Part 2: Self-Dealing Rules and their Impact on IRA Investments

In part 1 of this article, we reviewed the federal law on permitted investments for self-directed IRAs and the various tax, compliance and reporting rules that apply to individual retirement accounts (IRAs). Part 2 discusses the self-dealing rules.

Read Part 1 here.

The various administrative rules and limitations discussed in part 1 present an array of challenges for an IRA owner who wishes to make a non-traditional investment. The greatest challenge in many cases, however, is avoiding the prohibited transaction rules. As previously noted, IRAs are subject to the self-dealing rules of Section 4975. IRC §§ 408(e)(2); 4975(e)(1). As a tax-advantaged vehicle, IRAs are subject to transactional restrictions similar to those applied to private foundations. The tax policy behind the rules is that a taxpayer (or any related party, as defined in the Code) should not be able to benefit personally from the tax-advantaged status of the account. And, because the concepts of a “fair transaction” or a “transaction for adequate and full consideration” are inherently subjective in nature, the IRS applies a bright line rule and prohibits virtually all transactions between the account and “disqualified persons.”

The nature of non-traditional investments is such that many present a high risk of violating the prohibited transaction rules. The safest non-traditional investments will be those where the IRA owner is a purely passive investor in a third-party controlled entity, with no personal involvement (for example, as a director or officer), no separate, personal direct investment that is significant from the point of view of the fund, and no other business dealings. For entrepreneurial clients, this obviously narrows the range of “safe” non-traditional investments.

Disqualified Persons. Under the Code, the following persons and entities are disqualified persons:

• The IRA owner

• The IRA’s owner’s spouse, ancestors, and descendants

• Spouses of descendants

• Corporations, partnerships, or trusts that are 50% or more owned by the IRA owner and other family members who are disqualified persons (aggregation rules apply)

• The IRA provider.

The full disqualified person definition is found in Code Section 4975(e).

Prohibited Transactions. There are all types of prohibited transactions. Some simple, and hopefully obvious ones are:

• Purchase equity in an entity in which the IRA owner is an officer, director, or has a controlling equity position.

• Purchase a vacation home the IRA owner or family member will use.

• Purchase an asset from the IRA owner or a disqualified person.

• Provide a loan to the IRA owner or a disqualified person.

• Receive a commission for a sale of real estate to the IRA or by the IRA.

• Reciprocal arrangements with another IRA owner which would violate the rules if done personally.

Beyond the situations listed above, there can be many other prohibited transactions that are more difficult to identify and analyze. Formation and funding of companies presents several potential challenges. In Swanson v. Comm’r., 106 T.C. 76 (1976), the IRS had claimed that Mr. Swanson engaged in a prohibited transaction when his IRA purchased all the initial stock of a company he incorporated. The Tax Court held that the initial capitalization was not a prohibited transaction. The mere formation of a business does not violate the rules. However, once formed, the company was a disqualified person. If Mr. Swanson later wanted to contribute additional capital to the company (directly or through the IRA), loan the company funds, or engage in any other business transaction with it, that would be a prohibited transaction.

In Peek v. Comm’r., 140 T.C. No. 12 (2013), the IRA owner, Mr. Fleck, wished to use his IRA to invest in a fire alarm and fire protection company. His attorney, Mr. Peek, invested with him, through his IRA. They formed an acquisition entity, owned equally by the IRAs, and that entity purchased the fire alarm and protection company. The acquisition was in part seller-financed. The note obligation ran only to the acquisition company, but Fleck and Peek guaranteed the note. Both Fleck and Peek served as officers and employees of the business and drew salaries.

After the shareholders sold the business, at a considerable profit, the IRS asserted they had engaged in several prohibited transactions and should be taxed on the gain. The Tax Court agreed on the ground that the guarantee of the note to the seller by Fleck and Peek was an indirect extension of credit to the IRAs. The IRS also based its audit position on the fact that Fleck and Peek received wages from the company. See IRC § 4975(c)(1)(C). The Tax Court deemed it unnecessary to rule on this issue.

Code Section 4975(d)(10) and Treasury Regulation § 54.4975-6 creates an exemption for providing services, provided that the services are necessary for the operation of the account, the compensation is reasonable, and the IRA may terminate the services at will. The IRS argued that the regulation did not apply because the services were not for the IRA but were rendered to the entity. The question of what services would fall within the regulation remains unsettled. It is clear, though, that rendering any services for compensation creates risk. If the IRS successfully argued that the compensation was not reasonable, then the IRA owner could not claim the exemption, and a prohibited transaction would occur. The rendering of services for no compensation could be equally problematic if the services being provided are viewed as bestowing a substantial benefit on the IRA.

Rollins v. Comm’r., T.C. Memo 2004-260, is an example of the court applying the indirect self-dealing principle. It involved a 401(k) not an IRA but applied the self-dealing principles applicable to both. Mr. Rollins owned the financial firm that sponsored the 401(k) plan. As such, he directed the plan to loan funds to three businesses. In each, Mr. Rollins was the largest owner, but he was not the controlling owner of the businesses. The businesses were not disqualified persons. Nevertheless, the court found indirect self-dealing, because the loan from the IRA benefitted Mr. Rollins by allowing the business to borrow at favorable rates.

Exceptions. Section 4975(d) of the Code contains exceptions to the prohibited transaction rules. Many of the exceptions are for plan custodians or applicable to employer-provided plans. Some of the exceptions relevant to an individual IRA owner are:

• A “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.” IRC § 4975(d)(2).

• “[R]eceipt by a disqualified person of any reasonable compensation for services rendered, or for such reimbursement of expenses properly and actually incurred, in the performance of his duties with the plan….” IRC §4975(d)(10).

Consequences of a Prohibited Transaction. An IRA owner can correct a prohibited transaction within 14 days. This may be an option if the transaction is an administrative error that quickly is caught (for example, the IRA administrator mistakenly distributes funds to a disqualified person). If the transaction is not rectified, then the entire IRA will be treated as distributed, and taxed at the value as of the first day of the year. IRC §408(e)(2).

The last point in the preceding paragraph, full taxation of the IRA, should serve as sufficient motivation to exercise caution when using a self-directed IRA.