The Internal Revenue Code does not describe what a Self-Directed Roth 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 Roth IRAs for accumulation of retirement savings and to prohibit those in control of Roth IRAs from taking advantage of the tax benefits for their personal account. Self-Directed Roth IRA Prohibited Transactions have serious consequences for your retirement account.
Who is a “Disqualified Person”?
The IRS has restricted certain transactions between the Roth 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 Roth IRA holder, any ancestors or lineal descendants of the Roth IRA holder, and entities in which the Roth IRA holder holds a controlling equity or management interest. In essence, under Code Section 4975, a “Disqualified Person” means:
- A fiduciary (e.g., the Roth IRA holder, participant, or person having authority over making Roth IRA investments),
- A person providing services to the plan (e.g., the trustee or custodian),
- An employer, any of whose employees are covered by the plan (this generally is not applicable to Roth IRAs but dos include the owner of a business that establishes a qualified retirement plan),
- An employee organization any of whose members are covered by the Plan (this generally is not applicable to Roth IRAs),
- A 50 percent owner of C or D above,
- 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),
- 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.
- A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G,
- 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”.
Self-Directed Roth IRA Prohibited Transactions
Pursuant to Internal Revenue Code Section 4975, a Self Directed Roth 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: Tim sells an interest in a piece of property owned by his Roth IRA to his son.
Example 2: Cindy leases real estate owned by her Roth IRA to her father.
Example 3: Jerry uses his Roth 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: Paul lends his wife $10,000 from his Roth IRA.
Example 2: Jill personally guarantees a bank loan to her Roth IRA.
Example 3: Bill uses Roth 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: Rick buys a piece of property with his Roth IRA funds and hires his father to work on the property.
Example 2: Betsy buys a home with her Roth IRA funds and personally fixes it up.
Example 3: Nicky owns an apartment building with her Roth IRA and hires her father to manage the property.
Indirect Prohibited Transactions
4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of an IRA
Example 1: Allan is in a financial jam and takes $18,000 from his Roth IRA to pay his mortgage and credit card bill.
Example 2: Larry uses his Roth IRA to purchase a rental property and hires his friend to manage the property. The friend then enters into a contract with Larry and transfers those funds back to Larry.
Example 3: Tracy invests her Roth 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: Beth who is a real estate agent uses her Roth IRA funds to buy a home and earns a commission from the sale.
Example 2: Jim wants to buy a piece of property for $150,000 and would like to own the property personally but does not have sufficient funds. As a result, Jim uses $120,000 from in his Roth IRA and $30,000 personally to make the investment.
Example 3: Jen uses her Roth IRA funds to invest in a real estate fund managed by her Son. Jen’s son receives a bonus for securing Jen’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: Craig uses his Roth IRA funds to loan money to a company in which he manages and controls but owns a small ownership interest in.
Example 2: Tiffany uses her Roth IRA to lend money to a business that she works for in order to secure a promotion.
Example 3: Jason 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 Roth IRAs:
- Any contract with a disqualified person for office space, legal, accounting or other services necessary for the operation of the Roth IRA as long as reasonable compensation is paid. Note – this exemption does not apply to a Roth IRA fiduciary (the Roth IRA holder) as per Treasury Regulation Section 54.4975-6(a)(5).
- The provision of ancillary services to a Roth 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 Roth 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).
S Corporation Stock
Because of the shareholder restrictions imposed on “S” Corporations, a Roth IRA cannot own stock in an S Corporation. Note – a Roth 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.