I. Investment Restrictions – What Your IRA Cannot Invest In
The Internal Revenue Code does not say anywhere what investments are acceptable for an IRA. The only guidance in the Code is what investments are not acceptable – life insurance contracts[1] and “collectibles.”[2] “Collectibles” are defined as any work of art, any rug or antique, any metal or gem, any stamp or coin, any alcoholic beverage, and any other tangible personal property specified by the Secretary.[3] An exception to these restrictions exists for certain U.S. minted gold, silver and platinum coins, coins issued under the laws of any state, and gold, silver, platinum or palladium bullion.[4] If you direct your IRA to invest in any prohibited collectible, your IRA will be deemed to be distributed to you to the extent of the investment.[5] Everything else can be purchased in an IRA, provided that the custodian is willing to hold the asset. According to the Internal Revenue Service, “IRA trustees are permitted to impose additional restrictions on investments. For example, because of administrative burdens, many IRA trustees do not permit IRA owners to invest IRA funds in real estate. IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”[6] II. Transaction Restrictions – What Your IRA Cannot Do Legally Although the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited.[7] If your IRA enters into a prohibited transaction, there are severe consequences (see below), both for you as the IRA owner and for disqualified persons who participate, so it is important to understand what constitutes a prohibited transaction. The general rule is that a “prohibited transaction” means any direct or indirect –
- Sale or exchange, or leasing, of any property between a plan and a disqualified person;[8]
- Lending of money or other extension of credit between a plan and a disqualified person;[9]
- Furnishing of goods, services, or facilities between a plan and a disqualified person;[10]
- Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the plan;[11]
- 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;[12] or
- 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.[13]
Note that all of these transactions involve a “plan” (including an IRA) and a “disqualified person.” Therefore, in order to see whether or not a transaction is prohibited, you have to understand both what is prohibited and who is a disqualified person. In the next section disqualified persons will be discussed in more detail. Essentially, the prohibited transaction rules were made 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 owner (other than as a beneficiary of the IRA) or any other disqualified person. Investment transactions are supposed to be on an arms length basis. 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.[14] 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. There are various exemptions and exceptions to the definition of a prohibited transaction,[15] but unless you know of a specific exception, the wisest course is to stay away from a transaction involving one of the above situations. You may seek a one time individual prohibited transaction exemption (PTE) from the Department of Labor (DOL) if you want to do something which is prohibited. For example, you may be able to get a PTE to sell real estate owned by your IRA to you or another disqualified person for market value, even though this would normally be a prohibited transaction, by going through the formal process.[16] Also, if you are unsure about whether a transaction is prohibited you may ask the DOL for an Advisory Opinion Letter or the Internal Revenue Service for a Private Letter Ruling. Advisory Opinion Letters and Private Letter Rulings are only applicable to the person requesting them, but reviewing Advisory Opinion Letters and Private Letter Rulings often give hints about how the DOL or the IRS might interpret certain transactions. III. Person Restrictions – Who Your IRA Cannot Do Transactions With As noted above, all prohibited transactions involve both a plan and a disqualified person. The definition of a disqualified person is designed to make sure that transactions done in an IRA are on an arms length basis and for investment purposes only. Disqualified persons are deemed to be too close for a transaction to be arms length. There are four major classes of disqualified persons and five additional classes of disqualified persons who have relationships with the first four. The four major ones are: 1) A fiduciary,[17] 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.[18] 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 owner who exercises control over the management or disposition of its assets. 2) A person providing services to the plan.[19] This can include attorneys, CPA’s and your third party administrator. 3) An employer any of whose employees are covered by the plan.[20] 4) An employee organization any of whose members are covered by the plan.[21] The five additional classes of disqualified persons include: 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 in paragraphs 3 and 4.[22] 6) A member of the family[23] of any individual described above in paragraphs 1, 2, 3, and 5, 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).”[24] The focus in this case is not on the family member, who may not be a disqualified person or may fit within an exemption such as 4975(d)(2) (the “reasonable compensation” exemption), but rather on the benefit to the fiduciary, who is a disqualified person. 7) A corporation, partnership, trust, or estate owned 50% or more, directly or indirectly, by the first 5 types of disqualified persons described above.[25] Caution: Note that the ownership can be “directly or indirectly.”[26] This means that ownership by certain family members of a disqualified person counts as ownership by the disqualified person for purposes of this rule. For example, the ownership by an IRA owner of 25% and the ownership by the IRA owner’s spouse of 25% is aggregated together to disqualify the corporation, partnership, trust or estate.[27] 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.[28] Caution: This can catch some people by surprise. For example, suppose Ira N. Vestor and Will B. Richer are unrelated friends. They decide to purchase, rehab and sell real estate. To do this they form a limited liability company. Will B. Richer now is a disqualified person as to Ira N. Vestor’s IRA, even though they have no other relationship. Similarly, if Ira owns a business that is incorporated and his secretary earns at least 10% of the yearly wages paid by that corporation, she is a disqualified person and cannot enter into any transaction with Ira N. Vestor’s IRA. 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.[29] Caution: Note how far removed from the IRA this disqualified person is. In the above example where Ira N. Vestor and Will B. Richer formed an LLC, under this rule any 10 percent or more partner or joint venturer of their LLC is also a disqualified person. IV. Crime and Punishment – What Happens to Your IRA if You Make a Mistake For the IRA Owner. If the IRA owner enters into a prohibited transaction during the year, the IRA ceases to be an IRA as of the first day of that taxable year.[30] The value of the entire IRA is treated as a distribution for that year, and if the IRA owner is not yet 59 1/2, there could be premature distribution penalties also. Since the IRS often does not catch the prohibited transaction for several years, additional penalties can accrue for underreporting income from transactions in years after the prohibited transaction took place. For Other Disqualified Persons. Initially, an excise tax of 15% of the amount involved for each year (or part of a year) is paid by any disqualified person who participated in the prohibited transaction.[31] An additional tax equal to 100% of the amount involved is also imposed on a disqualified person who participates in the prohibited transaction if the transaction is not corrected within the taxable period.[32]
[1] See 26 USC 408(a)(3)