Understanding prohibited transaction rules and how to follow them is arguably the most important part of self-directed IRA investing. Sometimes, it’s easy for new IRA investors to get caught up in the excitement of possibilities that come along with self-directed investing strategies that they forget to take the time to research what isn’t allowed with IRAs. This is a very important topic when it comes to making sure your IRA stays compliant with the rules and regulations of the IRS.
The purpose of this article is to ease anyone who is new to self-directed IRAs into the topic of disqualified people and prohibited transactions. I have Quincy Long with us, the CEO of Quest Trust Company. He is joining me to talk a little bit about prohibited transactions and what that really means in relation to self-directed IRAs.
Sarah: Quincy, for those that may not know who you are… Can you tell me a little bit about yourself and how you started Quest Trust Company, formerly Quest IRA?
Quincy: Thank you. Yes, I actually had a bad day in the title company business. I was a fee attorney for American Title Company. I got in a scuffle with one of the realtors because of loan papers. Of course, the lender didn’t get it to me till 30 minutes before their closing. So, I was bored one day – kind of getting bored with being a title attorney. I had called my service provider for my self-directed IRA, and they said, “Oh, by the way, if you want, you can be our first affiliate in Texas.” When we did that, we formed a company predecessor called Entrust. Over the years it became a franchise. Then, we busted up the franchise and went our separate ways three years ago. Now, we turned into a trust company. We’re a fully licensed custodian for IRAs and other trust activities in Texas. I am the CEO, chairman of the board, and majority owner.
Sarah: Thank you for giving us a little bit of your background and how you started Quest. I love hearing the timeline. Now, when people are getting started and first discovering self-directed IRAs, we hear a lot about the benefits and what makes them great, which they are. Now, there are some things that people need to be aware of, though, one of those topics being disqualified people and prohibited transactions. Can you tell us – just very simply defined – what is a prohibited transaction?
Quincy: To define what a prohibited transaction is, you have to start with who or what is a disqualified person. And that’s a person that the IRS thinks is too close to you to make it “an arm’s length transaction”. The whole purpose of the rules is to keep certain people from interacting with or benefiting from transactions in your account. So, for example, a prohibited transaction is a sale and purchase, or exchanged for real estate between an IRA and a disqualified person. If you wanted to buy a house in your IRA, you could. That’s not a problem. But, if it’s from or to a disqualified person, then it’s basically a no-no; you can’t do that. The deal is that a prohibited transaction is simply one word on that list, that statutory list. The disqualified persons are not able to enter into deals with the IRA directly or indirectly, nor benefit directly or indirectly.
Sarah: Let’s talk about this disqualified persons list. How can someone determine who is a disqualified person? What are these rules?
Quincy: You have a statutory defined list of disqualified people. The list is kind of long, if you get to digging into it. [It’s] your spouse, your parents, your grandparents, your kids, your grandkids and their spouses… all are disqualified. But why? That’s the important question. They’re disqualified because they are related to the owner of the account, which is a fiduciary. When you have a fiduciary, the fiduciary brings along your family and any corporation, partnership, or trust where he or she owns a controlling majority interest in. And if the entity is disqualified, then a whole bunch of other people come in, too.
Sarah: So, one question that we get a lot… brothers or sisters, aunts and uncles. Would this be blatantly prohibited?
Quincy: No, it would not be blatantly prohibited. But remember, we have either direct or indirect. I have a perfect example from a story when I was younger doing the actual transactions. A guy called me up and said, “Can I loan money to my brother?” Well, it’s not disqualifying; your brother’s not a disqualified person. But, if there’s any way that this comes back as some benefit, that’s going to be prohibited. He said, “Well, I was going to loan the money to get the maximum amount personally.” Well, that’s taking two steps to do what you can’t do in one. That’s an example of the indirect benefit rule. He was going to benefit personally and indirectly. He knew he couldn’t transfer it directly to disqualified persons. But, he just took two steps. The list of disqualified persons is fixed. It’s a complicated list to decipher, and if you’re not even used to reading statutes (and I’ve written some materials to make it clear), it’s still a long list and it’s fixed by statute.
