Understanding Prohibited Transactions
Self-Directed IRAs (SDIRAs) and Solo 401(k)s provide investors with the flexibility to invest in alternative assets, such as real estate, private equity, and cryptocurrencies. However, these accounts are subject to strict rules under the Internal Revenue Code (IRC), particularly regarding prohibited transactions. Below, we discuss what transactions are considered ‘prohibited,’ as well as offer some guidance for best practices to avoid IRS scrutiny.
What Are Prohibited Transactions?
Prohibited transactions, as defined in IRC Section 4975, are transactions between a retirement account and a “disqualified person” that benefit the account holder or related parties personally, rather than the retirement account itself. Disqualified persons include the account owner, their spouse, lineal descendants (e.g., children, grandchildren, parent, and their spouses), and certain fiduciaries or entities in which the account holder has significant ownership.
Examples of prohibited transactions include:
Self-Dealing: Purchasing a property for personal use with retirement funds.
Lending: Borrowing from or lending to the retirement account.
Direct Benefit: Renting a property owned by the retirement account to a family member.
Business Transactions: Investing in a business owned by the account holder or a disqualified person.
Consequences of Prohibited Transactions
Violating IRC Section 4975 can result in the loss of the account’s tax-advantaged status, immediate taxation of all assets, and penalties. For instance, a $500,000 SDIRA engaging in a prohibited transaction could become fully taxable, leading to significant financial consequences.
Examples of Prohibited Transactions
Self-Dealing with Real Estate
Scenario: John, an SDIRA holder, used his retirement funds to purchase a vacation home, which he and his family used for personal vacations. The IRS determined this was a prohibited transaction under IRC Section 4975(c)(1)(D), as John directly benefited from the property. Outcome: The IRS disqualified John’s SDIRA, taxing the entire account balance and imposing a 10% early withdrawal penalty, as John was under 59½. John faced a tax bill exceeding $150,000, significantly depleting his retirement savings. Lesson: Retirement account assets must be used exclusively for the account’s benefit, not for personal use.
Lending to a Disqualified Person
Scenario: Sarah, a Solo 401(k) holder, lent $50,000 from her retirement account to her son to start a business. The IRS identified this as a prohibited transaction under IRC Section 4975(c)(1)(B), as her son is a disqualified person. Outcome: Sarah’s Solo 401(k) lost its tax-advantaged status, and she faced immediate taxation on the account’s $300,000 balance, plus penalties. The IRS also imposed excise taxes on the loan amount. Lesson: Loans between retirement accounts and disqualified persons are strictly prohibited, regardless of intent.
Business Investment with Ownership Conflict
Scenario: Mike, an SDIRA holder, invested $100,000 in an LLC he co-owned with his brother. The LLC operated a retail store, and Mike actively managed the business. The IRS ruled this a prohibited transaction under IRC Section 4975(c)(1)(E), as Mike was a fiduciary and disqualified person. Outcome: Mike’s SDIRA was disqualified, resulting in a tax liability of over $100,000. The IRS also scrutinized the LLC’s income for Unrelated Business Income Tax (UBIT). Lesson: Investments in businesses where the account holder has significant ownership or control can trigger prohibited transactions.
Best Practices
Identify Disqualified Persons: Review IRC Section 4975(c) to understand who qualifies as a disqualified person.
Ensure Arm’s-Length Transactions: All investments must benefit the retirement account exclusively.
Seek Professional Guidance: Consult tax and legal advisors to structure investments compliantly, especially for complex assets.
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