What is a Prohibited Transaction?
Prohibited transactions are just that, transactions that are disallowed in the Solo 401k plan. The Prohibited Transaction guidelines can be found in Section 4975 of the Internal Revenue Code. Prohibited Transactions often have the same rules for Solo 401k and Self-Directed IRA plans. You can also learn more about Prohibited Transactions directly from the IRS website.
While most prohibited transaction rules deal with whom the Solo 401k or IRA is prohibited from transacting with – there is a class of assets that are prohibited to purchase with retirement funds – Collectibles
Collectibles might include:
- Wine and/or other Alcoholic Spirits
- Collectible coins (such as numismatic precious metals)
- Precious gemstones
- Non-fungible tokens (NFT)
Aside from those handful of collectible items, there aren’t many assets or asset classes that are off-limits to a retirement plan.
Far more common is the prohibited transaction about who the retirement plan can engage with in a transaction. The parties whom are “off-limits” to doing deals with the retirement plan are called Disqualified Persons.
Who is a Disqualified Person?
The following is a list of disqualified persons to the retirement plan:
- Your spouse
- Any fiduciary of the retirement plan (person who makes investment decisions for the plan)
- Companies who provide services to the 401k plan
- Your lineal ascendants (parents, grandparents) or descendants (children, grandchildren, etc), and spouses of your lineal descendants (son-in law, daughter-in-law, etc)
- A corporation (or other entity) that is 50% or more owned (directly or indirectly) by yourself, your spouse, or any of your lineal ascendants or descendants
- An officer, director, 10% or more owner, or highly compensated employee of the corporation named above.
- A 10% or more (in capital of profits) partner or joint venturer of the corporation above
Every Solo 401k and Self-directed IRA investor should make this DQP list before making any investments.
Which family members are not disqualified?
Uncles, aunts, cousins, sisters, brothers, step-brothers and step-sisters.
Too many people seem to think of the list as only “the accountholder and his family”. As you can see it is a bit more involved than that. This doesn’t require calculus, but you should actually write out the list step by step to ensure that it is complete. This list can actually get quite extensive if you, your family member, or anyone who provides services to your plan has ownership in several companies.
Types of Prohibited Transactions
- Self-Dealing prohibited transactions: defined as when a fiduciary (someone who has financial responsibility over the plan, usually you and/or your spouse) acts in his own best interest in a transaction. In this instance the “own best interest” can be you or your 401k plan. Essentially, there is a conflict of interest if either you or your plan would benefit from the involvement of the other. An example of this might be that you act as real estate agent and earn a commission for a property sold to your Solo 401k.
- Direct prohibited transactions: defined as any transaction that would result in a loss of your tax-deferred status. These transactions generally fall into the categories of:
- 4975(c)(1)(A): sale or exchange, or leasing, of any property between a plan and a disqualified person. An example of this would be if your Solo 401k sold a property to your mother.
- 4975(c)(1)(B): lending of money or other extension of credit between a plan and a disqualified person. An example of this could be your Solo 401k loaning money to yourself to pay off some bills.
- 4975(c)(1)(C): furnishing of goods, services, or facilities between a plan and a disqualified person. An example of this might be buying a house with 401k funds and having your spouse perform the rehab.
- 4975(c)(1)(D): transfer to, or use by or for the benefit of a disqualified person of the income or assets of a plan. An example of this could be you taking rent money earned by a property owned by your Solo 401k and using that money personally.
- Conflict of interest transactions: This occurs when there is a conflict of interest between the benefit of you and your 401k plan. An example of this might be for your Solo 401k plan to lend money to your real estate agency to increase the agency’s advertising budget.
Common Examples of Prohibited Transactions
Example #1: Your Solo 401k purchases a piece of real estate. In an effort to save some money, you personally go in and do the rehab on the property, including tearing out carpet and repainting the walls.
Why this is prohibited: You are disqualified from transacting with your Solo 401k plan. Even if you are providing the rehab services for free, it is still considered a prohibited transaction. Self-dealing means that you (or your 401k) are benefitting from your involvement in the transaction. In other words, you wouldn’t find a construction company that would do the work for free. Because it’s your Solo 401k, you were inclined to do the work for free (a sweetheart deal), causing you to benefit personally from your involvement in the transaction with the Solo 401k therefore making it prohibited.
Example #2: Your Solo 401k purchases a piece of rental property, and you and your family decide to spend a weekend in the property.
Why this is prohibited: You and your family are disqualified from the Solo 401k plan which means you are not allowed to occupy or inhabit that property, even for one day per year. Any instance of you or any other DQP occupying the property would count as a prohibited transaction. Many attorneys will call this a “personal use” prohibited transaction as you are prohibited from using any Solo 401k assets for your personal benefit.
Example #3: Your Solo 401k purchases an office building. One of the tenants of the office building will be your daughter-in-law’s accounting firm.
Why this is prohibited: This is a prohibited transaction because your daughter-in-law is a lineal descendent and therefore a disqualified person. Any of her companies by extension are also disqualified.
