To fulfill their intended purpose in supporting saving for retirement, Congress grants the Individual Retirement Account (IRA) certain tax preferences, from tax-deductible contributions (in the case of traditional IRAs) to tax-free growth (for a Roth IRA). But to curtail potential tax abuse, the Internal Revenue Code also limits the range of permissible investments in an IRA, and explicitly bans life insurance contracts and collectibles (and under separate rules, S corporations cannot be owned in an IRA, either).
Furthermore, because an IRA is intended to be treated as a separate tax-preferenced retirement account from the other assets of the IRA owner, the Internal Revenue Code also contains a series of “prohibited transaction” rules intended to prevent the IRA owner from using the account to enrich themselves or their family members (without actually taking a taxable withdrawal). The prohibited transaction rules cause adverse tax consequences for the IRA if it engages in such prohibited transactions with any “disqualified person”, which includes the IRA owner themselves and his/her immediate family members (as well as certain related trusts and business entities).
Prohibited transactions themselves can include everything from buying or selling property between the IRA and a disqualified person, making the IRA assets available for a disqualified person’s use, or using IRA funds to compensate a disqualified person. Which is why it’s a prohibited transaction for an IRA owner to “fix up” a piece of IRA-owned real estate, or allow a family member to live in (for rent payments, or rent-free) property owned by the IRA, and even a financial advisor who earns a commission from selling an investment into a family member’s IRA can trigger a prohibited transaction (although level advisory fees are permitted). Similarly, an IRA owner must be caution not to pay any non-IRA investment management fees, or financial planning fees, using IRA assets (as the IRA should only pay its own advisory fees).
Fortunately, in the past the IRS has been fairly lax in pursuing and attempting to enforce against IRA prohibited transactions. But with the rise of self-directed IRAs buying real estate over the past decade, and more generally the popularity of using self-directed IRAs for “alternative” investments – which a recent GAO study estimates is now a $50B marketplace – there is a growing risk that the IRS will soon increase its enforcement on IRA prohibited transactions. Which means it’s crucial for IRA owners to take a careful look at how they’re using their IRA, especially for accounts that are not simply invested in “traditional” publicly traded securities… as even if a self-directed IRA provider affirms that it can hold a particular alternative investment, it’s still the legal responsibility of the IRA owner themselves to determine if it is permissible, and avoid triggering prohibited transactions!
Permitted Investments For IRA Accounts
The Individual Retirement Account (IRA) is a form of tax-subsidized savings account for retirement, where investors can enjoy a tax deduction on contribution, and ongoing tax-deferred growth, on their retirement investments. (Or alternatively in the case of a Roth IRA, no upfront tax deduction, but tax-deferred growth during the accumulation phase, and tax-free withdrawals of growth at the end.)
To ensure that retirement accounts are used “appropriately” for actual saving and long-term investing, though, IRC Section 408 places some limits the types of investments that can be held inside of an IRA. Thus, while most types of “traditional” (i.e., publicly traded) investments are permissible – like stocks and bonds, or mutual funds (or ETFs) that hold them – IRC Section 408(a)(3) explicitly prohibits IRA assets from being invested into life insurance contracts, and IRC Section 408(m) similarly prohibits investing IRA dollars into any form of collectibles (including artwork, rugs, antiques, gems, stamps, and coins, but not including certain gold, silver, or platinum coins or bullion). In addition, an S corporation cannot be owned by an IRA either – though not because it’s impermissible under the IRA rules, but instead because IRC Section 1361(b)(1) requires all S corporation owners to be “individuals”, and because an IRA is not merely akin to a grantor trust but is an entirely separate entity from the individual IRA owner, it is not an eligible S corporation owner, as affirmed under the Tax Court case of Taproot Administrative Services v. Commission of Internal Revenue Service (2009).
