Income and Assets · Retirement income

Prohibited transactions and their tax effects

Two entirely different consequences hide behind one phrase. For an employer plan, a prohibited transaction triggers an excise tax that recurs annually and then escalates. For an individual retirement account, there is no excise tax at all — the account simply stops being an IRA, backdated to the first day of the year, and is treated as having distributed everything in it. The second is far worse, and it is the one most clients are exposed to.

The rule

Six categories, direct or indirect. A prohibited transaction means any direct or indirect sale, exchange or leasing of property between a plan and a disqualified person; lending of money or other extension of credit between them; furnishing of goods, services or facilities between them; transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; an act by a disqualified person who is a fiduciary dealing with plan income or assets in his own interest or for his own account; and receipt of consideration for his own personal account by a fiduciary from a party dealing with the plan (IRC § 4975(c)(1)(A)–(F)).

Who is disqualified is wider than “the owner”. The term reaches a fiduciaryfiduciarySomeone legally responsible for managing property or money for another person's benefit, held to a high standard of care and loyalty. An executor and a trustee are both fiduciaries.; a person providing services to the plan; an employer whose employees are covered; an employee organization whose members are covered; a substantial owner of such an employer or organization; a member of the family of most of those; an entity substantially owned by them; and officers, directors and highly compensated employees (IRC § 4975(e)(2)(A)–(H)). Family is defined in § 4975(e)(6), and the ownership thresholds are in the table below.

The plan-side tax has two tiers. A tax of 15 percent of the amount involved is imposed for each year or part of a year in the taxable period, paid by any disqualified person who participated other than a fiduciary acting only as such (IRC § 4975(a)). If the transaction is not corrected within the taxable period, a further tax of 100 percent of the amount involved is imposed (IRC § 4975(b)).

For an IRA the rule is different in kind. If, during any taxable year of the individual for whose benefit the account is established, that individual or their beneficiarybeneficiaryThe person or entity entitled to receive money or property from a trust, estate, retirement account, or insurance policy. engages in any transaction prohibited by § 4975 with respect to the account, the account ceases to be an individual retirement account as of the first day of that taxable year (IRC § 408(e)(2)(A)). It is then treated as distributing all its assets at their fair market value on that first day (IRC § 408(e)(2)(B)).

And the excise tax then falls away. The individual and their beneficiaries are exempt from the § 4975 tax with respect to any transaction concerning the account where the account ceases to be an IRA under § 408(e)(2)(A) or where § 408(e)(4) applies (IRC § 4975(c)(3)). So the two consequences are alternatives, not cumulative — and the one that applies to an IRA owner is the harsher.

Each plan is treated separately. For § 408(e)(2) purposes each individual retirement plan of the individual is treated as a separate contract (IRC § 408(e)(2)(A)(iii)), so a prohibited transaction in one account does not destroy the others.

Pledging is narrower, and deliberately so. Where the individual uses the account or any portion of it as security for a loan, only the portion so used is treated as distributed (IRC § 408(e)(4)). That is a partial consequence rather than the total disqualification a prohibited transaction brings — a distinction that decides how much damage an act does.

Borrowing against an annuity is different again. Where the owner of an individual retirement annuity borrows any money under or by use of the contract, the contract ceases to be an individual retirement annuity (IRC § 408(e)(3)).

Current figures

How it works in practice

The exposure arises almost entirely with self-directed accounts holding real property, private businesses or loans. A conventionally invested IRA holding listed securities has essentially no way to engage a disqualified person; an IRA that owns a rental property has several, and they are not obvious ones.

Test the counterparty against § 4975(e)(2) before the transaction, and remember that family members are in the definition. An IRA buying property from the owner’s son, lending to a company the owner half controls, or paying the owner’s spouse to manage the property are all within the six categories, whatever the price or the commercial merits. Section 4975(c)(1) reaches indirect dealings too, so routing a transaction through an intermediary does not help.

