What Is IRC 4975 and How Does It Apply to Prohibited Transactions?

The IRS enforces strict rules on retirement accounts to prevent self-dealing and conflicts of interest. Internal Revenue Code (IRC) Section 4975 outlines prohibited transactions that could jeopardize a tax-advantaged account’s status. Violations can lead to severe financial penalties, making it crucial for anyone managing an IRA or other retirement plan to understand these restrictions.

Prohibited Transaction Criteria

Certain actions within tax-advantaged retirement accounts can trigger penalties if they violate IRC Section 4975. A prohibited transaction generally involves improper use of the account’s assets, often benefiting the account holder or related individuals in ways that undermine retirement savings.

One common violation occurs when an account holder uses retirement funds to purchase property for personal use. For example, if an individual buys a vacation home with their self-directed IRA and stays in it, the IRS considers this an improper benefit. Similarly, lending money from an IRA to a business owned by the account holder is prohibited, as it constitutes an improper extension of credit.

Transactions involving the purchase or sale of assets between the account holder and their IRA at non-market rates can also violate the rules. Selling a personally owned asset to an IRA at an inflated or discounted price is considered self-dealing. Likewise, using retirement funds to invest in a company where the account holder has a controlling interest creates a conflict of interest.

Disqualified Persons

IRC Section 4975 defines certain individuals and entities as “disqualified persons,” meaning they cannot engage in transactions with a tax-advantaged retirement account to prevent conflicts of interest.

The account holder is a disqualified person, along with family members such as spouses, children, parents, and grandparents. However, siblings, aunts, uncles, and cousins are not. For example, lending money from an IRA to a child is prohibited, but doing so with a sibling is not.

Entities such as corporations, partnerships, or trusts in which the account holder or their family members have significant ownership or control are also disqualified. If an individual owns 50% or more of a business, that business is subject to the same restrictions as a direct family member. Additionally, fiduciaries responsible for managing the retirement account, including advisors or trustees with discretionary authority, are disqualified persons due to their duty to act in the account’s best interest.

Exemptions

While IRC Section 4975 imposes strict limitations, certain exemptions allow some otherwise prohibited activities. These exemptions accommodate legitimate financial dealings that serve a functional purpose in retirement planning.

One key exemption applies to transactions with financial institutions. If a retirement account engages in transactions with a bank or brokerage firm where the account holder has an existing relationship, it does not automatically constitute a violation. For example, an IRA custodian may charge reasonable fees for administrative services without triggering a prohibited transaction. Similarly, a loan from a qualified employer plan, such as a 401(k), to a participant is permitted under IRC 4975(d)(1), provided it meets specific criteria, including a reasonable interest rate and repayment schedule.

Another exemption allows professionals such as investment advisors, attorneys, and accountants to provide services to an IRA or qualified plan, as long as their compensation is reasonable and does not involve self-dealing.

Excise Taxes

When a prohibited transaction occurs, the IRS imposes excise taxes under IRC Section 4975. These penalties increase the longer the violation remains uncorrected. The initial tax is 15% of the amount involved in the transaction, assessed annually until the issue is resolved. For example, if an individual improperly directs $50,000 from their retirement account, they would owe $7,500 each year until corrective action is taken.

If the transaction is not corrected within the IRS-mandated period, an additional 100% excise tax is levied on the amount involved. At this stage, the financial consequences become severe, as the total tax liability could reach 115% of the original transaction. If a prohibited loan of $50,000 remains outstanding, the account holder could ultimately owe $57,500 in penalties.

Correction Procedures

Addressing a prohibited transaction under IRC Section 4975 requires corrective action to minimize financial penalties and restore compliance. The IRS does not offer a formal self-correction program for these violations, so account holders must act quickly to unwind improper transactions and mitigate excise taxes.

If a prohibited transaction involves the improper transfer or use of retirement funds, the first step is to undo the transaction as soon as possible. This typically means returning any misused assets to the account, along with any lost earnings or appreciation. For example, if an IRA improperly purchased an asset from a disqualified person, the asset must be transferred back, and the account must be made whole. The IRS generally expects these corrections to be completed within the same tax year to avoid escalating penalties.

If the violation cannot be fully reversed, the account holder may need to pay the excise taxes and formally report the transaction on IRS Form 5330. This form calculates the 15% initial tax and any additional penalties if the issue remains unresolved. If the IRS audits the account and determines that the violation was willful or egregious, the tax consequences could extend beyond excise taxes, potentially leading to disqualification of the retirement account’s tax-advantaged status. Seeking professional tax advice is often necessary to navigate these complexities and ensure compliance.