Benefiting from tax-advantaged retirement funds before retirement age would be a beautiful thing, especially for those of that leverage the power of Solo 401(k)s and Checkbook IRAs. But, as that would defeat the intent of those accounts, the Prohibited Transaction Rules of IRC 4975 were created. Although written broadly, the innovative investor can contrive many ways to circumvent those rules.
However, beyond the letter of the law, the IRS has some additional tools at its disposal with which to counter creative strategies. Those include the Step Transaction Doctrine, the Exclusive Benefit Rule, and the Plan Asset Rule. For cases in which those rules may not apply, the IRS has the Department of Labor Interpretive Bulletin ERISA IB 75-2.
What is a Prohibited Transaction?
Prohibited Transactions are dealings between a retirement plan and certain “disqualified persons,” which result in unfavorable tax consequences. In certain cases, prohibited transactions can completely disqualify an IRA.
Key disqualified persons to be aware of are:
- The account-holder
- A plan service provider
- an employer whose employees are covered by the plan
- family members of any of the foregoing, which includes
– parents and grandparents (but not their spouses)
– lineal descendants and their spouses
- any entity in which combined ownership by any of the foregoing persons is 50% or more
Who is Not a Disqualified Person?
Anybody that’s not included in the Tax Codes definition of “disqualified person.” Sounds kinda obvious? Well, there are actually some people or entities that we would expect to be “disqualified” that are not. For example, aunts & uncles, siblings, friends, and entities in which the combined ownership by disqualified persons is 49% or less.
A “How-to” on Attempting to Circumvent the Prohibited Transaction Rules
It seems that I could have my IRA invest in an entity (in a manner that’s doesn’t subject it to the Plan Asset Rule; e.g., an operating company, a real estate operating company, etc.) and have that entity transact with the Disqualified Person. For example, my IRA could be a less that 50% owner of an LLC that will rent property to my business. Sounds good, doesn’t it? Although my business is a Disqualified Person to my IRA, it’s should be able to transact with the LLC that is not subject to the Plan Asset Rule.
Naturally, the IRS and DOL have setup roadblocks to the implementation of this strategy.
The DOL Interpretive Bulletin
The DOL actually addressed a case very closely resembling the one above and invoked its prior bulletin to explain why such dealings are in-fact Prohibited Transactions. In the words of the DOL, “Regulation section 2509.75-2(c) and Department opinions interpreting it have made clear that a prohibited transaction occurs when a plan invests in a corporation as part of an arrangement or understanding under which it is expected that the corporation will engage in a transaction with a party in interest (or disqualified person).”
Based on the DOL rule, investing with a non-disqualified person with the intent for that non-disqualified person to transact with a Disqualified Person results in a Prohibited Transaction. Therefore, my IRA cannot invest in an LLC with which I’ve arranged a transaction wi a business I own.
Anytime a transaction seems like it should be a Prohibited Transaction but doesn’t fall within the precise definition of a Prohibited Transaction per IRC 4975, it requires further analysis. One component of that analysis must be the DOL Interpretive Bulletin.