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Prohibited Transactions and Disqualified Basics Interview with Quincy Long

Posted on by Quest Trust Company
Estimated reading time: 12 minutes

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.

IRA Prohibited Transactions

Posted on by questadmin

Estimated reading time: 10 minutes

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)

[2] 408(m)
[3] 408(m)(2). No other personal property has been specified by the Secretary at this time.
[4] 408(m)(3)
[5] 408(m)(1)
[6] See IRS website at www.irs.gov in the Frequently Asked Questions on IRAs section.
[7] See 26 USC 4975(c)(1)
[8] 4975(c)(1)(A)
[9] 4975(c)(1)(B)
[10] 4975(c)(1)(C) [11] 4975(c)(1)(D) This is far easier to violate than you might imagine. See the Joseph R. Rollins v. Commissioner of Internal Revenue case.
[12] 4975(c)(1)(E) This provision and 4975(c)(1)(F) are known as the conflict of interest provisions. Note that in these two sections the disqualified person involved is a fiduciary of the IRA.
[13] 4975(c)(1)(F) [14] See 26 CFR 54.4975-6(a)(5)(i)
[15] See 4975(d), for example. Also, there are various class prohibited transaction exemptions (PTE’s) which are issued by the Department of Labor (DOL). These can be viewed on DOL’s website – www.dol.gov/ebsa/compliance_assistance.html.
[16] You may get more information on obtaining a PTE from the DOL website – www.dol.gov/ebsa/compliance_assistance.html.
[17] 4975(e)(2)(A)
[18] The definition of a fiduciary is in 4975(e)(3).
[19] 4975(e)(2)(B)
[20] 4975(e)(2)(C)
[21] 4975(e)(2)(D)
[22] 4975(e)(2)(E)
[23] 4975(e)(2)(F). The definition of who is included as a member of the family is in 4975(e)(6).
[24] IRM 4.72.11. This is available on the IRS website at www.irs.gov.
[25] 4975(e)(2)(G)
[26] The constructive ownership rules of Internal Revenue Code §267(c) are incorporated into this rule by 4975(e)(4) and 4975(e)(5), except that the members of the family are considered to be those described in 4975(e)(6).
[27] For an example of how the indirect ownership rule applies, see Advisory Opinion 2006-09A (Appelt), in which the Department of Labor ruled that ownership of shares of a corporation (or other entity) by certain family members of a fiduciary is imputed to that fiduciary. The relevant family members are the ones referenced in 4975(e)(6), which includes the fiduciary’s spouse, ancestor, lineal descendant, and any spouse of a lineal descendant. In the Appelt opinion letter, the ownership of a corporation 87.5% by Mr. Appelt’s daughter and son-in-law was imputed to him, so that the proposed transaction between Mr. Appelt’s IRA and the corporation was deemed to be a prohibited transaction under 4975(c)(1)(A) & (B).
[28] 4975(e)(2)(H)
[29] 4975(e)(2)(I)
[30] 408(e)(2)
[31] 4975(a)
[32] 4975(b)