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IRA Prohibited Transactions

All the rules and restrictions are outlined in the IRS Publication 590.  Not following these rules set forth for Traditional IRAs could affect the tax status of your account and could result in disqualification of the account and severe tax consequences.

Everything in the IRA has to be an arm’s length transaction which means you as the IRA owner can’t benefit from the asset owned by the IRA.    You should always remember that the IRA is intended for your future retirement and not for you benefit now.  Therefore, you must always be asking yourself if there is any personal benefit for you now in doing such a transaction.

 In general, prohibited transactions are any improper use of your traditional IRA account by you, your beneficiary or any disqualified person.

Examples of prohibited transactions are:

  • Borrowing money from IRA
  • Selling property to the IRA
  • Receiving unreasonable compensation for managing the IRA
  • Uses IRA for security on a loan
  • Buying property for personal use with IRA funds – i.e Personally using IRA property for a residence, office, vacation home, etc.

It is also important to remember that the IRA has to be a closed loop in terms of expenses and income or profit.  The expenses related to the property must be paid from the IRA directly and all the income/profits be paid directly to the IRA as well.  For example,  if your IRA owns a rental property then all the rent must be returned directly to the IRA and all the expenses such as maintenance, insurance, taxes, etc must be paid directly from the IRA.

Who are disqualified persons? They are you, your IRA holder, your spouse, parents, children and their spouses, grand children, grand parents and great grand parents, grand children and great grand children and their spouses.  In other words your ascendents and descendants.  Also, anyone acting as a fiduciary and service providers of the IRA like your attorney, CPA or financial advisor.   The weird thing is that brothers and sisters are not included but I personally would not take a chance since I think this was an oversight in the rules.

Who is considered a fiduciary? The custodian of the IRA would be one.  Anyone who provides investment advice for your IRA for a fee would be another.  Anyone who has discretionary authority or control in managing your IRA or disposing of its assets would also be considered a fiduciary.

What happens when my IRA engages in a prohibited transaction?  

  1. The account stops being a IRA as of the first day of that year in which it occurred.
  2. The account is treated as if all assets were distributed to you at their fair market values on the first day of the year.
  3. If the total of those values is more than the basis in the IRA, you will have a taxable gain that is included in your income.
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Investing In A Business With Your IRA

Many people do not know that they can invest in a business or even their own business (caution: you must follow the IRS rules for self dealing) using a self directed IRA. If you think a business has alot of potential to be a long-term success, why not make an investment in it using your retirement plan? It can be done, but you have to follow the IRS rules and be careful for self dealing if you are investing in a business you have ownership interest in (discussed below). If you are investing in a business that is an unrelated party then there should be no issues.

This isn’t the same as borrowing from your 401k. I believe it is not wise for a entrepreneur to borrow against your retirement assets since you do not get a return. On the other hand, using a self directed IRA allows you to build your retirement by getting a return on your investment. If you invest in a business that gives you interest income and some equity in the company, this is the best of both worlds. In my opinion, self-directed IRAs are an under appreciated tool for allowing entrepreneurs and their friends to invest retirement funds into a business.

As always, take care to do it right and to not cross the IRS. But investing funds from your self-directed IRA into your business or another business is a viable and potentially wise alternative you should consider. In fact, your siblings, friends and business associates can also invest in your business from their retirement funds and ensure their capital gains get favorable tax treatment. This could make an otherwise break-even investment proposition seem more attractive. In addition, it could make your investors more patient by extending their investment horizon to their retirement years, which is a huge benefit from your perspective. By suggesting self-directed IRAs to potential investors that you’re in discussions with, you can increase the chances that they close and that they become your long-term financial partners.

Here’s how it works. Move your IRA funds into a self-directed IRA. Then, direct your IRA to make an equity investment into the business of your choice. Many people have put small amounts of money in their IRA and grew they retirement dramatically when the company went public and all the returns go back into your tax free IRA. If your investing in your own business be careful and be aware of the self dealing rules. The trick is that the IRS is serious about IRAs being used to build funds for retirement and is on the lookout for schemes to use IRAs to enrich your life now.

So lets look at these important rules:

1. Don’t investment in S corporations. This is simply because of the tax definitions of this legal structure.
2. Respect the list of “prohibited transactions.” While friends, business associates and siblings may invest in your business via a self-directed IRA, your parents, children or a spouse may not.
3. You can’t be the key employee and key investor in the business. You can’t own more than 50 percent of the business in which you invest, and you can’t have a controlling interest in the company. Basically, someone else has to have the right to hire or fire you. The IRS wants to make sure you aren’t self-dealing or moving retirement funds in a way that might benefit you in the present through a salary or other immediate payments.

In addition to a startup type business, you can also buy a new business with your IRA. The business is then subject to a tax called the unrelated business income tax (UBIT), since IRAs are otherwise tax-free. But your equity position still appreciates in your IRA tax-free. AGAIN BE CAREFUL AND GET GOOD LEGAL ADVISE since there are fairly detailed tax and securities law involved with this and IRS rules for self dealing, so consult with trusted experts in the field.

I personally think it is cleaner if you don’t use your own IRA funds for buying a business but instead raised money from a handful of investors who will purchased stock or equity positions using their self-directed IRAs. Most of these investors have a long-term investment view and are cooperative and patient.

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