However, the reality is that there’s still a wide space of potential 'alternative' investments that lie between the extremes of permitted traditional stocks and bonds (or funds that hold them), and impermissible life insurance and collectibles and S corporations. Other types of investments that might be held in an IRA, but aren’t traditional publicly traded securities, include limited partnership investments (which might in turn invest into anything from energy interests to equipment leasing deals to tax liens or even crop farming), stock in a small (privately-held) business, or even a direct investment in real estate.
Yet while those investments aren’t specifically prohibited from being owned in an IRA, additional complexities do arise, because of the limitations that exist between IRA owners and their individual retirement accounts.
An IRA Owner’s Fiduciary Duty To His/Her IRA Account
The additional complications that arise with various types of alternative investments in an IRA derive from the fact that an IRA is technically a separate entity from its IRA owner who will ultimately use and benefit from the money. And as a result, the tax code requires that the assets of an IRA and its owner remain separate, and not be used in a manner where one indirectly enriches the other (above and beyond the permitted rules for making new IRA contributions, and taking IRA distributions).
Disqualified Persons and Prohibited Transactions Under IRC Section 4975
Specifically, IRC Section 4975 stipulates that an IRA owner (and anyone else responsible for the IRA account) is prohibited from commingling the financial interests of the IRA itself with its owner or any other related parties, all of whom are deemed to be “disqualified persons”.
Under IRC Section 4975(e)(2), self-directed IRA disqualified persons include:
- Any fiduciary to the account (which includes the IRA owner themselves)
- A member of the family (which includes a spouse, ancestor, lineal descendent, or a spouse of a lineal descendent)
- A corporation, partnership, trust, or estate where 50% or more of the shares/profits/beneficial-interests are owned by any of the above
- An officer, director, or 10%-or-more shareholder or partner of an entity described above
And to the extent someone (or some entity) is a “disqualified” person, he/she/it is prohibited under IRC Section 4975(c)(1) from any of the following direct or indirect transactions between the IRA account and a disqualified person:
- Sale, exchange, or leasing of property (even if transacted at a fair market value price)
- Lending of money or extending credit (in either direction)
- Furnishing of goods, services, or facilities
- Transfer, use, or benefit from assets
- Dealing assets for your own benefits as a fiduciary
- Receiving personal consideration as a fiduciary from a third-party that engaged in a transaction with the IRA
In addition, it’s crucial to recognize that for a transaction to be deemed a prohibited transaction, one of the above-listed exchanges merely needs to occur between the IRA owner (or other disqualified person) and the IRA. It doesn’t matter if the transaction was done for a fair market value, under the exact same terms that might have occurred in a third-party transaction. The fact that one of the proscribed transactions occurred between the IRA and a disqualified person is sufficient to trigger adverse consequences.
Tax Consequences And Penalties For Engaging In A Self-Directed IRA Prohibited Transaction
For those IRA owners (or other disqualified persons) who do engage in a prohibited transaction with an IRA, the tax consequences are severe.
The “standard” rule under IRC Section 4975(a) is that if a prohibited transaction occurs, there is a penalty tax of 15% of the amount involved in the transaction, imposed on any disqualified person engaged in the prohibited transaction. And if the prohibited transaction isn’t promptly unwound/corrected within the current tax year, the penalty tax is increased to 100%(!) of the transaction amount.
Notably, though, a prohibited transaction between a disqualified person and an IRA involves two parties – the disqualified person who conducted the transaction, and the retirement plan itself. And where there are two parties involved, both can be subject to penalties in a prohibited transaction!
As a result, in the case of a prohibited transaction between an IRA itself and the IRA owner (or his/her beneficiary), IRC Section 408(e)(2) stipulates that the IRA itself is fully “disqualified” – which means it loses its tax-deferred status, and is treated as though it was fully liquidated in a taxable distribution as of January 1st of the tax year in which the prohibited transaction occurred. And it’s the entire retirement account that loses its tax status (and not just the portion of the account involved in the prohibited transaction, as is the case with the penalty tax on a disqualified person).
