 4975.
Example 2: Jane ‘s Self Directed IRA LLC owns 100% of ABC, LLC, which operates a retail store. ABC, LLC makes a loan to Jane. The loan is subject to the Plan Asset Rules and will also be considered a prohibited transaction pursuant to Internal Revenue Code Section 4975. Note – any income generated by ABC, LLC that is allocated to the Self Directed IRA LLC would also likely be subject to the Unrelated Business Income tax.
Example 3: Steve’s Self Directed IRA LLC owns 15% of ABC, LLC, an investment company. Allan’s IRA owns 20% of ABC, LLC. Steve and Allan are unrelated. Since IRAs (Plans) own greater than 25% of ABC, LLC, an “investment company”, assets of ABC, LLC are Plan Assets and deemed owned by each IRA. Thus, if ABC, LLC makes a loan to Steve’s father, the loan would be a prohibited transaction under Internal Revenue Code Section 4975.
Example 4: Robert’s Self Directed IRA LLC invests in ABC, LLC, which will purchase a gas station, an “operating company”. Robert will take an annual salary of $50,000 to run the gas station. The payment of the salary would be a “prohibited transaction under Internal Revenue Code Section 4975 (self dealing indirect prohibited transaction). Note – any income generated by the as station that is allocated to the Self Directed IRA LLC would also likely be subject to the Unrelated Business Income tax.
Determining Whether a Specific Transaction is a Prohibited Transaction
Through an arrangement between the IRS and the Department of Labor (DOL), it is the DOL’s responsibility to determine whether a specific transaction is a prohibited transaction and to issue prohibited transaction exemptions. When the IRS discovers what appears to be a prohibited transaction in an individual’s IRA, it turns the matter over to the DOL to make the determination. The DOL reviews the situation and responds to the IRS, which in turn responds to the taxpayer. If the IRA grantor wants to apply for a prohibited transaction exemption, he or she must apply to the DOL. The DOL has the authority to issue prohibited transaction exemptions. Some, known as “prohibited transaction class exemptions” (PTCEs), are available for anyone’s reliance, while others, called “individual prohibited transaction exemptions” (PTEs), are issued only to the applicant.
Penalties for Engaging in a Prohibited Transaction
In general, the penalty under Internal Revenue Code Section 4975 generally starts out at 15% for most type of retirement plans; however, the penalty is harsher for self-directed IRAs.
In general, if the IRA holder (IRA owner) or IRA beneficiary engages in a transaction that violates the prohibited transaction rules set forth under Internal Revenue Code Section 4975, the individual’s IRA would lose its tax exempt status and the entire fair market value of the IRA would be treated as taxable distribution, subject to ordinary income tax. In addition, the IRA holder or beneficiary would be subject to a 15% penalty as well as a 10% early distribution penalty if the IRA holder or beneficiary is under the age of 59 1/2.
For more information on the penalties imposed on engaging in a prohibited transaction with a self-directed IRA LLC please view link below:
Work with Tax Professionals Who Know the IRA Rules
The IRA Financial Group was founded by a group of top law firm tax and ERISA lawyers who have worked at some of the largest law firms in the United States, such as White & Case LLP, Dewey & LeBoeuf LLP, and Thelen LLP. Over the years, we have advised thousands of clients on the Self-Directed IRA prohibited transaction and “disqualified person” rules. With our work experience at some of the largest law firms in the country, our retirement tax professionals’ tax and IRA knowledge in this area is unmatched.
To learn more about the Self-Directed IRA prohibited transaction, please contact one of our Self-Directed IRA Experts at 800-472-0646 for more information.
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