Prohibited Transactions in a Self Directed IRA LLC
Saving and investing money is a crucial task in order to retire comfortably. It is so important that in 1974 the US government created legislation known as the Employee Retirement Income Security Act (ERISA) to encourage taxpayers to save for retirement. ERISA allowed for the establishment of special retirement accounts, such as IRAS. In turn for participating in these plans, taxpayers can enjoy tax deferred status (Traditional IRA or Solo 401(k)) or tax-free profits (Roth IRA or Solo 401(k)).
However, with this account there are several rules and transactions that are prohibited in order to ensure that the benefits are protected for retirement.
- A Prohibited Transaction is any improper interaction between you (or another Disqualified Person) and your IRA.
- Common Prohibited Transactions include selling an IRA-property to one of your children, making a personal loan to your IRA, or staying in one of your IRA-owned properties.
- Sometimes a Prohibited Transaction can be fixed. If not, the IRA will be considered distributed, taxes will come due, and the account holder will be assessed a penalty.
What is a prohibited transaction?
As defined by the IRS, a prohibited transaction is “any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.” Prohibited transactions do not limit what an IRA can invest in, but rather who an IRA can transact with. Let’s visualize it as an equation: “Retirement Plan Asset” + “Disqualified Person” = Prohibited Transaction.
A “Retirement Plan Asset” is any asset or entity owned by the retirement account/plan. A “Disqualified Person” is the IRA owner, certain family members, a company in which the majority is owned/controlled by the IRA owner, or key persons in a company owned 50% or more by disqualified persons. See Disqualified Persons to find out more about who qualifies to cause a Prohibited Transaction.
3 Categories of Prohibited Transactions in an IRA LLC
Per Se Prohibited Transactions
This occurs when an IRA “transacts” with a disqualified person. According to the Internal Revenue Code, a transaction includes the sale, lease, lending of money or extension of credit, or the furnishing of goods and services.
Think of it this way, an IRA may transact with third parties, but may not transact with close family members or closely held entities.
Extension of Credit Prohibited Transactions
This occurs when an IRA extends credit to the IRA owner personally or when the owner personally extends credit to their IRA. If a loan is issued to the IRA, it can only be guaranteed by the item being purchased and not by an IRA owner’s personal guarantee. For example, if you obtain a loan for real estate investment, the loan must be backed by the property and not by the borrower’s personal guarantee.
To avoid an extension of credit prohibited transaction, loans issued to an IRA must be non-recourse.
Self-Dealing Prohibited Transactions
This arises when a disqualified individual personally benefits from the IRA’s investments.
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|IRA LLC Activity||Prohibited Transaction|
|IRA owner sells or purchases a property which he/she owns personally with retirement funds.||Yes - Per Se|
|IRA owner leases property to their parents, son/daughter, or to a company that they personally own.||Yes - Per Se|
|IRA owner does landscaping or repairs property on their own.||Yes - Per Se|
|IRA owner borrows funds from a disqualified person.||Yes - Per Se|
|IRA owner obtains a loan issued to the IRA from a local bank and then personally guarantees repayment of the loan.||Yes - Extension of Credit|
|IRA owner purchases a vacation rental property and stays there for a weekend.||Yes - Self-Dealing and Per Se|
|IRA engages in a transaction with a company who pays the owner compensation.||Yes - Self-Dealing|
|IRA owner lends IRA money to a company that he has a minority ownership interest in, allowing him/her to receive interest payment above the market rate.||Yes - Self-Dealing|
|IRA owner receives commission on a property purchased/sold by their IRA||Yes - Self-Dealing|
|Paying Vendors, Ordering Supplies, or Hiring Workers.||No|
|IRA owner receives a non-recourse loan from a third party lender. Loan is backed by the property.||No|
|IRA owner sells property to a company that they have less than 50% ownership interest in.||No|
There are hefty penalties if a prohibited transaction occurs in your IRA LLC.
If the IRA owner or his/her beneficiaries engages in a prohibited transaction in connection with an IRA account at any time during the year, the IRA stops being an IRA as January 1st of the year in which the transaction occurred. In this case, the ENTIRE account is considered distributed and the IRA owner is subject to any applicable taxes on the distributed amount. The distributed amount is based on the fair market value on the first day of the year the prohibited transaction took place. If the IRA owner is younger than age 59.5 at the time of the transaction, a 10% early withdrawal penalty also applies. Taxes also apply to any income and gains earned by the IRA after the prohibited transaction took place.
If an individual other than the IRA owner (e.g. broker, financial planner or advisor engaged by the IRA), a 15% excise tax is applied to the amount involved. If the prohibited transaction is not corrected by the IRA owner, a 100% penalty may apply.
The easiest way to deal with a prohibited transaction is to not have one occur in the first place. However, if a prohibited transaction does take place, the IRA owner must undo the transaction as soon as possible.
For example, a common prohibited transaction is when an IRA owner sells an investment held by their IRA LLC and the funds go directly to the account holder instead of into the IRA or the custodian. To correct this, the account holder will send the funds back to the investment and then the funds will be sent to the correct IRA or custodian.
There are many different scenarios that may incur a prohibited transaction. The IRS’s rules to correct a prohibited transaction can be found here: 4.72.11 Prohibited Transactions.
There are a few transactions that the IRS exempts (page 33) from being prohibited transactions. For example, it is not a prohibited transaction if you are a disqualified person and receive benefits to which you are entitled as a plan participant or beneficiary. The one caveat is that the benefit must be on the same terms for all other participants and beneficiaries.
A prohibited transaction may occur in many different scenarios. The IRS does not provide an exhaustive list of all transactions that are prohibited. It is best to obtain legal and tax advice before engaging in a transaction that may be questionable. As a first step, you can ask yourself several questions to safeguard your Self Directed IRA LLC:
- Are any disqualified persons involved in this transaction?
- Am I or any of my close relatives personally benefiting (as opposed to my IRA) either directly or indirectly from this transaction?
- Are any business entities that I have personal ownership or influence over benefiting directly or indirectly from this transaction?
- Am I personally guaranteeing (as opposed to a non-recourse loan) a loan obtained for my IRA LLC?