To coordinate between the two – and ensure that a retirement account owner doesn’t end out penalized for more than the entire value of the account, by both paying a prohibited transaction penalty tax as an individual and via the disqualification of his/her IRA – a coordinating provision under IRC Section 4975(c)(3) stipulates that if the retirement account is disqualified (due to a prohibited transaction of the IRA owner or his/her beneficiary), the penalty tax on a disqualified person will not also apply.
Thus, the 15% or 100% penalty taxes effectively only apply if the prohibited transaction occurs with a disqualified person besides the IRA owner (or his/her beneficiary), or in the case of prohibited transactions with other types of retirement accounts (e.g., employer retirement plans).
Even though the language of IRC Sec. 4975(c)(3) seems to clearly exempt IRA owners and their beneficiaries from the 15% and 100% penalty taxes when an IRA is disqualified due to a prohibited transaction, the IRS has often taken the position that IRA owners are by definition "disqualified persons", and therefore they (and their family members) are subject to penalty taxes on prohibited transactions in addition to any taxes owed due to the disqualification of the IRA.In other words, despite plain language to the contrary in the law as written, plan owners and their beneficiaries who engage in prohibited transaction can still end out paying taxes and penalties on the entire account value, plus the 15% or 100% penalty tax on the value of the prohibited transaction.
Common Prohibited Transactions With Self-Directed IRAs
Fortunately, the reality is that prohibited transactions with IRAs are quite rare, due to the simple fact that the overwhelming majority of IRA assets are just invested into traditional publicly traded securities, where a prohibited transaction generally isn’t feasible in the first place. Even if you buy the stock of the company you work at, when it’s a publicly traded company, and you own a miniscule fraction of the available shares, the ownership doesn’t come remotely close to the threshold necessary for it to constitute a disqualified person and potential prohibited transaction. Furthermore, most IRA custodians or trusteed IRA providers only offer “traditional” investment opportunities, where there’s virtually no potential to trigger a prohibited transaction anyway.
However, if someone establishes a self-directed IRA with the aim to invest IRA dollars into a small private held business that they control or own – such that the business entity, and/or their role in the business, can cause it to be a disqualified person – there is a risk that allocating IRA dollars to own that business can cause the IRA itself to become disqualified (and treated as fully distributed as a taxable event). After all, if the IRA puts money into the business, and the business then uses that money to pay a salary to the IRA owner (as an officer of the business), the IRA owner has effectively used the assets of the IRA to enrich themselves. Which, again, can be deemed a prohibited transaction, and disqualify the IRA (as the IRA owner would be a party to the prohibited transaction). (Michael’s Note: Slightly more flexible rules apply in the case of an employer retirement plan, such as a 401(k) or profit-sharing plan, that invests into a closely-held C corporation that may employ the account owner, under the so-called ROBS strategy, though the IRS is increasingly scrutinizing those transactions as well.)
Similarly, where an IRA owner invests into direct real estate, and then does repair work to it (e.g., “fixing up” the property), a prohibited transaction has occurred, because the IRA owner rendered services to/for an asset of the IRA. (Instead, the IRA itself needs to hire someone to repair or otherwise provide services to the property. And the IRA itself must pay for those services out of the IRA’s own cash, as the IRA owner paying for services on behalf of the IRA asset would again be a prohibited transaction, or at least a deemed contribution.)
Other common prohibited transaction complications with direct real estate in an IRA include renting out the real estate to the IRA owner or other members of his/her family (who are also disqualified persons), allowing family to stay for free in the real estate (which is still prohibited as a “use of the asset” by a disqualified person), or hiring family members to work on/in the real estate property. And of course, trying to transfer existing real estate the IRA owner already owns into the IRA would be prohibited (because even an arms’ length fair-market-value sale of the real estate from the IRA owner to the IRA is still a prohibited transaction, as the IRA owner is still a disqualified person).
