Introduction to Prohibited Transactions

The term “prohibited transaction” is taken from Section 4975 of the tax code, titled “Tax on Prohibited Transactions.” As implied by their name, the prohibited transaction rules outline the tax implications for retirement plans transacting with certain disqualified persons. The prohibited transaction rules do not address what asset classes or investments are permitted to retirement plans, rather they govern with whom retirement plans may transact.

To maintain the tax-favored treatment of their accounts and avoid tax penalties, Check-Book Control account-holders must be aware of the prohibited transaction rules. The application of the prohibited transaction rules is straightforward in the majority of scenarios. More complex transactions may require analysis by a qualified tax practitioner that is knowledgeable about this highly specialized area of tax law.

Prohibited Transaction Basics

A prohibited transaction is comprised of 3 elements, (1) a retirement plan, (2) a disqualified person, and (3) a transaction between those two. Each of the 3 elements are defined in Section 4975 of the Tax Code, as summarized below.

“Prohibited transactions” may result from dealings between a retirement plan and any of the below disqualified persons.

  • 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

Transactions listed below, if engaged in by a retirement plan and a disqualified person, may result in a “prohibited transaction.”

  • sale, exchange, or leasing of any property
  • lending of money or other extension of credit
  • transfer to or use of plan assets
  • furnishing of goods, services, or facilities
  • account-holder dealing with plan assets in his own interest (self-dealing)
  • receipt of payment by the account-holder in connection with the plan

The prohibited transaction rules apply to the plans listed below and their disqualified persons.

  • 401k plans
  • Defined benefit plans
  • Profit-sharing plans
  • Keogh Plans
  • IRAs
  • Individual Retirement Annuities
  • Archer MSA
  • Health Savings Accounts (HSAs)
  • Coverdell education savings accounts (Coverdell IRA)

Consequences of a Prohibited Transaction

Checkbook Control 401k and Defined Benefit Plans

For Solo 401S(k)s and Self-directed Defined Benefit Plans, the tax treatment is the same regardless of which disqualified person engaged in the transaction, as follows:

  • An initial tax of 15% of the amount involved in the prohibited transaction
  • If the prohibited transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved in the transaction may be applied

Checkbook Control IRAs

The effect of a prohibited transaction on a Checkbook Control IRA LLC depends on which disqualified person engaged in the transaction, as summarized below:

If the account-holder or account-beneficiary engage in a prohibited transaction, the IRA loses its status as a tax favored account as of the beginning of the taxable year in which the transaction took place and results in the following:

  • The fair market value of the entire IRA is considered to have been distributed to the account-holder as of the first day of the taxable year
  • The amount deemed distributed will be included in gross taxable income of the account-holder in accordance with rules governing traditional and Roth IRAs
  • A 10% penalty may be applied to amounts deemed distributed, in accordance with the early withdrawal penalties applicable to traditional and Roth IRAs
  • All such taxes will be reportable on the income tax return of the account-holder for the tax year in which the IRA was deemed to have been distributed

If disqualified persons other than account-holders and beneficiaries engage in a prohibited transaction with the IRA – the IRA is not disqualified – and that disqualified person will have to pay taxes, as follows:

  • An initial tax of 15% of the amount involved in the prohibited transaction
  • If the prohibited transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved in the transaction may be applied

Prohibited Transaction FAQs

Can a Checkbook Control Retirement Plans transact with disqualified persons if arms-length pricing is used?

No, even if fair market value is paid, Checkbook Retirement Plans may not transact with disqualified persons.

Can a Checkbook Retirement Plan loan money to the account-holders brother?

Yes, although a brother is family member, for purposes of prohibited transactions he is not a disqualified person and the retirement account may transact with him.

Can a Checkbook Retirement Plan sell property to the account-holders uncle or aunt?

Yes, uncles and aunts are not disqualified persons under the prohibited transaction rules and the retirement plan may do business with them.

Can a Checkbook Retirement Plan buy property from the account-holders father-in-law or mother-in-law?

Yes, a Checkbook Retirement Plan may purchase property from the account-holders in-laws as they are not disqualified persons under the tax law.

Can a Checkbook Retirement Account do business with the second husband of the account holder’s mother?

Yes, ancestors (parents, grandparents, great-grandparents) of the account-holder are disqualified persons, but their spouses are not. In contrast, spouses of lineal descendants (children, grandchildren, great-grandchildren are disqualified persons to the retirement account.

Can I take a salary as manager of my IRA-LLC?

No, you should not take any form of compensation from your IRA-LLC retirement plan. Although there are circumstances under which a disqualified person may take compensation, it is not advisable under any circumstances.

Can the account-holder do rehab work on real-estate owned by an IRA-LLC or a Solo 401k?

No, disqualified persons should not due work that would constitute furnishing goods, services, facilities or otherwise contributing value to their IRA-LLC or Individual 401k. You may manage the books and records and do all that is necessary to make investment decisions and manage the investments.

Can a Solo 401(k) or Checkbook IRA borrow funds to invests, such as using a mortgage to finance the purchase of real estate?

So long as the lender has no recourse against the account-holder in the event of default, a Checkbook Retirement Plan may borrow funds to finance investments. If the lender has recourse against the account-holder, meaning the account-owner could be personally liable for the debt, an extension of credit prohibited transaction has occurred. In the case of a Checkbook IRA, leveraged real-estate deals may result in UDFI tax (Unrelated Debt Financed Income tax) when a nonrecourse loan is used. One of the great benefits of a Checkbook 401k is that real estate acquisition indebtedness does not result in UDFI.

May my Checkbook IRA-LLC or Self-directed Individual 401k have a credit or debit card?

Yes to debit cards, no to credit cards. Credit cards debt will generally have recourse against the retirement plan owner, resulting in an extension of credit prohibited transaction. Debit cards, assuming no overdraft, do not involve credit and their use would not result in a prohibited transaction – just don’t accidentally use it for personal use.