Prohibited Transactions (PT)

There’s no sugar-coating it: a Prohibited Transaction (PT) can devastate someone’s entire retirement account. We’ll delve into what constitutes a PT, how to avoid these transactions properly, and discuss topics hotly debated by professionals in the IRA realm.

Before we define a PT, it’s essential to understand why they exist. The best approach is to introspect. In the eyes of the IRS, you are a taxable entity. Whenever you earn income from employment, business ownership, or investments, you’re required to pay taxes. Consequently, the IRS isn’t concerned about how you earn money, as long as they receive their due taxes promptly.

However, there are avenues to establish entities that the IRS deems non-taxable upfront. A prime example is the self-directed IRA. When your IRA engages in investments and earns profits, those gains are considered tax-free. Consider your 401(k) with your employer: when its value appreciates, do you pay taxes on those gains? No. The same principle applies to IRAs and investment activities. Essentially, you can establish a self-directed IRA, pursue almost any investment, and evade immediate taxes.

Prohibited transactions revolve around two core aspects: disqualified individuals/entities and prohibited investments. Let’s start with disqualified individuals.

Disqualified Individuals:

Yourself: You’re directly barred from benefiting directly or indirectly from your IRA. For instance, you cannot use your self-directed IRA funds to invest in your own business. The IRS views this as channeling funds from a non-taxable entity into a taxable one.

Your Spouse: Your spouse is subject to the same disqualification as you. Using your IRA to invest in your spouse’s business or renting a property to your spouse constitutes indirect self-benefit.

Your Lineal Descendants: This includes children, grandchildren, and beyond. Investing your IRA in your children’s startup or renting property to them is prohibited.

Your Lineal Ascendants: This encompasses parents, grandparents, and higher generational levels. Using your IRA to purchase a property for your parents’ use is impermissible.

Spouses of Your Ascendants and Descendants: Attempting to lend funds to your daughter-in-law or son-in-law using your IRA is forbidden.

It’s essential to note that these individuals are directly disqualified from your IRA, as per the IRS. Other individuals, such as roommates, romantic partners, stepchildren, or inheritors, may also be disqualified, depending on the circumstances, analyzed on a case-by-case basis.

Disqualified Entities:

Alongside disqualified individuals, certain entities are equally disqualified by the IRS, typically due to the involvement of disqualified individuals:

Companies You or a Disqualified Person Own 50% or More of: Establishing an entity like an LLC to conceal a disqualified person from the IRS is ineffective. If you or any disqualified person holds a 50% or more stake in a company, your IRA cannot lend money or transact with that company.

Companies Where a Disqualified Person Receives 10% or More of Annual Income: Merely owning less than 50% of a company doesn’t absolve it from disqualification. If you or any disqualified person receives over 10% of the company’s annual income, it remains a prohibited transaction.

Management-Style Decisions: Making managerial decisions for a company, regardless of ownership or compensation, renders your IRA ineligible to transact with that entity. This criterion requires case-by-case examination.

Disqualified Investments:

While your self-directed IRA can invest in various assets, certain investments are prohibited directly or indirectly by the IRS:

Life Insurance Contracts: Using retirement funds to invest in life insurance contracts is prohibited. Even attempts to utilize entities like LLCs or trusts for such investments indirectly will trigger a prohibited transaction.

Collectibles: Your IRA cannot acquire items deemed collectibles or lacking a hard asset value, such as works of art, antiques, stamps, coins, alcoholic beverages, and more.

Consequences of Prohibited Transactions

The consequences of engaging in a prohibited transaction are severe and multifaceted:

First Tax Implication: Each PT incurs a tax equivalent to 15% of the involved amount for each year since the transaction. For example, lending $100K from your IRA to your business three years ago would result in a $45K tax penalty ($15K per year).

Second Tax Implication: Failure to rectify the PT triggers a tax penalty equal to 100% of the involved amount. This correction must occur within the taxable period, typically the first year. In the same example, you’d face a $100K tax penalty atop the original $45K after three years.

Third Tax Implication: Upon a PT, the IRA ceases to exist, and its current balance is distributed in the year of the transaction. Continuing the example, if your IRA was worth $500K and you lent $100K to your business three years ago, the $500K would be distributed to you three years ago, subjecting you to taxes at your applicable bracket, in addition to the previous tax penalties.

Fourth Tax Implication: If you’re under 59 ½ at the time of a PT, you could incur a 10% penalty on the entire distributed amount.

The severity of taxes and penalties associated with prohibited transactions underscores the power of self-directed IRAs. Remember, the IRS views your IRA as a tax-exempt entity, offering significant tax benefits for investments. Because of this, adhering to the rules is crucial.

Recap:

  • Certain individuals and investments are disqualified from IRAs.
  • IRAs cannot invest in disqualified entities or investments.
  • Penalties for Prohibited Transactions are severe.
  • When in doubt, consult a CPA, tax attorney, or IRA expert.
  • Refer to IRS Revenue Code 4975 for a comprehensive list of prohibited items.
DISCLAIMER: The content of this website and any associated content is for informational purposes only, is not intended to and does not constitute an offer to sell or the solicitation of an offer to purchase to any person in any jurisdiction, and is not and shall not be construed as investment, legal, business, or tax advice.