What are the consequences of engaging in a prohibited transaction?
The IRS has strict rules governing what an Individual Retirement Account (IRA) can and cannot do. One of the most serious violations is engaging in a prohibited transaction, which can result in severe tax consequences, including the loss of the IRA’s tax-advantaged status and potential IRS penalties.
Understanding the risks of prohibited transactions is essential for maintaining compliance and protecting your retirement funds.
What Is a Prohibited Transaction?
A prohibited transaction occurs when an IRA engages in improper dealings with a disqualified person, violating IRS Code § 4975. These include:
- Self-dealing (using IRA assets for personal benefit).
- Buying, selling, or leasing property between an IRA and a disqualified person.
- Providing services to an IRA-owned investment.
- Lending money to or borrowing from the IRA.
Example of a Prohibited Transaction
❌ Taking Personal Use of an IRA-Owned Property
An IRA purchases a rental property, and the IRA owner stays in the property for a weekend. Even if rent is paid, this is considered a personal benefit and is prohibited.
Consequences of a Prohibited Transaction
1. Immediate Taxation of the IRA
If a prohibited transaction occurs, the IRS disqualifies the IRA as of January 1st of the year the transaction took place. This means:
- The entire IRA balance is treated as a fully taxable distribution.
- The account owner must pay income tax on the total balance at their ordinary tax rate.
2. Early Withdrawal Penalty
- If the IRA owner is under 59½, an additional 10% early withdrawal penalty applies.
3. IRS Penalties for Prohibited Transactions
In addition to taxation and early withdrawal penalties, the IRS may assess additional penalties, including:
- Accuracy-related penalties: Up to 20% of the underpaid tax if the IRS determines there was negligence.
- Fraud penalties: If the IRS deems the transaction was intentional, penalties can be as high as 75% of the underpaid tax.
- Failure to pay penalties and interest: If taxes resulting from the prohibited transaction are not paid on time, additional penalties and interest will accrue.
4. Impact on the IRA at American Estate & Trust (AET)
From AET’s perspective, a prohibited transaction may result in:
- Distribution of the asset involved in the prohibited transaction.
- Forced distribution of the entire IRA if the violation is severe.
- The closure of the IRA account, depending on the circumstances.
Examples of Prohibited Transactions and Their Consequences
Example 1: Using an IRA-Owned LLC for a Personal Distribution
❌ Prohibited: A client sets up an IRA-owned LLC and writes a check directly to themselves as a distribution.
🚨 Consequence: The IRS considers this a full distribution of the IRA, making the entire account taxable and subject to penalties. AET would treat this as an improper transaction and force a full distribution of the account.
Example 2: Loaning Money to a Family Member
❌ Prohibited: An IRA issues a private loan to the account owner’s child.
🚨 Consequence: The full IRA balance is taxed as income, plus a 10% penalty if the owner is under 59½. The IRS may also impose additional penalties for underpayment of taxes.
Example 3: Managing an IRA-Owned Rental Property
❌ Prohibited: An IRA owns a rental property, and the IRA owner personally performs maintenance work to save money.
🚨 Consequence: Even if the work was unpaid, it is considered providing a service to the IRA, leading to disqualification of the entire IRA. AET would process the full account as a taxable distribution.
How to Avoid a Prohibited Transaction
To prevent accidental disqualification, follow these guidelines:
✔ Do not use IRA funds for personal benefit.
✔ Do not transact with disqualified persons.
✔ Do not provide services to your IRA investments.
✔ Consult a professional before making complex transactions.
By understanding IRS rules and seeking professional guidance, you can ensure your IRA remains compliant and tax-advantaged.