One of the most misunderstood facets about the IRS prohibited transaction rules involves using a Self-Directed IRA to invest in a business where one is an officer or highly compensated employee.  This article will detail how the IRS prohibited transaction rules under Internal Revenue Code (IRC) Section 4975 work involving a retirement account investment into an entity where the retirement account owner is an officer or executive.

What are the IRS Prohibited Transaction Rules?

Ever since IRAs were created in 1974 by ERISA, the IRC does not describe what a retirement account can invest in, only what it cannot invest in. Sections 408 & 4975 prohibits “disqualified persons” from engaging in certain types of transactions.  In general, as long as the Self-Directed IRA does not purchase life insurance, collectibles, or engage in a prohibited transaction outlined in 4975, the investment can be made.

Who is a “Disqualified Person”

To trigger the IRS prohibited transaction rules, one must involve his or her retirement account into a transaction with a “disqualified person.”

As per IRC Section 4975(e)(2):

For purposes of this section, the term “disqualified person” means a person who is—

• (A)  a fiduciary;
• (B)  a person providing services to the plan;
• (C)  an employer any of whose employees are covered by the plan;
• (D)  an employee organization any of whose members are covered by the plan;
• (E) an owner, direct or indirect, of 50 percent or more of—
• (i)  the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation,
• (ii)  the capital interest or the profits interest of a partnership, or
• (iii)  the beneficial interest of a trust or unincorporated enterprise, which is an employer or an employee organization described in subparagraph (C) or (D);
• (F)  a member of the family (as defined in paragraph (6)) of any individual described in subparagraph (A), (B), (C), or (E);
• (G) a corporation, partnership, or trust or estate of which (or in which) 50 percent or more of—
• (i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,
• (ii)  the capital interest or profits interest of such partnership, or
• (iii) the beneficial interest of such trust or estate, is owned directly or indirectly, or held by persons described in subparagraph (A), (B), (C), (D), or (E);
• (H) an officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person described in subparagraph (C), (D), (E), or (G); or
• (I) a 10 percent or more (in capital or profits) partner or joint venturer of a person described in subparagraph (C), (D), (E), or (G).

In sum, the definition of a disqualified person 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.

Officer, Director, Executive, or 10% or More Shareholder

In most cases, the determination of whether an individual or entity will be treated as a disqualified person is quite obvious. For example, a lineal descendant or an entity 50% or more owned or controlled by a disqualified person will be deemed disqualified.  For some reason, when it comes to analyzing transactions involving a company officer, director, highly compensated employer or 10% or more shareholder of an entity, the prohibited transaction analysis seems unclear.  However, the analysis is actually quite simple. 

If you refer to Sections H & I above, the Code does not suggest that an officer, director, highly compensated employee, or a 10% or more shareholder makes the entity a disqualified person.  What is does state is that only where an entity is deemed a disqualified person, meaning it is owned or controlled 50% or more by disqualified persons, will an officer, etc. be deemed a disqualified person. 

Below are two examples that best demonstrate the application of IRC Code Sections 4975(e)(2)(h) & (i):

Example 1: Ken owns 60% of ABC Inc.  Lori is an officer of ABC Inc.  Lori needs money for a new home and asks Ken for a loan.  If Ken used his IRA to lend money to Lori, the transaction would likely violate the IRC prohibited transaction rules.  Ken owns 50% or more of ABC Inc., and Lori is an officer of the company making Ken and Lori disqualified persons and prevent them from transacting using a retirement account

Example 2:  Ken owns 46% of ABC Inc.  Lori is an officer of ABC Inc.  Lori needs money for a new home and asks Ken for a loan.  Ken would be able to use his IRA to lend funds to Lori because Ken did not own more than 50% of ABC Inc.; Ken and Lori will not be treated as “disqualified persons to each other.”

Conclusion

The IRC prohibited transaction rules are not as complicated as some make them out to be. Just because one is an officer at a company doesn’t automatically preclude that person from using his or her Self-Directed IRA to invest in the business. However, other factors may deem the business a disqualified person under the rules listed in this article. If that’s the case, it would indeed be a prohibited transaction and the IRA would not be able to invest in the business.

Obviously, you need to check the specifics before making the investment. You don’t want to make the investment if it could be a prohibited transaction, which would have a negative impact on your tax-advantaged IRA. Don’t be afraid to make an investment just because you think it may be prohibited. Do you homework to determine if it is, and then proceed accordingly.