Example #4: Your Solo 401k decides to purchase shares of a small start-up. You own 51% of the company and several other shareholders make up the other 49%.
Why this is prohibited: You own more than 50% of the company in which you plan to invest and you are disqualified from transacting with your Solo 401k.
Example #5: You, your brother, and your sister own a C-corp. Your sister is the CEO, your brother is the CFO and you are the COO. You own 20%, your brother owns 15%, and your sister owns 65%. You decide you’d like your Solo 401k to purchase your brother’s 15% shares.
Why this is prohibited: Even though you are less than a 50% owner in the original corporation, this is still a prohibited transaction because you are disqualified from your Solo 401k plan. In this instance your Solo 401k would be transacting with a company you own, and therefore would be prohibited.
Example #6: You want to loan your son some money after he graduates college so your Solo 401k does a private note to him with repayment and interest.
Why this is prohibited: Your son is a lineal descendent, and thus disqualified from transacting with your Solo 401k plan.
Example #7: You buy a rental property with Solo 401k funds. After a couple years the boiler needs replacing but you don’t have enough money in your Solo 401k account so you pay for the boiler replacement with your personal funds.
Why this is prohibited: This is a Prohibited transaction because your Solo 401k is disqualified from transacting with you. You are not allowed to mix personal and retirement funds in a single transaction.
Example #8: You are a real estate agent and your Solo 401k purchases a property where you receive the real estate commission on the deal.
Why this is prohibited: You are disqualified from transacting with your retirement plan. You personally benefitted as the agent on the deal with your Solo 401k plan.
A step transaction is when you put a third party in place in the transaction to make it appear as if the transaction is not Prohibited.
Example #1: You own a rental property and want to get it into your Solo 401k. You sell it to your brother with a handshake understanding that he’ll sell it to your Solo 401k in 30-60 days.
Why this could be considered prohibited: Your brother is not disqualified from transacting with your Solo 401k, an auditor may determine that the transaction with your brother happened only so that your Solo 401k could purchase the property you owned personally.
Example #2: You want to invest your Solo 401k funds into your business, but that is prohibited. Instead, your Solo 401k loans money to your friend, with the understanding that he’ll then invest that money back into your business so you get access to the cash.
Why this could be considered prohibited: Even though your friend is not disqualified from your Solo 401k plan, this is a roundabout way for you to do a prohibited transaction with a third-party placed in the middle. If an IRS auditor chose to “look through” the transaction, it would be clear you are attempting to perform a prohibited transaction by your 401k loaning money to your friend, who then, in turn, loans the money back into your business.
What are the Consequences of a Prohibited Transaction?
Even if you committed a prohibited transaction by accident, the tax consequences are the same. Typically, your Solo 401k will have to pay federal taxes, and penalties.
The IRS outlines the consequences of a prohibited transaction in the following way:
A disqualified person must pay an initial tax on a prohibited transaction of 15% of the amount involved for each year (or part of a year) in the taxable period. If the disqualified person does not correct the transaction within the taxable period, there is an additional tax of 100% of the amount involved.
Both taxes are payable by any disqualified person who participated in the transaction.
This means both parties involved in the prohibited transaction would ultimately have to pay a tax. In Example #3 above, we discussed how your Solo 401k could purchase an office building and if the 401k leased office space to your daughter-in-law’s accounting firm, that would be a transaction. According to the IRS rules, both your Solo 401k and your daughter-in-law (as the disqualified person) would then have to pay the taxes, penalties and consequences of the prohibited transaction.
Can a Prohibited Transaction Be Corrected?
The IRS states:
“A disqualified person who participated in a prohibited transaction can avoid the 100% tax by correcting the transaction as soon as possible. Correcting the transaction means undoing it as much as you can without putting the plan in a worse financial position than if you had acted under the highest fiduciary standards.”
In short answer, yes. If you are quick to correct a prohibited transaction, you can potentially avoid the 100% tax. Correcting the prohibited transaction essentially means undoing the transaction without harming the plan. The plan should be made whole as much as possible and everything should continue on as if you had adhered to the highest “fiduciary standards” in the first place.
If you think you’ve committed a prohibited transaction, you should correct as soon as possible within the taxable period.
If the IRS finds out about the transaction, they may send you a notice of deficiency if the transaction is not corrected within the taxable period the transaction took place. The disqualified party usually has an additional 90 days after receiving the notice in which to correct (undo) the transaction. If appropriate action is taken to correct the prohibited transaction within the stated timeframe, the IRS will generally credit, refund, or abate the 100% tax that was charged.
General Best Practices
- Keep great records of your Solo 401k transactions.
- Don’t do any deals with yourself or your family (or businesses you or your family own).
- Hire unaffiliated third-parties to work on, and manage any real estate owned by your retirement account.
- Don’t personally use assets owned by your retirement account.
- Seek advice from legal counsel if you have any question to the validity of your retirement account transaction.