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Prohibited Transactions and Disqualified Persons

With all the benefits that self-directed accounts offer, investors must be aware of the unique limitations related to these account types, primarily around prohibited transactions. While the IRS does not state what you can do with your funds, they are clear on what you cannot do.

With the benefits that self-directed IRAs, 401(k)s, and Health Savings Accounts offer, investors must be aware of unique limitations.

Below we provide an overview of the rules and relevant definitions found in IRC, Section 4975 that investors should know.

What is a Disqualified Person or Entity?

A disqualified person or entity is used to describe certain individuals or entities who are not allowed to do business with tax-advantaged plans. The reasoning for this limitation is these entities would benefit from the account’s funds, bypassing contribution and withdrawal limits, through receipt of economic benefit.

While this specific list is not exhaustive, it does provide general principles regarding who can and cannot do business with a self-directed IRA, Solo 401(k), or Health Savings Account.

  • The account holder (you)
  • The account holder's linear ascendants (parents, grandparents, etc.)
  • The account holder's linear descendants (children, grandchildren, etc.)
  • Spouses of the aforementioned individuals
  • Fiduciaries to the account (accountants, financial advisors, attorneys, etc.)
  • Tax-advantaged savings accounts held by any of the aforementioned individuals
  • Businesses or entities owned or controlled by any of the aforementioned individuals

What is a Prohibited Transaction?

The IRS defines prohibited transactions as any sale, exchange, or lease of an asset between disqualified parties. Furthermore, any transfer or furnishing of goods or funds between a plan and a disqualified entity is equally prohibited. The account cannot conduct any business with a disqualified entity to prevent misuse and abuse of tax-advantaged funds.

Conversely, the property cannot directly and immediately benefit, be it financial or otherwise, from the IRA holder. For instance, he or she cannot personally perform repairs and renovations or pay for them with personal funds. Doing so would effectively contribute to the value of the tax-deferred account and potentially exceed the annual contribution limits. Expenses incurred must be paid by the account, just as income enjoyed must be retained by the account.

The account cannot conduct any business with a disqualified entity, thus preventing misuse and abuse of tax-advantaged funds.

  • Purchase, sell, or exchange assets with the account
  • Yield a commission/fee for the purchase, sale, or exchange of assets
  • Rent, occupy, or otherwise use property owned by the account
  • Personally execute renovations/repairs on property owned by the account
  • Retain account earnings on a personal basis
  • Cover account expenses with personal, non-account funds

Who are Non-Disqualified Persons?

The IRS does not consider siblings, their spouses, aunts, uncles, or cousins to be disqualified persons, so you can do business with them on your tax-advantaged plans as you wish. 

  • Brother
  • Sister
  • Brother-In-Law
  • Sister-In-Law
  • Uncle
  • Aunt
  • Niece
  • Nephew
  • Cousin

Penalties

IRS audits are extremely thorough, so it would behoove you to keep your financial affairs in order. Unlike within our judicial system, the accused is guilty until proven innocent. The burden of proving innocence falls on the accused taxpayer.

The penalties for prohibited transactions can be harsh. Each case is judged on a case-by-case basis. An IRA that committed a prohibited transaction will almost certainly lose its tax-deferred status (the IRA would be immediately distributed to the account holder). This can create an unexpected tax liability as well as penalties if the account holder is under the age of 59.5. On top of that, the IRS will most likely impose a 15% prohibited transaction penalty. There have been extreme cases when the prohibited transaction resulted in 100% loss of the IRA. Prohibited transactions are not to be taken lightly.

The Bottom Line on Prohibited Transactions

Your IRA receives special treatment from the IRS via the tax benefits afforded by the account. In order to maintain that treatment, it is important that the IRA investments are just that–investments. If you want to use the IRA funds or benefit from the IRA funds, you would need to take a distribution and then pay any applicable taxes. However, while they remain in the IRA you (and your direct lineal family members) should not benefit from what the IRA is doing.