Watch for the categories that do not involve money changing hands. Subparagraph (D) reaches the use by or for the benefit of a disqualified person of plan assets — so the owner staying a weekend at an IRA-owned holiday property, or storing goods in an IRA-owned warehouse, is within it. Nothing was bought or sold and the account is still destroyed.

Where a client is already exposed, quantify the damage before advising. For an IRA the deemed distribution is measured at first-day fair market value, so a transaction in December is valued at the previous 1 January — which may be more or less than the current value, and is a figure the custodian can supply. The distribution is includible under § 408(d)(1), and § 72(t) will apply to the includible portion unless an exception reaches it. There is no correction procedure that undoes § 408(e)(2).

How this has changed

Section 4975 is among the more stable provisions in this outline. The six categories, the definition of a disqualified person, the two-tier rate structure and the § 408(e)(2) consequence have all been in place for decades, and the first-tier rate has been raised only once since enactment. Older material is therefore unusually reliable here, which is not true of most of the retirement topics around it.

What has changed is the exposure rather than the rule. Self-directed accounts holding real property, private company interests and promissory notes were once rare and are now widely marketed, so a provision written for plan fiduciaries now most often bites individual account owners who have never heard of it. Nothing in the section moved; the population it reaches did.

One drafting point is worth carrying forward because it is easy to read past. Section 4975(c)(3) exempts the IRA owner from the excise tax, which reads like relief and is not — it is the statute allocating a single, harsher consequence rather than stacking two. A source that lists the two excise tiers as the consequence of an IRA prohibited transaction has the mechanism backwards.

Exam focus

Know that the IRA consequence is disqualification under § 408(e)(2), not the § 4975 excise tax, and be able to say that § 4975(c)(3) is what allocates it that way.

Know that disqualification is as of the first day of the taxable year and that the whole account is deemed distributed at that day’s fair market value.

Know the six categories well enough to spot the one that needs no consideration — use by or for the benefit of a disqualified person.

Distinguish pledging from borrowing: § 408(e)(4) reaches only the portion pledged, while a loan from the account is a prohibited transaction destroying the whole thing.

Check yourself

1. An IRA owner sells a piece of land to their own IRA at an independently appraised market price. What is the consequence?

Answer: the account is destroyed. IRC § 4975(c)(1)(A) makes any direct or indirect sale or exchange of property between a plan and a disqualified person a prohibited transaction, and the owner is a disqualified person. The price is irrelevant — the category is structural. IRC § 408(e)(2)(A) then provides that the account ceases to be an IRA as of the first day of that taxable year, and § 408(e)(2)(B) treats all its assets as distributed at their first-day fair market value.

2. Does the 15 percent excise tax apply to an IRA owner who engages in a prohibited transaction with their own account?

Answer: no. IRC § 4975(c)(3) exempts the individual for whose benefit the account is established, and their beneficiaries, from the § 4975 tax with respect to any such transaction where the account ceases to be an IRA under § 408(e)(2)(A) or where § 408(e)(4) applies. The consequence is disqualification of the account instead — a single, harsher outcome rather than both.

3. A taxpayer pledges a quarter of their IRA as collateral for a personal loan. How much is treated as distributed?

Answer: the quarter pledged. IRC § 408(e)(4) provides that where the individual uses the account or any portion of it as security for a loan, the portion so used is treated as distributed. The rest of the account remains an IRA — unlike a prohibited transaction, which under § 408(e)(2) destroys the whole account from the first day of the year.

4. An IRA owns a commercial building. The owner’s brother rents a unit at full market rent. Is there a problem?

Answer: yes. IRC § 4975(e)(2)(F) makes a member of the family of a disqualified person a disqualified person, and § 4975(e)(6) defines family. Leasing property between a plan and a disqualified person is within § 4975(c)(1)(A). Market rent is no answer, because the category asks who dealt with the plan rather than whether the terms were fair, and § 408(e)(2) then disqualifies the account from the first day of the year.