IRS Prohibited Transaction Rules

The Internal Revenue Code does not describe what a Self-Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of IRAs for accumulation of retirement savings and to prohibit those in control of IRAs from taking advantage of the tax benefits for their personal account.

The foundation of the IRS prohibited transaction rules are based on the premise that investments involving IRA and related parties are handled in a way that benefits the retirement account and not the IRA owner. The rules prohibit transactions between the IRA and certain individuals known as “disqualified persons”.

The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest

In general, the type of transactions that could fall under the IRS prohibited transaction rules pursuant to Internal Revenue Code Section 4975 can be viewed in the context of three categories:

Direct IRS Prohibited Transaction Rules

4975(c)(1)(A): The direct or indirect Sale, exchange, or leasing of property between an IRA and a “disqualified person”

• Ben leases an interest in a piece of property owned by his Self-Directed IRA to his son
• Jen sells real estate owned by her Self-Directed IRA to her father
• Todd sells real estate he owns personally to his Self-Directed IRA
• Carl transfers property he owns personally to his Self-Directed IRA
• Mary Purchases real estate with her IRA funds and leases it to her mother
• Kevin uses his Self-Directed IRA funds to purchase an interest in an entity owned by his wife
• Peter Transfers property he owns personally subject to a mortgage to his Self-Directed IRA.
• Tracy uses personal funds to pay expenses related to her Self-Directed IRA real estate investment
• Lara uses personal funds to pay taxes and expenses related to her Self-Directed IRA real estate investment

4975(c)(1)(B): The direct or indirect lending of money or other extension of credit between an IRA and a “disqualified person”

• Keith lends his son $4,000 from his IRA
• Joe Uses the assets of his Self-Directed IRA as security for a loan
• Mr. Peek and Mr. Fleck personally guarantee a business loan owned by their Self-Directed IRA
• Tammy personally guarantees a bank loan to her Self-Directed IRA
• Bill uses his personal assets as security for an Self-Directed IRA investment
• Allan uses Self-Directed IRA funds to lend an entity owned and controlled by his father $25,000
• Terry acquires a credit card for his Self-Directed IRA LLC bank account

4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between an IRA and a “disqualified person”

• Dan purchases real estate with his Self-Directed IRA funds and personally makes repairs on the property
• Larry purchases a condo with his Self-Directed IRA funds and paints the walls without receiving a fee
• Kris buys a piece of property with his Self-Directed IRA funds and hires his son to work on the property
• Karen buys a home with her Self-Directed IRA funds and her son makes repairs for free
• Lisa owns an office building with her Self-Directed IRA and hires her son to manage the property for a fee
• Shari owns an apartment building with her Self-Directed IRA funds and has her father manage the property for free
• Joe receives compensation from his Self-Directed IRA for investment advice
• Troy acts as the real estate agent for his Self-Directed IRA

4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of an IRA

• Steve uses a house owned by his Self-Directed IRA for personal uses
• Tim deposits Self-Directed IRA funds in to his personal bank account
• Pat is in a financial jam and takes $12,000 from his Self-Directed IRA to pay a personal debt
• Mark buys precious metals using his Self-Directed IRA funds and uses them for personal gain
• Jack purchases a vacation home with his Self-Directed IRA funds and stays in the home on occasion
• Amy buys a cottage on the lake using her Self-Directed IRA and rents it out to her daughter and son-in-law
• Sylvia purchases a condo on the beach with her Self-Directed IRA funds and lets her son use it for free
• Richard uses his Self-Directed IRA to purchase a rental property and hires his friend to manage the property. The friend then enters into a contract with Richard and transfers those funds back to Richard
• Pam invests her Self-Directed IRA funds in an investment fund and then receives a salary for managing the fund.
• Charles uses his Self-Directed IRA funds to purchase real estate and earns a commission as the real estate agent on the sale
• Keith uses his Self-Directed IRA funds to lend money to a company he owns and controls
• John invests his Self-Directed IRA funds into a business he owns 75% of and manages

Self-Dealing IRS Prohibited Transaction Rules

4975(c)(1)(E): The direct or indirect act by a “Disqualified Person” who is a fiduciary whereby he/she deals with income or assets of the IRA in his/her own interest or for his/her own account

• Sara makes an investment using her Self-Directed IRA funds into a company she controls which will benefit her personally
• Jason uses his Self-Directed IRA funds to invest in a partnership with himself personally in which he and his family will own greater than 50% of the partnership
• Helen uses her Self-Directed IRA funds to invest in a business she and her husband own and operates and her and her husband earns compensation from the business
• Steve uses his Self-Directed IRA funds to lend money to a business in which he controls and manages
• Victor invests his Self-Directed IRA funds in a Trust in which Victor and his wife would gain a personal benefit
• Brenda uses her Self-Directed IRA funds to invest in a real estate fund managed by her Son. Brenda’s son receives a bonus for securing her investment.
• Frank invests his Self-Directed IRA funds into a real estate project that his development company will be involved in order to secure the contract
• Ryan uses his Self-Directed IRA funds to invest in his son’s business that is in financial trouble
• David uses his Self-Directed IRA funds to buy a note on a piece of property for which he is the

Conflict of Interest IRS Prohibited Transaction Rules

Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Conflict of Interest Prohibited Transaction” generally involves one of the following:

4975(c)(1)(F): Receipt of any consideration by a “Disqualified Person” who is a fiduciary for his/her own account from any party dealing with the IRA in connection with a transaction involving income or assets of the IRA

• Jay invests his Self-Directed IRA funds into a corporation in which he manages and controls but owns a small interest in. Betty uses her Self-Directed IRA funds to loan money to a company she owns a small interest in but manages and controls the daily operations of the company
• Sally uses her Self-Directed IRA to lend money to a business that she works for in order to secure a promotion
• Lance uses his Self-Directed IRA funds to invest in a real estate fund that he manages and where his management fee is based on the total value of the fund’s

Conclusion

It is highly advisable to consult with a tax attorney or tax professional, specifically one with a strong understanding of the IRS prohibited transaction rules, before using a Self-Directed IRA to invest in a private business.  Give us a call @ 800.472.1043 anytime to discuss.