Prohibited Transactions in Qualified Retirement Plans: What You Need to Know


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Business owners often set up qualified retirement plans and then decide what to do with the plan assets. Many have a perception that they can earn a higher return investment in other areas and also would like to engage in transactions with the retirement plan.

Most people will invest in qualified assets, like stocks, bonds, and mutual funds. But some people want to self-direct the assets. There are additional administrative headaches in this situation. In addition, the possibility of getting yourself into trouble with the IRS is heightened.

Many business owners believe they can set up a plan and then have interrelated transactions between the plan, companies controlled by the owner, and even family members. In this article, we’re going to discuss prohibited transactions in retirement plans. We will also give you some examples of transactions that can run afoul of the IRS. Let’s jump in.

Background

A retirement plan is intended to be a separate tax-advantaged retirement structure apart from the owner’s other assets. The IRS lists several “prohibited transactions” intended to prevent the retirement plan owner from using the funds to enrich themselves (or even their family members) without taking money out as a taxable distribution.

The prohibited transaction rules can result in adverse tax consequences for the retirement plan owner if it engages in such transactions with any “disqualified person.” This includes the retirement plan owner, and their immediate family members (along with certain related business entities and trusts).

Prohibited transactions can include a variety of transactions, including buying or selling real estate or property between the retirement plan and a disqualified person, making the retirement assets available for a disqualified person’s use, or using retirement funds to compensate a disqualified person.

IRS Code Section 4975 states that a retirement plan owner (and any other party to the retirement account) is prohibited from commingling the financial interests of the qualified retirement plan itself with the plan owner or other related parties, all of whom are considered to be “disqualified persons.”

What is a Prohibited Transaction?

To the extent an entity or person is a “disqualified” person, they are prohibited by the IRS under IRC Section 4975(c)(1) from any of the following direct or even indirect transactions between the qualified retirement plan and a disqualified person:

  • Sale, lease, or exchange of property (even if done at a fair value price);
  • Lending or borrowing of money or extending credit (in either direction);
  • Furnishing or supplying goods, services, or facilities;
  • Dealing in the assets for your benefit as a fiduciary or related party;
  • Transfer, use, or benefit from assets;
  • Receiving personal funds or other consideration as a fiduciary from a third-party that is engaged in a transaction with the retirement plan;

In addition, it’s critical to understand that for a transaction to be considered a prohibited transaction, one of the above-listed exchanges must occur between the retirement plan owner (or other disqualified person) and the plan itself. It does not matter to the IRS if the transaction was completed for fair market value (FMV) under similar terms that could have occurred with an independent third-party. Simply the fact that one of the transactions occurred between the retirement plan and a disqualified person is sufficient to trigger adverse consequences.

Who is a Disqualified Person?

Disqualified persons include:

  • Any plan fiduciary to the retirement account (which includes the plan owner themselves);
  • A family member (including a spouse, lineal descendent, ancestor, or a spouse of a lineal descendent);
  • A trust, corporation, partnership, or estate whereby any of the above owns 50% or more of the shares/profits/beneficial interests;
  • A director, officer, or 10%+ partner or shareholder of an entity described above;

Example of Prohibited Transactions

The following are some examples of possible prohibited transactions:

  • A retirement plan owner borrowing money from the plan (not under the loan provisions provided to all participants);
  • An owner selling property to the plan;
  • A retirement plan owner “fixing up” real estate held with a retirement plan;
  • A family members living in (for rent payments or even rent-free) property owned by the retirement plan;
  • Using the plan assets as security for a loan;
  • Buying real estate or other property for personal use with retirement funds;

Tax on Prohibited Transactions

A disqualified person is required to pay a tax on the prohibited transaction of 15% of the actual amount involved for each year (or part thereof) in the taxable period. If the disqualified person is not able to correct the prohibited transaction in the taxable period, there is an additional tax applied of 100% of the amount involved. Both the 15% and the 100% tax are due by any disqualified person who participated in the prohibited transaction.

The amount that is involved in a prohibited transaction is the greater of the following:

  • The cash and fair market value (FMV) of any property given
  • The cash and FMV of the property received

If any services were provided, the amount involved would be the excess compensation received or given. The taxable period begins on the date of the transaction and ends on the earliest of the following days.

  • The day when the IRS tax is assessed.
  • The day the correction of the prohibited transaction is completed.
  • The day the IRS mails the taxpayer a notice of deficiency for the related tax.

A disqualified person who was involved in a prohibited transaction can avoid paying the 100% tax penalty by correcting the applicable transaction as soon as possible. Correcting the transaction means unwinding it as much as possible without putting the retirement plan in a worse financial situation than if you had acted properly under the fiduciary standards.

Final Thoughts

Business owners need to be careful when engaging in transactions with their retirement plans. Any prohibited transactions can have severe tax consequences.

The above represents a few instances of prohibited transactions. Make sure you reach out to us before you engage in a questionable transaction.

Paul Sundin

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