In addition, for IRA owners who work with financial advisors, the most common prohibited transaction to be wary of is the use of IRA assets to (inappropriately) pay an investment advisor’s fees! The reason is that while an IRA can absolutely pay an investment advisory fee – it’s a legitimate expense of the IRA itself under IRC Section 212 – the IRA’s assets should only pay the IRA’s own advisory fees. Using IRA assets to pay the investment advisory fees of other (i.e., non-IRA) accounts is a prohibited transaction of using IRA assets to pay the “personal” investment expenses of the IRA owner, which can disqualify the IRA. Similarly, using the IRA to pay a financial planning fee – which is technically an expense of the IRA owner who receives the financial planning services, and not the IRA itself – is also using IRA assets for personal expenses of the IRA owner, a prohibited transaction that can disqualify the IRA! Notably, it is permissible to use non-IRA assets to pay an IRA’s investment advisory fees – and even to potentially deduct them – but the IRA itself should only pay its own (pro-rata share of) investment advisory fees (not financial planning fees, nor financial-planning-centric bundled fees!), and those IRA-paid fees will not be deductible (but only because they were already paid from a pre-tax account).
Financial Advisor Prohibited Transactions For Investing Family Members’ IRAs?
While the most ‘common’ disqualified person associated with an IRA is the IRA owner themselves, it’s important to bear in mind that family members are also disqualified persons. As noted earlier, this means that the IRA should not buy anything from, nor loan any money to, a family member. In addition, IRA assets can’t be used to hire and pay for the services of family members (e.g., to do repair work on IRA-owned real estate). However, the caveats on potential prohibited transactions for services between IRAs and family members don’t end there. The rules can also potentially apply to a family member who provides – and gets paid for, from IRA assets – investment services to the IRA!
In other words, if an IRA pays for financial advisory services to a financial advisor who is a related family member to the IRA owner, it can disqualify the IRA in a fully taxable event!
Fortunately, an exception under IRC Section 4975(d)(17) does stipulate that investment advice provided to a retirement account is not subject to the prohibited transaction rules, but only as long as it is delivered as a part of an “eligible investment advice arrangement”. In this context, an eligible investment advice arrangement – under IRC Section 4975(f)(8) – is one where the advisor is either paid a level fee that does not vary depending on the investments selected (akin to the “level fee fiduciary” exemption under DoL fiduciary), or makes the recommendation based on the computer model requirements of IRC Section 4975(f)(8)(C) (which must meet certain objectivity requirements, and be certified as such).
In the case of an independent RIA providing paid investment management services to a family member’s IRA, this provision shouldn’t present a challenge, as long as the investment adviser doesn’t charge differently for different investment options or models (i.e., has the same advisory fee for all investment options). However, for a registered representative of a broker-dealer who gets paid a commission for investing a family member’s IRA, the payment actually could constitute a prohibited transaction, if the advisor is a disqualifying family member (i.e., grandparent or parent of the IRA owner, spouse of the IRA owner, or a child or grandchild or spouse thereof).
In such a situation, the broker would face the 15% penalty tax for engaging in a prohibited transaction as a disqualified person, potentially rising to a 100% penalty tax if the transaction isn’t reversed (i.e., the commission isn’t undone) by the end of the tax year. Though as long as the broker isn’t the IRA owner or his/her beneficiary, the IRA itself should remain intact and not be disqualified. (On the other hand, if a broker actually buys a commissionable product in his/her own IRA, and actually receives the commission payment, it can disqualify the entire IRA in a taxable event!)
And of course, it’s important to note that if an advisor more overtly directs IRA assets to be invested into a business with which they have a relationship – for instance, if they’re a fiduciary to the account and direct assets to be invested in their own real estate, or startup business, etc. – the end result may also be a prohibited transaction.
