Life and Death Planning for Retirement Benefits

Chapter 8: Investment Issues; Plan Types

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Do not engage in a prohibited transaction (PT) involving your IRA. To avoid PT problems, make sure that the IRA never enters into any transaction with the IRA owner (other than accepting legal contributions and making permitted distributions), or any person or entity related to the IRA owner, or any person or entity with whom or with which the IRA owner has any type of business or personal relationship outside of the IRA; and that the IRA owner never engages in any transaction outside the IRA that involves a payment in connection with assets inside the IRA. A. The penalty for an IRA PT. The penalty on an IRA owner (or beneficiary) for “engaging” in a PT involving the IRA is that the IRA is disqualified. The account ceases to be an IRA and is deemed to have been entirely distributed to him on January 1 of the year in which the transaction occurs. § 408(e)(2) ; Reg. § 1.408-4(d)(1) . The result is that the individual must pay income tax on the account value just as if it had been distributed to him. The same penalty applies to a Roth IRA. § 408A(a) ; Reg. § 1.408A-1 , A-1(b). In the case of a Roth IRA, disqualification is an even more drastic punishment because it presumably causes loss of the tax-exempt status otherwise applicable to Roth IRA distributions ( ¶ 5.2.04 ). B. Transactions that are prohibited. PTS include just about any direct business transaction (such as sale, leasing of property, payments for goods or services, lending of money or property, etc.) between the IRA and a disqualified person (DQP; see “C” below). § 4975(c)(1)(A)–(D). These transactions are PTS even if the plan is not harmed. For example, a participant’s bargain sale of property to an IRA would be a PT even though the IRA is getting a good deal. There are other ways to have a PT besides these catalogued transactions between the IRA and a related party. An IRA transaction with a party who is not a DQP can be a PT if it indirectly benefits a DQP. This rule has been used to find PTS when IRAs engaged in transactions with entities that were less than 50 percent owned by DQPs; even though the entity was therefore not a DQP (see “C”), the transaction was found to indirectly benefit DQPs who were minority owners of (or otherwise related to) the entity. Rollins, T.C. Memo 2004-260 (2004); PLR 9119002; DOL Advisory Opinion 93-33A. A transaction in which the IRA is not even involved could be a PT; for example, if the IRA owner receives a payment, outside the IRA, for a transaction involving the IRA’s assets. § 4975(c)(1)(F). The IRS and DOL have even been known to claim that any transaction involving a conflict of interest between the IRA and the owner as “fiduciary” is, itself, a PT, without (apparently) the necessity of proving that any DQP benefitted from the transaction, though this IRS/DOL position has not been tested in court. See Reg. § 54.4975-6(a)(5)(i), DOL Advisory Opinion 2000-10A, PLR 2001-28011. Finally, if the IRA owns or controls an entity, a DQP’s transaction with or involving the IRA-controlled entity may be a PT under a set of look-through rules called the “plan asset rules.” See 29 CFR § 2510.3-101(a)(1), (f)(2)(ii); DOL Advisory Opinion 2000-10A. C. Who are disqualified persons? DQPs include the IRA owner (who is considered a “fiduciary” of his own IRA) and certain related parties, namely, the IRA owner/fiduciary’s spouse, ancestors, descendants, and spouses of descendants. An entity that is controlled or more than 50 percent owned by DQPs (after application of attribution rules) is also a DQP. § 4975(e)(2). Under the “plan assets rule” (see “B” above), managers of a plan-owned entity are also considered fiduciaries and thus are DQPs.