Prohibited Transactions

Self-Directed Checkbook 401k Plans for the Self-Employed

If you’re reading this, you’ve no doubt heard about at least some of the great things you can do with a self directed retirement account such as the IRA LLC or the Solo 401k. It’s also important to know about the things you cannot do when it comes to self directed investing. These things are called prohibited transactions.

Prohibited transactions are transactions between a plan and a disqualified person.

What is a disqualified person? For your retirement account, disqualified persons include you and most of your family members. More specifically, these disqualified persons include you, your spouse, your lineal ascendants, your lineal descendants and their spouses, as well as fiduciaries and service providers to your plan. Businesses owned by disqualified persons should also be considered disqualified persons.

Let’s say, for instance, you have a Solo 401k plan and you want to buy a piece of real estate with your plan for investment purposes. Your Solo 401k purchases the rental home from a completely unrelated person. You find a non-disqualified person to rent the home at fair market value and your Solo 401k receives rent payments and continues to grow in asset value all while deferring taxes. Congratulations, on your first Solo 401k deal!

In the above example, had your Solo 401k purchased that investment property from your son, the purchase would have been a prohibited transaction. That’s because your son is a disqualified person with respect to your Solo 401k and the purchase was a transaction between your Solo 401k and your son.

Similarly, if your Solo 401k purchased the property from an unrelated person, but you decided to rent the property out to your mother, a prohibited transaction has occurred since your mother is a disqualified person in relation to your Solo 401k plan.

The IRS states that disqualified persons include the following:

  1. A fiduciary of the plan.
  2. A person providing services to the plan.
  3. An employer, any of whose employees are covered by the plan.
  4. An employee organization, any of whose members are covered by the plan.
  5. Any direct or indirect owner of 50% or more of any of the following.
    1. The combined voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of a corporation that is an employer or employee organization described in (3) or (4).
    2. The capital interest or profits interest of a partnership that is an employer or employee organization described in (3) or (4).
    3. The beneficial interest of a trust or unincorporated enterprise that is an employer or an employee organization described in (3) or (4).
  6. A member of the family of any individual described in (1), (2), (3), or (5). (A member of a family is the spouse, ancestor, lineal descendant, or any spouse of a lineal descendant.)
  7. A corporation, partnership, trust, or estate of which (or in which) any direct or indirect owner described in (1) through (5) holds 50% or more of any of the following.
    1. The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation.
    2. The capital interest or profits interest of a partnership.
    3. The beneficial interest of a trust or estate.
  8. An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10% or more shareholder, or highly compensated employee (earning 10% or more of the yearly wages of an employer) of a person described in (3), (4), (5), or (7).
  9. A 10% or more (in capital or profits) partner or joint venturer of a person described in (3), (4), (5), or (7).
  10. Any disqualified person, as described in (1) through (9) above, who is a disqualified person with respect to any plan to which a section 501(c)(22) trust is permitted to make payments under section 4223 of ERISA.

That’s a good list to be familiar with. A good check to make sure you’re not engaging in any prohibited transactions is to make sure you’re not directly or indirectly transacting with or benefiting any people or entities on that list.

The prohibited transactions rules are found in US Code section 4975. This section lists the following as the types of transactions to avoid:

(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
(B) lending of money or other extension of credit between a plan and a disqualified person;
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

It’s important to understand these rules when you’re considering a transaction with your Solo 401k. The penalties for prohibited transactions can be severe and getting into trouble with the IRS or the Department of Labor is likely to be more trouble that the transaction is worth.