For self-directed IRA (SDIRA) owners, engaging in a prohibited transaction (PT) can upend retirement savings. While other SDIRA mistakes—such as excess contributions or required minimum distribution failures—can be fixed pretty easily, PTs require terminating and fully distributing the IRA. This may result in immediate taxation and possible penalties. But knowing the rules and recognizing possible PTs will help you steer clear of these wealth-destroying transactions.
Prohibited Transaction Basics
The PT rules prohibit transactions between the IRA and certain parties—or ones that give plan fiduciaries an improper windfall or kickback. Sometimes IRA PTs are hard to spot because the SDIRA owner wears two hats: one role is to direct the IRA custodian to invest assets in a certain way; the other role is as the beneficiary of the IRA. Common sense would seem to dictate that the SDIRA owner should invest assets to gain the most benefit for the owner of the IRA. After all, SDIRA owners would not logically make choices that are contrary to their best interests. But it is still possible to enter into transactions that benefit the owner outside the IRA or that unduly enrich those who may have certain duties to the IRA.
To give clarity to IRA owners, Internal Revenue Code Section 4975(c)(1) defines prohibited transactions as certain direct or indirect transactions between an IRA and a “disqualified person.” The statute identifies six PT categories, including the sale or exchange of property, lending of money, furnishing of goods or services, and the transfer or use of plan assets for the benefit of a disqualified person.
Who Is a Disqualified Person?
Under § 4975(e)(2), disqualified persons include
- The IRA owner;
- The IRA owner's spouse;
- The IRA owner's ancestors (parents, grandparents) and lineal descendants (children, grandchildren), and the spouses of those descendants;
- Any fiduciary of the IRA; and
- Any entity—corporation, partnership, trust, or estate—in which the above persons own 50% or more of the interest.
Notably absent from this list: siblings, cousins, aunts, uncles, and friends. Transactions between an IRA and those individuals are not automatically prohibited under the PT rules because they are not considered disqualified persons. But other PT provisions may apply.
The Prohibited Transaction “Catch-All” Rules
Two PT categories deserve special attention for IRA owners. The first covers any act by a fiduciary — which alwaysincludes the IRA owner — that involves dealing with IRA assets in that fiduciary’s own interest. The second covers receipt of personal consideration from any party dealing with the IRA in connection with a transaction involving IRA assets. Both of these go to the heart of what prohibited transaction rules are designed to prevent: an IRA owner using a tax-advantaged account for personal benefit rather than solely for retirement savings.
It is quite clear that individuals cannot sell property that they already own to their SDIRAs. This is a textbook PT: a sale between an IRA and a disqualified person. But what if the brother of the SDIRA owner sells property to the SDIRA? Siblings are not included in the disqualified persons definition. So on its face, the transaction may seem perfectly permissible, especially if the purchase price reflects separate, independent appraisals. But such transactions can give rise to PTs. Consider, for example, the consequences of an “understanding” that, because of the property sale to the SDIRA, the selling brother agrees to cancel a debt that the buying brother owes? This “receipt of personal consideration” by the SDIRA-fiduciary in connection with the SDIRA transaction creates a PT just as surely as a direct transaction with a disqualified person.
A PT Around Every Corner?
This is not to suggest that there are PTs lurking everywhere. But SDIRA owners need to understand that even arm’s-length transactions between permissible parties can create PTs. It is only natural that certain investment opportunities are discovered through friends and relatives. But even if these transactions seem proper, they need to be structured carefully to avoid potential PT problems. And as a reminder, here are some of the more common prohibited transaction scenarios.
- Buying property from (or selling property to) yourself or a disqualified family member
- Personally using SDIRA-owned assets
- Lending money between the SDIA and a disqualified person
- Providing services (e.g., repairs or management) to SDIRA-owned investments
- Receiving compensation related to SDIRA transactions
Flee from the PT
The best way to avoid PTs is to know the rules. Understanding the PT pitfalls will help you ask the right questions—before entering into any transaction.
- Does this transaction involve a disqualified person in any way—directly or indirectly?
- Will I or any family member personally benefit from this investment?
- Am I receiving anything of value from a third party connected to this transaction?
If you answer “yes” to any such question, seek sound advice before proceeding. Better to pass on a possible PT than to blow up your SDIRA. And Mainstar Trust can help. We cannot evaluate specific investments, but we can help you understand the prohibited transaction rules better. Reach out to our SDIRA experts to help you keep your retirement accounts compliant.