How to Avoid Prohibited Transactions With Your IRA
If you engage in a prohibited transaction, the IRS has the power to treat the IRA as 100% taxable immediately! Furthermore, if the IRA owner is under the age of 59 ½, the 10% premature distribution will apply. Prohibited transaction situations are not something to fool around with.
Definitions of Key Terms-Prohibited Transaction, Disqualified Person, and Fiduciary
Internal Revenue Code Section 4975 defines the term “prohibited transaction” to mean any direct or indirect:
(a) sale or 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 interests or for his own account;
(f) receipt of any consideration for his own person 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 assests of the plan.
Internal Revenue Code Section 4975 defines the term “disqualified person” to mean a person who is:
(a) a fiduciary;
(b) a person providing services to the plan;
(c) an employer any of whose employees are covered by the plan;
(d) an employee organization any of whose members are covered by the plan;
(e) an owner, direct or indirect, of 50 percent of stock or more of –
(i) the combined voting ower of all classes of stock entitled to vote or the total
value of shares of all classes of stock of a corporation,
(ii) the capital interest or the profits interest of a partnership,
(iii) the beneficial interest of a trust or unimcorporated enterprise,
which is an employer or an employee organization described in subparagraph (c) or (d);
(f) a member of the family of any individual described in subparagraph (a), (b), (c) or (e)
for purposes of this paragraph the family of any individual shall include his spouse,
ancestor, lineal descendant, and any spouse;
(g) a corporation, partnership, or trust or estate of which (or in which) 50 percent or more of
(i) the combined voting power of all classes of stock entitled to vote or the total
value of shares of all classes of stock of such corporation,
(ii) the capital interest or profits interest of such partnership, or
(iii) the beneficial interest of such trust or estate is owned directly or indirectly,
or held by persons described in subparagraph (a), (b), (c), (d), or (e);
(h) 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
described in subparagraph ©, (d), (e), or (g); or
(i) a 10 percent or more (in capital or profits) partner or joint venturer of a person described
in subparagraph (c ), (d), (e), or (g).
Internal Revenue Code Section 4975 defines the term “fiduciary to mean any person who –
(a) 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,
(b) 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
(c) has any discretionary authority or discretionary responsibility in the administration of such plan.
In summary, a disqualified person is the IRA owner’s spouse, ancestors, descendents, spouses of descendents, any entity owned 50% by any of these individuals, and anyone who provides an indirect benefit to the IRA owner.
Department of Labor Rules
The Department of Labor has set out rules that say when assets held by an entity become plan assets for determining whether a anyone exercising control over those assets becomes a fiduciary of the IRA and therefore a disqualified person. The follow-through is that if the person is a disqualified person, then any act by that disqualified person is a prohibited transaction.
Generally, the assets of an entity are considered to be plan assets for determining if a prohibited transaction has taken place unless:
1) the investment in the entity is debt, not equity,
2) the entity is publicly traded,
3) the combined investment in the entity is less than 25% provided
(a) the share of anyone having authority or control over the assets of the
entity is included in the 25%,
(b) all investing IRAs are included in the 25%,
(c) all investing entities in which the combined investment in the entity is 25% or
or more are included in the 25%
4) the entity is an operating company, including a real estate operating company
or a venture capital operating company – subject to look through if 100% of the
operating company is owned by a group of related plans.
Examples of Prohibited Transactions
1) The IRA pays a management fee to the IRA owner or a related party.
2) IRA owner or related party uses IRA assets to purchase, in whole or part, personal assets, for example a personal residence, a vacation home, a retirement home, etc.
3) IRA owner or related party buys a life insurance policy on his or her life with IRA assets.
4) IRA owner or related party uses IRA funds to buy collectibles.
5) IRA owner or related party loans or borrows funds to or from an IRA.
6) IRA owner or related party pays expenses personally related to an IRA asset and is reimbursed by the IRA.
7) IRA owner or related party collects rents personally related to an IRA asset, pays expenses from the rents, and remits the net rent to the IRA account.
8) IRA owner or related party personally paints the IRA asset.