Sarah: I agree, it is definitely complicated! And it can get even more difficult to understand when you factor in direct and indirect benefits. Can you go a little bit further into what that exactly means?
Quincy: Well, the IRS is not crazy. They know that if they don’t have some rules, that you’ll just do anything and move money into the account. They’re trying to avoid you benefiting now, because it’s an individual retirement account, not an individual NOW account, right? So, retirement is the key. When you put the retirement age – or some other qualifying distribution – then that’s when you’re allowed to take it. You really have to look at this as “you” and “I”, or “Mr. IRA”, as we call him. Mr. IRA is a separate legal person from you. And, because he’s a separate legal person and you are his fiduciary or caretaker, you’ve got to do everything for the benefit of Mr. IRA, not you or any other disqualified person like you. So, you say, “That’s my money!” Well, no… it’s Mr. IRA’s money. Mr. IRA may be generous and give you some money. You have to do everything for the benefit of Mr. IRA. Now, direct and indirect. Directly, well, you can’t buy a house from your IRA and your IRA can’t buy a house for you or anything like that, simply because it involves a disqualified person, which is you. That’s one of the things you can’t do.
People then come up and say, “Well, I have this idea. All of my friends started the LLC, so I’ll sell it to my friend and then have my friend sell it to me.” Again, that’s just taken two steps, which you’re not permitted to do. That’s indirect benefit.
Sarah: Right. And those examples are really helpful.
Quincy: The other thing is that it also comes in the context of whether an entity, a partnership, trust, corporation, or estate is a disqualified person. Then, the rules say that several other people are disqualified, too. This is where the indirect rule comes in to play. Ownership of family members of the fiduciary (the IRA owner) and also their ownership percentages are attributed to the fiduciary. So, for example, I own less than 50%, because I own 48%. My wife owns 48% and a non-related party owns 2%. I’m good, right? Wrong. Her ownership is attributed to me, because she’s one of the best qualified people. You can try to stick another party in there or some other fact in there, but it’s not going to work.
Sarah: What are some of the most common prohibited transactions that you’ve seen people involved in?
Quincy: So, I don’t know what the most common one is. It’s more like… the most common way to do prohibited transactions is by not understanding what it is that you’re doing. And that, again, starts with a list of disqualified people. It gets complicated for people to understand. Also, another thing that they fail to understand is that a transaction can be prohibited under more than one section. So, they say, “The entity is not disqualified. I’m done.” No, you’re not. There are a few more things you’ve got to ask. There still could be a prohibited transaction under a different section. The mistake is not understanding how to analyze it in this sense. See, 100% of the time, there’s always at least one disqualified person involved and who’s that?
Sarah: The IRA.
Quincy: That’s correct. People don’t get this concept. So, the question is never “is there a problem?” or “Is there a disqualified person”? The question is, “is there a disqualified person acting in an inappropriate way,”? In this case, inappropriate meaning, in violation. Without that understanding, people think they can get away with stuff that they can’t, because they’re not remembering that the rules apply indirectly, as well as, directly.
Sarah: I think that’s a good way to answer that question, because there really aren’t “common” prohibited transactions. If you understand what you’re doing, hopefully you’re not going to be involved in them at all.
Quincy: And we do a lot of educating.
Sarah: We sure do. We actually have a really good class on our YouTube page about ways to avoid these common mistakes. It also discusses disqualified persons, but let’s talk about business partners. Can my Self-Directed IRA enter into a transaction with my business partner who is not a family member? What if they are a family member?
Quincy: Well, that, of course, depends on the facts and circumstances. Here’s what it depends on: if you, the IRA owner, control 50% or more of an entity of some type, then that entity is disqualified. That’s the first step. Then you bring in a whole bunch of other people who are disqualified. Once you are, the entity is disqualified. That would include 10% or more partners in the entity. So, the answer to your question is… is it owned 50% or more by you or your family members (which again, their ownership is attributed to you)? That’s where it can be kind of tricky. You’ve got to go into this, that, that if not this, etc. And the thing is, we’re used to analyzing it every day. We don’t give advice, but we educate people. We were just kind of used to it.
