What Are IRA LLC Prohibited Transactions?

An IRA LLC allows investors to diversify retirement portfolios with alternative assets, such as real estate or private equity, granting the owner direct “checkbook control.” While this offers flexibility, it introduces prohibited transaction regulations designed to prevent the IRA owner from using the account for personal benefit. The Internal Revenue Service (IRS) establishes these rules to ensure all transactions serve the exclusive benefit of the retirement account. A violation can trigger tax consequences that jeopardize the entire fund.

Defining Disqualified Persons

The foundation of the prohibited transaction rules is understanding who is a “disqualified person.” Internal Revenue Code Section 4975 provides a detailed list of individuals and entities forbidden from engaging in certain transactions with an IRA. These rules are in place to prevent self-dealing and conflicts of interest.

The primary disqualified person is the IRA owner, who acts as a fiduciary with a legal responsibility to manage the IRA’s assets for the account’s exclusive benefit. The owner’s spouse is also listed as a disqualified person, preventing transactions that could indirectly benefit the household.

The definition extends vertically through the family tree to include the IRA owner’s ancestors, such as parents and grandparents. It also covers lineal descendants, which includes children, grandchildren, and their respective spouses.

Any fiduciary providing services to the IRA is also a disqualified person. This can include the IRA custodian responsible for holding the assets or an investment manager who provides advice. This rule prevents fiduciaries from using their position to benefit personally from the IRA’s transactions.

The rules also apply to entities in which disqualified persons have significant ownership. A corporation, partnership, or trust is considered a disqualified person if 50% or more of its ownership is held by other disqualified persons. This provision prevents an IRA owner from using a controlled company to conduct a prohibited transaction.

Identifying Prohibited Transactions

The Internal Revenue Code outlines specific actions that are strictly forbidden between an IRA and a disqualified person. These rules are comprehensive and aim to prevent any form of self-dealing. The following are considered prohibited transactions:

• The sale, exchange, or leasing of any property. For example, an IRA owner cannot sell a personally owned property to their IRA LLC.
• The lending of money or extension of credit. An IRA owner cannot borrow from their IRA, nor can they personally guarantee a loan for the IRA LLC.
• The furnishing of goods, services, or facilities. An IRA owner who is a contractor cannot be paid to renovate a property owned by their IRA LLC.
• The transfer or use of IRA assets by or for the benefit of a disqualified person, which captures many forms of indirect benefits.
• A fiduciary dealing with the IRA’s assets for their own interest (self-dealing) or receiving personal consideration from a transaction involving plan assets.

Common Scenarios in an IRA LLC Context

A frequent issue involves the personal use of an asset owned by the IRA LLC. For instance, an owner cannot stay for a weekend in a vacation cabin that their IRA purchased as a rental property. This action constitutes a personal benefit derived from an IRA asset and is prohibited.

An owner might believe they should be paid for managing the IRA LLC, but this is a form of self-dealing. The IRA owner, as a fiduciary, cannot deal with the assets of the plan for their own interest, which includes paying oneself a salary.

Transactions with family members are a significant area of risk. An IRA LLC cannot purchase a property from the owner’s son or daughter, as they are disqualified persons. Similarly, the IRA cannot provide a loan to a child’s business.

The concept of “sweat equity” also leads to prohibited transactions. If an IRA LLC owns a rental property that needs repairs, the owner cannot personally perform the work. This is considered the furnishing of services, so the IRA LLC must hire an unrelated contractor.

Personal guarantees on loans are a more subtle but equally prohibited action. If the IRA LLC needs a mortgage, the owner cannot personally guarantee it. This act is considered a prohibited extension of credit from a disqualified person to the plan.

Co-investing, where an owner invests personal funds alongside their IRA LLC’s funds, is a complex area. The arrangement can easily lead to indirect benefits and self-dealing. If the investment structure disproportionately favors the owner’s personal stake over the IRA’s, it could be deemed a prohibited transaction.

Consequences of a Prohibited Transaction

Engaging in a prohibited transaction with an IRA results in severe and immediate consequences. A single violation disqualifies the entire IRA, as the penalties are designed to discourage any form of self-dealing.

The primary consequence is that the IRA ceases to be an IRA as of the first day of the tax year in which the transaction occurred. The IRS treats the entire fair market value of the account’s assets as if they were distributed to the owner on that date in a “deemed distribution.”

This deemed distribution means the full value of the IRA’s assets becomes part of the owner’s gross income for that tax year. The amount is subject to ordinary income tax rates and applies to the entire account, not just the funds involved in the specific transaction.

If the IRA owner is under age 59½ at the time of the deemed distribution, the entire amount is also subject to a 10% early withdrawal penalty. This penalty is assessed on top of the ordinary income tax, further eroding the value of the retirement savings.