Prohibited Transactions and Your Retirement Plan

The tax law has strict rules about what you can and cannot do when it comes to your qualified retirement plans and IRAs. The funds are designed for retirement savings; the rules prevent you from self-dealing and certain other actions that are thought to run counter to the purpose of these plans.

What are prohibited transactions?
Paraphrasing the Senate Report from 1974, the purpose of prohibited transactions is to prevent taxpayers from using their qualified retirement plans to engage in transactions that could place plan assets and income at risk of loss before retirement. Prohibited transactions are listed in Section 4975 of the Internal Revenue Code. They include, whether done directly or indirectly:

  1. Sale, exchange, or leasing, of any property between a plan and a disqualified person.
  2. Lending of money or other extension of credit between a plan and a disqualified person.
  3. Furnishing of goods, services, or facilities between a plan and a disqualified person.
  4. Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan.
  5. Action by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account.
  6. 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.

The fact that a transaction would qualify as a prudent investment under the highest fiduciary standards does not change the character of the transaction. 

What are the consequences of prohibited transactions?
Prohibited transactions are subject to excise taxes:

  • 15% excise tax. For example, failing to deposit employee contributions into 401(k) plans on time is a prohibited transaction subject to a 15% excise tax. It's a prohibited transaction because the company is holding onto the funds (i.e., a disqualified entity is using funds for its own purposes).
  • 100% excise tax if the prohibited transaction is not corrected in time.

In some situations, the prohibited transaction results in the loss of tax-deferred status for the plan or account as of the first day of the year in which the prohibited transaction occurs. This means that all of the funds in the account become immediately taxable to the account owner. And, if the account owner is under age 59 1/2 at the time, there is a 10% early distribution penalty as well.

How do the prohibited transactions rules affect self-directed IRAs
Some business owners use self-directed IRAs so that the accounts can own their businesses. This is a way to finance the business: the funds in the account buy the business interests and the IRA owner owns the business indirectly, through ownership of the IRA. While this is not a prohibited transaction per se, it is fraught with minefields that can set off a prohibited transaction. Take the following Tax Court case:

An individual had a sizable 401(k) from his years of working at a large pharmaceutical company. When he left the job, he organized a limited liability company (LLC) for used car sales and planned that 98% would be owned by a self-directed IRA he would later set up and fund with distributions from his 401(k). When he did this, the IRA transferred $319,500 to the LLC. He became the general manager of this used car business and received a salary for his work. His compensation was paid by the LLC's checking account.

Under these facts, the court concluded that the formation of the LLC using funds from his IRA was not a prohibited transaction. However, receiving compensation from the LLC was a transfer to a disqualified person and, thus, was a prohibited transaction. While compensation for services provided to a plan is exempt from prohibited transactions, in this case he received compensation for services to the LLC and was paid from the LLC.

The penalty for his self-dealing: The IRA ceased to be a tax-deferred plan as of the first day of the year in which the prohibited transaction occurred, which was the year that compensation was paid to him. Thus, all of the funds in the IRA were taxable to him. And, because he was under age 59 1/2, he was subject to a 10% early distribution penalty.

Bottom line
Always talk with a knowledgeable tax advisor before making any moves with a qualified plan or IRA that could raise questions about self-dealing. The cost of this professional advice is much less than the tax cost of making a big mistake.

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