Entity Investments in Your IRA – Prohibited Transactions and Disqualified Persons

This article is part of a series of articles discussing some issues arising when investing your IRA into an entity, such as a limited liability company, corporation, limited partnership, or trust.  Other articles in this series include advantages and cautions when making entity investments, unrelated business income (UBI) and unrelated debt-financed income (UDFI) as it relates to entity investments, the plan asset regulations and other regulations which may apply, and formation and management issues, including the “checkbook control” LLC which has become so popular in the self-directed IRA industry.

As with any self-directed IRA investment, when investing your IRA in an entity you must know what transactions are prohibited and who is disqualified from doing business with your IRA or benefiting from your IRA’s investments. The general rule, as defined in Internal Revenue Code (“IRC”) Section 4975(c)(1), is that a “prohibited transaction” means any direct or indirect

A)       Saleor exchange, or leasing, of any property between a plan and a disqualified person;

B)        Lending of money or other extension of credit between a plan and a disqualified person;

C)        Furnishing of goods, services, or facilities between a plan and a disqualified person;

D)        Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the plan;

E)        Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or

F)         Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

Essentially, the prohibited transaction rules are intended to discourage disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA holder (other than as a beneficiary of the IRA) or any other disqualified person.  Investment transactions are supposed to be on an arms length basis.  There are various exceptions and class exemptions to the prohibited transaction rules, but unless you know of a specific exception, the wisest course is to stay away from a transaction involving one of the above situations.

Note that the last two restrictions listed above (E and F) apply to a special class of disqualified persons who are also fiduciaries.  These two provisions are designed to ensure that the fiduciary does not participate in a transaction in which he or she may have a conflict of interest.  At least in the context of a self-directed IRA, the IRA holder is considered to be a fiduciary of the plan.  Other fiduciaries may include officers, directors and managers of entities owned by IRA’s.  Fiduciaries of retirement plans owe a duty of undivided loyalty to the plans for which they act.  The prohibitions are therefore imposed on fiduciaries to deter them from exercising the authority, control, or responsibility which makes them fiduciaries when they have interests which may conflict with the interests of the plans for which they act.  Any action taken where there is a conflict of interest which may affect the best judgment of the fiduciary is likely to be a prohibited transaction.

All prohibited transactions involve a plan and a disqualified person.  There are nine different classes of disqualified persons.  They are:

1)         A fiduciary, which is defined to include any person who – exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets; renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so; or has any discretionary authority or discretionary responsibility in the administration of such plan.

Note that this definition of a fiduciary is much broader than in traditional trust law, and at least with a self-directed IRA includes the IRA holder who exercises control over the management or disposition of its assets.

2)         A person providing services to the plan.  This can include attorneys, CPA’s and your third party administrator.

3)         An employer any of whose employees are covered by the plan.

4)         An employee organization any of whose members are covered by the plan.

5)         An owner, direct or indirect, of 50 percent or more of the voting power of stock in a corporation, the profits or capital interest in a partnership, or the beneficial interest in a trust or other unincorporated enterprise which is an employer or employee organization described above.

6)         A member of the family of any of the above individuals, which is defined to include only a spouse, ancestor, lineal descendant and any spouse of a lineal descendant.

Caution:  Although other members of the family are not disqualified persons (for example, brothers, sisters, aunts, uncles, step-children), dealing with close family members may still be a prohibited transaction because of the indirect rule.  For example, in the IRS Audit Manual it states:  “Included within the concept of indirect benefit to a fiduciary is a benefit to someone in whom the fiduciary has an interest that would affect his/her fiduciary judgement (sic).  An example would be the retention by the fiduciary of his/her son to provide administrative services to the plan for a fee.”  This is true even though the son’s provision of services to the plan may be exempt under the “reasonable compensation” exception.

7)         A corporation, partnership, trust, or estate owned 50% or more, directly or indirectly, by the first 5 types of disqualified persons described above.  Note that indirect ownership may include ownership by certain related parties such as spouses.

8)         An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person who is an employer or employee organization, the owner of 50% or more of an employer or employee organization, or a corporation, partnership, trust, or estate which is itself a disqualified person.

9)         A 10 percent or more (in capital or profits) partner or joint venturer of a person who is an employer or employee organization, the owner of 50% or more of an employer or employee organization, or a corporation, partnership, trust, or estate which is itself a disqualified person.

As I always say, “Don’t mess with the IRS, because they have what it takes to take what you have!” A Quest Trust Company self-directed IRA is an excellent tool to help your retirement savings grow, often at rates far exceeding those of ordinary IRA’s.  Knowing these rules is a critical step in learning to use your self-directed IRA in a way that will safely lead to vastly improved retirement wealth.