In late 2022, President Biden signed into law SECURE Act 2.0, which is included in the 4000+ page, $1.7 trillion spending bill — which would fund the government for the 2023 fiscal year.  SECURE Act 2.0 contains over 90 provisions relating to retirement accounts.  However, one important provision offered guidance on a path for Self-Directed IRA investors to better protect their IRA funds from the impact of prohibited transaction penalties.

What is a Self-Directed IRA?

The Internal Revenue Code does not describe what a Self-Directed IRA can invest in, only what it cannot invest in. 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 benefit.

Internal Revenue Code Sections 4975 & 408 prohibit fiduciary and “disqualified persons” from engaging in certain types of transactions.  In sum, in order to trigger an IRS prohibited transaction you would need two parties: (i) a retirement account and (ii) a disqualified person. The IRS considers the following a prohibited transaction:

• Life Insurance Policies (a 401(k) plan may purchase life insurance contracts)
• Collectibles, such as art and antiques
• Any Transaction involving or personally benefiting directly or indirectly a disqualified person. Pursuant to IRC 4975, a disqualified person essentially includes the IRA holder, any ancestors or lineal descendants of the IRS holder, and entities in which the IRS holder holds a controlling equity or management interest. Exceptions include siblings, cousins, aunts, uncles, friends and neighbors.

Who is a “Disqualified Person” in Depth

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. Under Code Section 4975(e)(2), a “disqualified person” means:

• A) A fiduciary (e.g., the IRA holder, participant, or person having authority over making IRA investments)
• B) A person providing services to the plan (e.g., the trustee or custodian)
• C) An employer, any of whose employees are covered by the plan (this generally is not applicable to IRAs, but does include the owner of a business that establishes a qualified retirement plan)
• D) An employee organization any of whose members are covered by the Plan (this generally is not applicable to IRAs)
• E) A 50 percent owner of C or D above
• 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)
• 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 stock holdings/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
• H) A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G
• I) A 10 percent or more partner or joint venture of a person described in C, D, E, or G

In sum, the most common examples of a “disqualified person” are the following:

• The IRA owner
• Lineal ascendants and descendants of the IRA owner
• Entities or trusts controlled or 50% owned by a “disqualified person”
• A 10 percent owner, officer, director, or highly compensated employee of an entity or trust controlled or 50% owned by a “disqualified person”

IRC 4975 Self-Directed IRA Prohibited Transaction In-Depth

• 4975(c)(1)(A): The direct or indirect Sale, exchange, or leasing of property between an IRA and a “disqualified person.”
  • Example: Ben 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.”
  • Example: Nick lends his wife $10,000 from his IRA.
• 4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between an IRA and a “disqualified person.”
  • Example: Jen buys a piece of property with her IRA funds and hires her father to work on the property
• 4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of an IRA.
  • Example: Alan is in a financial jam and takes $12,000 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.
  • Example: Sara who is a real estate agent uses her IRA funds to buy a home and earns a commission from the sale.
• 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: Mike uses his IRA funds to loan money to a company in which he manages and controls but owns a small ownership interest in.

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).  The most common statutory exemptions to the IRS prohibited transaction rules is the 401(k) loan and the ability to purchase qualifying employer securities by the 401(k), which is the foundation of the ROBS solution.

IRS Prohibited Transaction Penalties

Section 4975(a) imposes a 15% excise tax (the first-tier excise tax) on a prohibited transaction. In addition, Code Section 4975(b) imposes a 100% excise tax (the second-tier excise tax) on a prohibited transaction if that prohibited transaction is not corrected during the taxable period. The tax applies to any disqualified person who participates in the prohibited transaction (other than a fiduciary acting only as such). Under Code Section 4975, the applicable excise tax is applied to the amount involved in the prohibited transaction.

Section 4975(f)(4) defines the term “amount involved,” generally, as the greater of (1) the amount of money and the fair market value of the other property given or (2) the amount of money and the fair market value of the other property received in such transaction. For purposes of the first-tier excise tax, the fair market value is determined as of the date on which the prohibited transaction occurs, whereas, for purposes of the second-tier excise tax, the fair market value is the highest fair market value during the taxable period described in Code Section 4975(f)(2). Section 4975(f)(2) defines the term “taxable period” as the period beginning with the date on which the prohibited transaction occurs and ending on the earliest of (1) the date of the mailing of a statutory notice of deficiency, (2) the date on which the first-tier excise tax is assessed, or (3) the date on which correction of the prohibited transaction is completed.

SECURE Act 2.0 – 2023 Guidance

Under Section 322 of the SECURE Act 2.0, when an individual engages in a prohibited transaction with respect to his or her Self-Directed IRA, the IRA is disqualified and treated as distributed to the individual, irrespective of the size of the prohibited transaction. Section 322 clarifies that if an individual has multiple IRAs, only the IRA with respect to which the prohibited transaction occurred will be disqualified. This provision is effective for taxable years beginning after the date of enactment of this Act (in 2023).

Section 322 is important because it provides a Self-Directed IRA investor with clarity that if they are electing to engage in a potentially prohibited transaction under IRC 4975, he or she should isolate that investment into a separate IRA.  The provision now makes it clear that each Self-Directed IRA is treated as a separate IRA with respect to the application of the prohibited transaction rules.

Conclusion

The excise taxes involved in the triggering of a prohibited transaction are significant.  Section 322 of SECURE Act 2.0 confirms that each IRA will be treated separately for purposes of the IRS prohibited transaction rules.  Hence, if you are seeking to use a Self-Directed IRA to make an investment that could potentially be deemed prohibited, you should consult with tax professionals, such as IRA Financial, and should also consider setting up a separate IRA for that particular investment.