The Internal Revenue Code does not describe what a Self Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of IRAs for accumulation of retirement savings and to prohibit those in control of IRAs from taking advantage of the tax benefits for their personal account.
Who is a “Disqualified Person”?
The IRS has restricted certain transactions between the IRA and a “disqualified person”. The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed.
The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest. In essence, under Code Section 4975, a “Disqualified Person” means:
• A fiduciary (e.g., the IRA holder, participant, or person having authority over making IRA investments),
• A person providing services to the plan (e.g., the trustee or custodian),
• An employer, any of whose employees are covered by the plan (this generally is not applicable to IRAs but dos include the owner of a business that establishes a qualified retirement plan),
• An employee organization any of whose members are covered by the Plan (this generally is not applicable to IRAs),
• A 50 percent owner of C or D above,
• A family member of A, B, C, or D above (family members include the fiduciary’s spouse, parents, grandparents, children, grandchildren, spouses of the fiduciary’s children and grandchildren (but not parents-in-law),
• An entity (corporation, partnership, trust or estate) owned or controlled more than 50 percent by A, B, C, D, or E. Whether an entity is a disqualified person is determined by considering the indirect stock-holdings/interest which would be taken into account under Code Sec. 267(c), except that members of a fiduciary’s family are the family members under Code Sec. 4975(e)(6) (lineal descendants) for purposes of determining disqualified persons.
• A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G,
• A 10 percent or more partner or joint venturer of a person described in C, D, E, or G.
Note: brothers, sisters, aunts, uncles, cousins, step-brothers, step-sisters, and friends are NOT treated as “Disqualified Persons”.
Pursuant to Internal Revenue Code Section 4975, a Self Directed IRA is prohibited from engaging in certain types of transactions. The types of prohibited transactions can be best understood by dividing them into three categories: Direct Prohibited Transactions, Self-Dealing Prohibited Transactions, and Conflict of Interest Prohibited Transactions.
Direct Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Direct Prohibited Transaction” generally involves one of the following:
4975(c)(1)(A): The direct or indirect Sale, exchange, or leasing of property between an IRA and a “disqualified person”
Example 1: Jack sells an interest in a piece of property owned by his IRA to his son.
Example 2: Judy leases real estate owned by her IRA to her father.
Example 3: Brian uses his IRA funds to purchase an LLC interest owned by his son.
4975(c)(1)(B): The direct or indirect lending of money or other extension of credit between an IRA and a “disqualified person”
Example 1: Keith lends his wife $10,000 from his IRA.
Example 2: Amy personally guarantees a bank loan to her IRA.
Example 3: Peter uses IRA funds to lend an entity owned and controlled by his mother $60,000.
4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between an IRA and a “disqualified person”
Example 1: Eric buys a piece of property with his IRA funds and hires his father to work on the property.
Example 2: Marilyn buys a home with her IRA funds and personally fixes it up.
Example 3: Sara owns an apartment building with her IRA and hires her father to manage the property.
4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of an IRA
Example 1: Dan is in a financial jam and takes $12,000 from his IRA to pay his mortgage and credit card bill.
Example 2: Steve uses his IRA to purchase a rental property and hires his friend to manage the property. The friend then enters into a contract with Steve and transfers those funds back to Steve.
Example 3: Victoria invests her IRA funds in a real estate fund and then receives a salary for managing the fund.
Self-Dealing Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Self-Dealing Prohibited Transaction” generally involves one of the following:
4975(c)(1)(E): The direct or indirect act by a “Disqualified Person” who is a fiduciary whereby he/she deals with income or assets of the IRA in his/her own interest or for his/her own account
Example 1: Jessica who is a real estate agent uses her IRA funds to buy a home and earns a commission from the sale.
Example 2: James wants to buy a piece of property for $110,000 and would like to own the property personally but does not have sufficient funds. As a result, James uses $90,000 from in his IRA and $20,000 personally to make the investment.
Example 3: Dana uses her IRA to funds to invest in a real estate fund managed by her Son. Dana’s son receives a bonus for securing Dana’s investment.
Conflict of Interest Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Conflict of Interest Prohibited Transaction” generally involves one of the following:
4975(c)(i)(F): Receipt of any consideration by a “Disqualified Person” who is a fiduciary for his/her own account from any party dealing with the IRA in connection with a transaction involving income or assets of the IRA
Example 1: Joe uses his IRA funds to loan money to a company in which he manages and controls but owns a small ownership interest in.
Example 2: Michelle uses her IRA to lend money to a business that she works for in order to secure a promotion.
Example 3: Brandon uses his IRA funds to invest in a hedge fund that he manages and where his management fee is based on the total value of the fund’s assets.
Under Internal Revenue Code Section 4975(d), Congress created certain statutory exemptions from the prohibited transaction rules outlined under Internal Revenue Code Section 4975(c). For these certain transaction, Congress believed there is a legitimate reason to permit them. For these transactions, Congress has issued a blanket statutory exemptions permitting these transactions assuming that certain requirements specified are satisfied. Below is a list of some of the statutory exemptions found in Internal Revenue Code Section 4975(d) that apply to IRAs:
• Any contract with a disqualified person for office space, legal, accounting or other services necessary for the operation of the IRA as long as reasonable compensation is paid.Note – this exemption does not apply to an IRA fiduciary (the IRA holder) as per Treasury Regulation Section 54.4975-6(a)(5).
• The provision of ancillary services to an IRA by a bank trustee
• Receipt by a disqualified person of any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries;
Life Insurance and Certain Collectibles
In general, an IRA cannot Invest in life insurance contracts or collectibles defined below:
• Any work of art
• Any metal or gem
• Any alcoholic beverage
• Any rug or antique
• Any stamp
• Most coins
Types of Collectibles That may be Purchased Using IRA Funds
• one, one-half, one-quarter or one-tenth ounce U.S. gold coins (American Gold Eagle coins are the only gold coins specifically approved for IRAs. Other gold coins, to be eligible as IRA investments, must be at least .995 fine (99.5% pure);
• one ounce silver coins minted by the Treasury Department;
• any coin issued under the laws of any state;
• a platinum coin described in 31 USCS 5112(k) ; and
• gold, silver, platinum or palladium bullion (other than bullion that is made into a coin) of a certain fineness that is in the physical possession of a trustee that meets the requirements for IRA trustees under Code Sec. 408(a).
S Corporation Stock
Because of the shareholder restrictions imposed on “S” Corporations, an IRA cannot own stock in an S Corporation. Note – an IRA can own stock in a “C” Corporation.
In general, an IRA can generally make any investment other than the following categories:
- Stock of an S Corporation
- Life Insurance
- Any investment involving a “disqualified person”
When using an IRA to invest in things other than the usual stocks and bonds, be sure to follow the rules so the IRS doesn’t come after you and your hard-earned money. The tax experts at the IRA Financial Group can help reduce your risk and steer you to the best financial decisions when it comes to meeting (and exceeding) your retirement goals. Give them a call at 800.472.0646 or visit their website today!