Background of Prohibited Transactions
In 1974 the US government instituted legislation which was aimed at encouraging its taxpayers to save for retirement. To accomplish this objective, the government permitted special retirement accounts like IRAs which allow taxpayers to save money and enjoy deferred tax benefits. These tax benefits could be accrued in a tax deferred status (with a traditional IRA or Solo 401k) or tax-free profits (with a Roth IRA or Solo 401k). However, to ensure that the benefits are preserved until retirement, the tax law does not allow the IRA or Solo 401k owner to take any personal benefit from his or her plan before the age of retirement. Dealings that violate this clause are known as “Prohibited Transactions.”
The formula that defines a prohibited transaction is simple:
“Retirement Plan Asset” + “Disqualified Person” = Prohibited Transaction.
A “Retirement Plan Asset” is any asset or entity owned by the retirement account/plan. A “Disqualified Person” includes any person directly related to the plan’s owner in a vertical fashion, as well as anybody with a substantial connection to the plan in question. Examples of a disqualified person include:
- The Solo 401k or self-directed IRA owner and his/ her spouse
- The owner’s ancestors
- The owner’s descendants and their spouses
- The fiduciary of the Self Directed IRA/Solo 401k and anyone else that provides services to the account/plan (e.g. accountant, financial advisor)
- Any entity (e.g. corporation, partnership, LLC, etc.) that is owned 50% or more, singularly or collectively, by disqualified persons (e.g. the persons described above).
- Once an entity becomes disqualified, then all of its officers, directors, highly-compensated employees, and other owners (owning 10% or more) become Disqualified Persons as well.
IRC §4975 defines prohibited transactions to include any direct or indirect:
- Sale, lease, or exchange of property between a plan and a disqualified person.
- Lending of money or other extension of credit between a plan and a disqualified person.
- Furnishing of goods or services between a plan and a disqualified person.
- Use or transfer of plan assets for one’s benefit between a plan and a disqualified person.
- Dealing with the assets of a plan for one’s personal interest by the Solo 401k or self-directed IRA accountholder or fiduciary.
- Receipt of consideration from anyone in connection with a transaction involving plan assets by the accountholder or other fiduciary.
The following are some common examples of IRA prohibited investments and prohibited transactions. The self-directed IRA or Solo 401k accountholder may not:
- Sell a property that he/ she owns personally to the Solo 401k or self-directed IRA
- Lend money from the self-directed IRA or Solo 401k to his or her parent, child, or other disqualified person (Loans to the Solo 401k account-holder are permitted subject to conditions).
- Personally guarantee a loan for a real estate purchase by the Solo 401k or self-directed IRA
- Use any property owned by the self-directed IRA or Solo 401k
- Receive a salary or fee for managing one’s self-directed IRA or Solo 401k
- Receive a commission on a property purchased or sold by one’s Solo 401k or self-directed IRA
- Hire a business owned by oneself or other disqualified person to provide a service to a plan asset
- Personally purchase a property owned by one’s Solo 401k or self-directed IRA
- Lend money to one’s self-directed IRA or Solo 401k (there are limited exceptions)
- Allow a child to live in a rental unit owned by the self-directed IRA or Solo 401k, even if he or she pays fair rent
- Pay oneself, or other disqualified person, for performing work to a property owned by one’s Solo 401k or self-directed IRA, (similarly, performing that work for free would be considered a non-cash contribution to your self-directed IRA or Solo 401k which is also not allowed.)
The Self-Directed IRA penalties for engaging in a prohibited transaction are severe, so it is very important that all Solo 401k or Self-Directed IRA owners follow the rules. Before entering into any transaction, the owner must always review the formula and confirm that the proposed transaction does not directly or indirectly violate any of the prohibited transaction rules. And like all rules, there are exceptions, but one should never enter into a transaction without first confirming that the transaction is not prohibited or that an exception applies.
The above is a general explanation meant to familiarize you with the prohibited transaction rules, and is in not meant to be a substitute for professional advice specific to your situation.