Rising Scrutiny Of IRA Prohibited Transactions
The reality is that the prohibited transaction rules for IRAs have existed as long as IRAs themselves have existed. And for most of their history, they were largely ignored, because they were largely irrelevant. After all, as noted earlier, in a world where most IRA custodians were structured to facilitate investing in “traditional” publicly traded investment securities, it was nearly impossible to create a situation where a prohibited transaction could occur in the first place (beyond, perhaps, improperly billed financial planning or investment advisory fees!).
However, with the rise of new “self-directed IRA custodian” platforms like Pensco, Equity Trust, and Entrust Group, there are more and more options for investors to pursue “non-traditional” alternative investments in retirement accounts. The desire to invest retirement account dollars into something besides stocks and bonds appears to have initially gained momentum during the real estate investing craze of the 2000s – when some wanted to use their retirement accounts to buy, invest in, and “flip” residential real estate – and then extended to other forms of alternative asset classes in the aftermath of the financial crisis, given concerns about the risks of stock market investing and the mediocre yield of many fixed income investments.
Yet the rise of these types of self-directed retirement accounts, and their facilitation of alternative investments that could potentially trigger a prohibited transaction that causes substantial tax penalties, or even disqualification of the entire retirement account, has caused concern for many, including lawmakers in Washington. As a result, the Government Accountability Office (GAO) recently conducted a study to evaluate whether lawmakers and/or regulators should get more involved in the oversight of retirement accounts investing in non-traditional assets… noting that as of now, the risks and potential disqualification of an IRA when investing in alternatives was only recently added to IRS Publication 590 (in 2015), and there is still limited guidance on how to track and report hard-to-value assets (which is crucial for calculating required minimum distribution obligations). Despite the fact that the study found there are now nearly half a million accounts with $50B of collective value being invested in “unconventional” assets in IRAs.
And the lack of consumer education is concerning, given that avoiding “mistakes” in an IRA that could cause a prohibited transaction is still the responsibility of the account owner. In fact, the GAO study specifically notes that some self-directed IRA custodians are implying that their offerings are “preapproved by the IRS” or that they are conducting the due diligence necessary to ensure that the unconventional/alternative asset is permissible in the IRA, even though in the end the IRA custodian is only responsible for affirming it is administratively feasible to hold the asset and fulfill its IRA custodian duties (not whether it would be a prohibited transaction for the IRA owner). In fact, the GAO expresses concern that some types of alternative investments are sold into self-directed IRAs in a manner that enriches the salesperson or promoter if the deal closes, but disowns any liability if the investment turns out to be a prohibited transaction, because in situations where the self-directed IRA provider offers “checkbook control”, it’s ultimately still up to the IRA owner to determine that each and every check is compliant with the prohibited transaction rules.
In other words, “ignorance is no excuse” when it comes to prohibited transactions in IRAs, nor are the assurances of a self-directed IRA provider about the feasibility of holding various alternative assets in a self-directed IRA. And with the GAO study finding that there are causes for concern, it may only be a matter of time before some additional IRS enforcement comes to bear on the issue… especially as it appears there really are IRA owners engaging in prohibited transactions (albeit perhaps unwittingly). The starting point is to understand the scope of the issue, and then the IRS will determine what strategies to target, and start asking more questions.
Which means it’s time to be more cognizant of the risks of prohibited transactions, and the situations that can trigger them – not only with respect to self-directed IRAs and the growing use of various types of “alternative” investments that can trigger adverse consequences, but also the “simpler” situations like potential prohibited transactions with financial advisors who are compensated for investing the IRA dollars of family members. Especially given that even just a “small” prohibited transaction mistake in an IRA can disqualify the entire retirement account, triggering both income taxes and potential early withdrawal penalties!
So what do you think? Do you have a process in place for ensuring that prohibited transactions are avoided in client IRAs? Are most financial advisors aware that being compensated for investing IRA dollars of family members could disqualify the account? Please share your thoughts in the comments below!