9) Related party works as an employee for a business owned by the IRA.
10) IRA owner obtains a mortgage on real estate in the IRA but has to personally guarantee the mortgage.
Using IRAs to Invest in Real Estate – Some Questions
Suppose the property needs $15,000 of improvements and the IRA owner wants to put the $15,000 into the account. How will the IRA owner avoid the excess contribution 6% penalty which would apply for every year the excess remains in the account? Suppose, the IRA owner becomes 70 ½ and needs to take required minimum distributions. How is the beginning balance value to be determined? Will the real estate throw off enough cash flow to meet the required distribution? Cash flow on real estate is usually low, nonexistent, or worse, negative. Where will funds come from to finance improvements? Normally, real estate throws off depreciation and upon sale, the gain is taxed at capital gain rates. Since the distributions from an IRA are taxed at ordinary marginal rates, how will ownership of real estate by an IRA overcome that tax disadvantage? In the case of death, the IRA account is not stepped up to the fair market value at date of death, which is not the case if real estate is owned outside the IRA. How will this disadvantage be offset by IRA ownership? Where will the IRA owner find a financial institution/professional management firm that is able to abide by the Prudent Man rules regarding asset allocation?
Don’t do it unless you are going to hire a professional manager with expertise in dealing with prohibited transactions and will perform all functions. The IRA owner must maintain a complete 100% hands-off posture, with no relationships or transactions with family members. The IRA owner must have sufficient cash reserves to allow that to happen. The IRA account used should be a new one, not one with prior contributions and rollover monies that would be at risk should a prohibited transaction accidently or negligently occur. Any questionable transaction should be submitted to the Department of Labor for approval before doing the transaction. There are just too many ways to make a mistake. It only takes one mistake, one prohibited transaction to disqualify the IRA tax-deferred status.
If an IRA owner really wants the diversity of real estate investments, there are plenty of Real Estate Investment Trusts (REITs) available. If they are publicly traded, they are excluded automatically from the danger of prohibited transactions.
What about retirement accounts for the same individual in the same bank that exceed $250,000? Ahh, that’s a problem, but there are solutions. The standard direct trustee-to-trustee transfer method of moving funds from one financial institution to another works if the bank presently holding the retirement accounts will allow the transfer(s). That’s a key question. If the bank will not allow the direct trustee-to-trustee transfer(s), the only alternative of moving funds is to take a check from Bank A to Bank B.
How should the payee read on the check? It should read as follows: “Bank B as trustee of the Individual Retirement Account for John Doe” or Trustee of ABC Company 401(k) Plan”. The IRA owner must orchestrate this, for clerks at Bank A may not be sophisticated enough to appreciate the importance of getting this right. The IRA owner should refer the clerk to IRS Regulation §1.401(a)(31)-1. It will tell the clerk exactly how to make out the check.
Suppose the IRA owner is not diligent, ignoring the IRS regulation. Bank A will make out the check to John Doe, withhold 20% federal income tax, and now John Doe has 60 days to put the full pre-tax amount into the new retirement account at Bank B. John will also have to use his reserve cash to fill in the gap caused by the withholding tax. Now John is dealing with a technical rollover. John is now exposed to the risk of missing the 60 day deadline for accomplishing the rollover.
Additionally, John is going to have to check whether or not there has been a rollover (as opposed to the direct trustee-to-trustee transfer) within the last 365 days on this account that he wants to move from Bank A to Bank B. If the contemplated transfer is a second rollover within 365 days, then safety better be a huge issue, because the withdrawal will be taxable and if John is under 59 ½, the 10% premature penalty will apply.
Securities Investor Protection Corp. (SPIC) Insurance
Most, if not all, brokerage firms are SPIC members. As such, they contribute to a reserve fund that provides up to $500,000 per customer for broker theft or brokerage firm failure. This protection covers only brokerage accounts, not bank accounts. A few firms carry private insurance that is unlimited. Fidelity Investments is one of those firms. Therefore, all account balances with Fidelity Investments are protected, preventing the need to do trustee-to-trustee transfers.
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