Clients will often ask me what I think is the most important thing for them to learn before they have us set them up with a CheckBook IRA LLC. I always answer that the subject of prohibited transactions is by far the most important. It can sometimes seem a bit confusing, especially for those who have just found out they can combine a self directed IRA and LLC, but hopefully this series will make it a bit easier.
(NOTE : For purposes of this series, I will use disqualified and prohibited interchangeably when speaking of parties that are not allowed to deal with the IRA LLC; the two terms mean the same thing, and you’ll see both used. So, a disqualified person is the same as a prohibited person or party, a prohibited entity is the same as a disqualified entity, etc…)
The first thing we’ll look at is the section of the code that defines a prohibited transaction. Let’s look at USC›Title 26›Subtitle D›Chapter 43›§ 4975 (c)(1):
(c) Prohibited transaction
(1) General rule
For purposes of this section, the term “prohibited transaction” means 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 a 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; 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.
So there it is. You could take this entire section and reduce it to the following sentence “Any direct or indirect deal or transaction of any kind between a plan and any disqualified person is a prohibited transaction.” Pretty straightforward, but I can’t emphasize how important it is to understand that any deal or transaction of any kind, between any prohibited person is off-limits. This is a black and white rule; no exceptions.
Further, notice that the Service has used the words “direct or indirect” to encompass as wide a berth as possible. We’ll get into some examples in a later post. If a prohibited person deals with, or benefits from any deal or transaction that the CheckBook IRA LLC engages in, then that transaction is prohibited. Now that we know that a prohibited transaction occurs when the CheckBook IRA LLC deals with a prohibited person, in the next part we’ll identify exactly who is considered a prohibited person.
Invest intelligently. Enjoy the rewards.
Prohibited Transaction Rules, Part II: Who is a Prohibited Person?
Prohibited Transaction Rules, Part III: Disqualified Entities
What if my IRA makes a loan to my son for say college tuition, but does it at fair market value, so everything would be on the level. So long as he paid the loan back, and it wasn’t a no interest loan or anything like that, wouldn’t that be ok to do?
It would be prohibited transaction if your IRA or IRA LLC were to loan money to your son for any reason whatsoever. I point out in Prohibited Transaction Rules, Part IV: IRA LLC Examples that any transaction of any kind between the IRA LLC and any prohibited party would result in a prohibited transaction.
The important thing to realize here is that your son is a prohibited party. So, any transaction with him would be off-limits. The fact that the transaction would be at fair market value and would be on the level, so to speak, is irrelevant. The controlling issue is that a transaction would occur between the IRA LLC and a prohibited party.
Some of these rules can seem counterintuitive, and so that’s why its always good to ask questions. Feel free to contact us directly at 1-800-482-2760 or through our Contact Us page. We’ll be more than happy to go through any investments you have in mind, and make sure you won’t be engaged in any prohibited activity.
So how are the exemptions handled as stated in 26 U.S. Code § 4975 – Tax on prohibited transactions: The first 5 of 22 which I’ve listed below. Does the IRS ignore these? If so, under what legal premise? If not, how can they be utilized to the taxpayer’s advantage?
(d) Exemptions
Except as provided in subsection (f)(6), the prohibitions provided in subsection (c) shall not apply to—
(1) any loan made by the plan to a disqualified person who is a participant or beneficiary of the plan if such loan—
(A) is available to all such participants or beneficiaries on a reasonably equivalent basis,
(B) is not made available to highly compensated employees (within the meaning of section 414 (q)) in an amount greater than the amount made available to other employees,
(C) is made in accordance with specific provisions regarding such loans set forth in the plan,
(D) bears a reasonable rate of interest, and
(E) is adequately secured;
(2) any contract, or reasonable arrangement, made with a disqualified person for office space, or legal, accounting, or other services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefor;
(3) any loan to an [1] leveraged employee stock ownership plan (as defined in subsection (e)(7)), if—
(A) such loan is primarily for the benefit of participants and beneficiaries of the plan, and
(B) such loan is at a reasonable rate of interest, and any collateral which is given to a disqualified person by the plan consists only of qualifying employer securities (as defined in subsection (e)(8));
(4) the investment of all or part of a plan’s assets in deposits which bear a reasonable interest rate in a bank or similar financial institution supervised by the United States or a State, if such bank or other institution is a fiduciary of such plan and if—
(A) the plan covers only employees of such bank or other institution and employees of affiliates of such bank or other institution, or
(B) such investment is expressly authorized by a provision of the plan or by a fiduciary (other than such bank or institution or affiliates thereof) who is expressly empowered by the plan to so instruct the trustee with respect to such investment;
(5) any contract for life insurance, health insurance, or annuities with one or more insurers which are qualified to do business in a State if the plan pays no more than adequate consideration, and if each such insurer or insurers is—
(A) the employer maintaining the plan, or
(B) a disqualified person which is wholly owned (directly or indirectly) by the employer establishing the plan, or by any person which is a disqualified person with respect to the plan, but only if the total premiums and annuity considerations written by such insurers for life insurance, health insurance, or annuities for all plans (and their employers) with respect to which such insurers are disqualified persons (not including premiums or annuity considerations written by the employer maintaining the plan) do not exceed 5 percent of the total premiums and annuity considerations written for all lines of insurance in that year by such insurers (not including premiums or annuity considerations written by the employer maintaining the plan);
The DOL has a procedure in place to apply for exemptions. You can find an overview on the DOL’s site here.
The exemptions you listed below don’t apply to IRAs; they only apply to a plan that is sponsored by an employer, such as a 401(k), the only exception would be SIMPLE IRAs. If you read through each exemption, the context of each of them is an employer plan and its employees. IRAs (except for a SIMPLE IRA) are individual accounts, with no employer sponsor and no employees.
When the DOL issues exemptions, they issue them in two classes. The first is an individual exemption, in which they clear a transaction only for that particular person. No one else can claim the same transaction under that exemption, other than the applicant. The other is a class exemption. A class exemption is an exemption to anyone who’s situation is the same as the applicant’s.
I have a traditional IRA+LLC set up by your firm. It currently owns two rental houses. One major problem is distributing a parcel of real estate due to tax implication. Would it be considered a disqualified transaction to sell on contract or otherwise to a Roth IRA held by the same individual?
Technically, the law reads “between a plan and a disqualified person”. But because of the implications, this requires a knowledgeable answer rather than my simplistic interpretation…
Hi Pete,
Thanks for the question. I think it would be best if you call us directly at 1-800-482-2760. This is a tricky issue that depends on a person’s situation, so it would be inappropriate for me to try to answer this via blog comment.
Would a loan to a step son or step daughter be allowed? Is a step son or step daughter considered a lineal descendant?
Hi Joel,
Step children are not included in the definition of prohibited party. The only reference I can point to here is a bankruptcy case in Georgia, in which the judge identified that step children are not considered prohibited parties, though he qualifies that statement with the following: