What is a Prohibited Transaction?

While vague in nature, the Prohibited Transaction guidelines do provide a solid foundation of things an IRA owner should avoid.

According to the IRS, a prohibited transaction is, any improper use of an IRA account or annuity by the IRA owner, his or her beneficiary, or any disqualified person” (IRS, 2019).

You see, the tax advantages provided by the IRA account is intended exclusively for retirement saving; and therefore, may only provide personal benefit after making a formal withdrawal from the account and paying any tax due. With that being said, any self-dealing, commingling of personal assets, or immediate personal benefit from the use of those funds or assets owned by the account, while still in the IRA account, is strictly forbidden.

We will break these down individually, but for now, as shown in the Internal Revenue Code IRC § 4975, as a general rule, a Prohibited Transaction (PT) means any direct, or indirect:

  • IRC § 4975 (c)(1)(A)  – Sale, exchange, or leasing, of any property between a plan and a disqualified person
  • IRC § 4975 (c)(1)(B)  – Lending of money or other extension of credit between a plan and a disqualified person
  • IRC § 4975 (c)(1)(C)  – Furnishing of goods, services, or facilities between a plan and a disqualified person
  • IRC § 4975 (c)(1)(D)  – Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan
  • IRC § 4975 (c)(1)(E)  – Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account
  • IRC § 4975 (c)(1)(F)  – Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan

These guidelines will often overlap and may be more relevant to certain investments. To simplify, we will place these into three categories: Per Se Prohibited Transactions, Self-Dealing Prohibited Transactions, and Extension of Credit Prohibited Transactions.

Per Se Prohibited Transactions – IRC § 4975 (c)(1)(A)

A Per Se prohibited transaction is any “transaction” (direct or indirect) occurring between a qualified plan and a disqualified person.

So what is a transaction exactly? A transaction as defined by the IRS is the sale, exchange, or leasing of any property between a plan and a disqualified person. While pretty self-explanatory, a prohibited transaction of this kind would happen if an IRA directly, or IRA owned LLC (indirectly), would purchase something from any disqualified entity.

Such would be the case if your IRA account purchased a personal asset, such as your home, or if your IRA account owned property was leased to your children or other disqualified person.

In most instances it’s easy to clearly identify the parties involved in a transaction. Yet in the cases of complex transactions, often involving multi-member LLC’s, the disqualified parties to the transaction may be a little harder to distinguish.  

Whenever trying to identify a Per Se prohibited transaction I like to think of it in terms of buying a car. On one side of the negotiation table you have a buyer and on the other side a seller. If your IRA account, or IRA LLC, is on one side of the table, you must always ensure that a disqualified person or entity is not on the other side. The trick is determining who exactly is sitting across the table from your IRA or IRA owned LLC.

We will cover partnerships in a later section, but it’s worth mentioning that an IRA and a disqualified person may sit together on the same side of the table, as partners to an investment; this is assuming the partnership does not violate any other of the prohibited transaction rules to follow.

Extension of Credit Prohibited Transactions – IRC § 4975 (c)(1)(B)  

The extension of credit prohibited transaction rules apply to the credit, or borrowing activities of an IRA account. Essentially, this rule prohibits the IRA owner, or any other disqualified person/entity, from personally guaranteeing a loan, or offering their personal credit and/or assets in order to secure financing or credit for an IRA account; again, this also applies to the IRA LLC obtaining a loan.

A common example of this is when a self-directed IRA is seeking financing to purchase an investment property.

Conventional loans and lines of credit generally require the borrower to pledge personal assets as a part of the underwriting process. Because the IRA owner is a disqualified person to the IRA, they would not be able to provide the guarantee needed by the bank to approve the loan. Rather, the IRA would need to seek non-recourse financing from a lender who provides this type of loan. Non-recourse loans do not require a personal pledge, but will generally have higher interest rates and larger down payment requirements (35%-45%).

Self-Dealing Prohibited Transactions – IRC § 4975 (c)(1)(C) – (F)

The first two Prohibited Transaction categories we covered, IRC § 4975 (c) (1) (A) and (B), are pretty straight forward. Self-dealing transactions however are a much broader and vague set of guidelines. Identifying these types of transactions isn’t quite as clear as the prior two as these transactions can often be based on subjective factors.

Self-dealing, in a nutshell, is when a disqualified entity receives any immediate benefit from the use of the IRA account or its assets.

This also includes the co-mingling of personal and plan assets, such as storing IRA LLC assets at your personal residence; gold coins for instance. In addition, the IRA account itself is prohibited from receiving benefit, such as favorable treatment orchestrated by and/or provided by a disqualified entity.

With that said, whether using a custodial IRA or an IRA LLC strategy, the activities that the IRA owner engages in must always be at “arms-length”. Meaning, your personal assets, relationships, opportunities, and intent must be called into question prior to making your investment of choice. Let’s have a look at these statutes individually to help further understand self-dealing.

IRC § 4975 (c) (1) (C) – Furnishing of goods, services, or facilities between a plan and a disqualified person.

Examples of this might include:

  • Providing labor for your IRA owned real estate in the form of sweat equity
  • Storage of personal property on IRA owned property
  • Storage of IRA owned property on personal property
  • Providing personal assets or services to the IRA

IRC § 4975 (c) (1) (D) – Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan

Examples of this might include:

  • Using your IRA owned land to hunt or fish on
  • Vacationing at your IRA owned vacation rental
  • Withdrawing cash from the IRA LLC for personal use, or utilizing IRA LLC assets for personal benefit
  • Receiving compensation for your role as Manager in the IRA LLC

IRC § 4975 (c) (1) (E) – Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account.

Examples of this might include:

  • Using your IRA to buy the vacant lot next to your personal residence because you would rather not have neighbors
  • Transacting with vendors with the expectation of a personal favors in the future
  • Utilizing IRA account funds to create a job for yourself
  • Non-economic transactions; i.e. non-investment use, sweetheart loans

IRC § 4975 (c)(1)(F)  – Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

Examples of this might include:

  • Serving as agent and receiving a commission from your IRA’s real estate purchase
  • Receiving personal compensation or bonuses for your IRA’s involvement in a transaction
  • Receiving swag from your IRA’s investment in a crowd funding campaign
  • Receiving personal preferential treatment for your IRA’s involvement in an investment

While many of these statutes may seem to paint a clear picture of what you can and cannot do with your IRA LLC, in the case study post we will explore the subjective and vague nature of these rules.