Sarah: Right, not everyone is, but that’s where we come into play. Now, let’s say they hadn’t taken the time to educate themselves. If the IRS were to catch the IRA owner that has done a prohibited transaction, what would happen?
Quincy: What would happen is, the IRA would become disqualified and not an IRA, basically, as of January 1st for the year in which the prohibited transaction took place. And all the money that you thought you were earning in the SDIRA? No.
Sarah: Losing all the money you had been saving does NOT sound like fun.
Quincy: And that’s not all, though. The prohibited transaction rules also have a penalty for any other disqualified person participating. As an example, suppose that I loaned money to my son or daughter. Well, they’re disqualified persons under the family rule. A loan to them from me, directly or indirectly, is going to be a prohibited transaction. There can be penalties for the IRA owner, as well as for other disqualified persons who may have participated or benefited from the transaction.
Sarah: It’s best to just not get involved in one in the first place. So, Quincy, what are some of your top few tips for people that are starting to invest with their self-directed IRA? What tips can you give to help ensure that they don’t find themselves involved in a prohibited transaction?
Quincy: Figure out what to disqualify. Make a list of every transaction and try to determine whether they are not disqualified persons. Always start the list with yourself, or the owner, as the first person on the list. Even if it’s not prohibited, you’re always on the list, so you can’t benefit directly or indirectly. Understanding that is critical to the rest of it. Once you do that, you go through the rules themselves. They’re not too hard, well, don’t seem too hard until you get down to some of the other ones. So, it’s understanding who to disqualify and what the direct or indirect part in it is. Even worse, when you go down the list and then say you can’t provide goods, facilities, or services. What the heck does that mean? It’s pretty easy. Let’s start with those goods, like building materials or something like that. They’re physical, tangible things. Also, if you have a piece of property in your IRA, can you donate all of the materials to build a house on it? No. Then, facilities… that’s self-explanatory. If you have our own warehouse, can you keep your junk in it? No, because that’s providing facilities. But what is services? Nobody knows. Nobody knows what the definition of service is, but can you go down to stay in your beach house in Belize that’s owned by your IRA? No, because you’re benefitting yourself.
Sarah: Those are great examples, and I often have investors ask me questions about those exact scenarios.
Quincy: If you have to ask yourself the question, “Is this a prohibited transaction?”, then it probably is in one way or another. Do you just get the “ick” factor? If you can’t go to lunch with your friend, the IRS auditor, and laugh about what it is you’re doing and share it directly with him or her, then you probably shouldn’t do it. It’s probably prohibited in some way or manner or could be. If you have a situation and you’re not sure, get a lawyer. Get somebody who’s familiar with these things. Don’t be myopic. Don’t be focusing on whether the entity is disqualified and then stopping there. You have to analyze the whole thing for the whole length of the transaction and decide whether you could have a problem in the future.
Sarah: That’s a great answer, and I was going to add one other thing, but you kind of took the words right out of my mouth. If you’re reading this and ever have questions or suspicions, you can always call us and we can provide as much education as possible. Like you already mentioned, we don’t provide any tax, legal or investment advice, so seeking an outside professional would probably be a really good option if you have more in-depth questions. Any final remarks regarding prohibited transaction information that you’d like to share before we hear about it?
Quincy: Just don’t do it. You can do a whole lot of transactions and make millions of dollars tax-deferred, and in some cases, tax-free. It’s not worth it to play with the rules.
Sarah: You’re so right. Not when it’s your life savings. Absolutely not. Well, thank you so much for your time! I know this will be very helpful for those trying to understand prohibited transactions and disqualified persons.
Following the prohibited transaction and disqualified people rules will help ensure your account stays compliant with the IRS and doesn’t incur any hefty penalties. If you ever have questions about a potential investment or scenario that might be prohibited, give a Quest Trust Company Certified IRA Specialist a call at 855-FUN-IRAs (855-386-4727). To learn more about how to get started investing with a self-directed IRA, schedule a 1-on-1 consultation with an IRA Specialist by clicking HERE.