Among the first concepts introduced to self-directed IRA and Solo 401(k) investors are “prohibited transactions” and “disqualified persons.” While those are certainly key concepts, there several others to be aware of; among those is the “Exclusive Benefit Rule.”
Summary of the Prohibited Transaction Rules
The prohibited transaction rules, set out in IRC 4975, disallow transactions between tax-advantaged retirement plans and disqualified persons. There are 6 types of transactions, enumerated in the Tax Code, that result in adverse tax consequences if engaged by the plan and a disqualified person, directly or indirectly:
- Sale, exchange, or leasing
- Lending or extension of credit
- Furnishing of goods and services or facilities
- Transfer to, use by or for the benefit of, a disqualified person of plan assets
- Self-dealing with plan assets by a disqualified person who is a fiduciary
- Receipt of compensation in connection with a transaction involving plan assets by a disqualified person who is a fiduciary
A prohibited transaction, regardless of which of the 6 categories it falls into, always involves a disqualified person.
What is a Disqualified Person?
A condensed list of disqualified persons includes:
- 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 spouses, 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?
A review of the foregoing list indicates that there are many people that may have close relationships with the account holder that are not disqualified persons. Notably, siblings, parents-in-law (I wrote only that these people may have a close relationship with the account-holder), aunts & uncles, nieces & nephews, and friends.
The Exclusive Benefit Rule
The Section of the Tax Code governing 401(k) plans states that the plan must be for the exclusive benefit of employees or their beneficiaries.
According to the IRS, among the factors that should be considered to determine whether the exclusive benefit rule is being followed are:
1. The cost of an investment, which must not exceed its fair market value (FMV) at the time of its purchase.
2. A fair return commensurate with the prevailing rate must be provided.
Similar exclusive benefit language is included in the section of the tax code that governs IRAs.
In conclusion, if an investment is not a prohibited transaction is it permitted? In the IRS’s word “…even though a transaction may be exempt from IRC 4975 taxes, it must still meet the exclusive benefit and the assignment or alienation requirements.”