Recognizing Prohibited Transactions

Recognizing Prohibited Transactions

Learning Objectives Understand the sources of prohibited transaction rules Differentiate between different kinds of prohibited transactions and penalties Identify how to prevent a prohibited transaction and how to resolve if one has occurred Recognize the concepts of unrelated business taxable income (UBTI) and when it applies 2

Background

Background: Why Do We Have Prohibited Transaction Rules? Ensure transactions benefit plans, not owners Prevent misuse of plan assets and conflicts of interest Prevent unwarranted risks with assets Prevent selfdealing by persons holding key positions (disqualified persons) Singular motive main purpose of plan is to maximize accumulation of retirement assets 4

Prohibited Transaction Ground Rules

Potential for Conflicts of Interest Some actions or relationships are always strictly prohibited. Other actions offer the potential for actions or decisions that are not in the best interest of an IRA or retirement plan account. 6

Test Your Instincts #1 Ida, whose business isn t doing well, uses her employees 401(k) deferrals to cover payroll until business improves. Prohibited Transaction Not a Prohibited Transaction 7

Test Your Instincts #2 Martin directs his IRA custodian to purchase investment property, which the IRA owner not only expects to appreciate substantially in value over time, but which he and his family intend to use for vacation. Prohibited Transaction Not a Prohibited Transaction 8

Test Your Instincts #3 Brenda gives $25,000 from her self-directed IRA to her brother, Arnold, as a personal loan. Arnold signs a promissory note stating that he will make loan payments directly to the IRA custodian at a reasonable stated rate of interest. Prohibited Transaction Not a Prohibited Transaction 9

Prohibited Transaction Ground Rules Retirement Plan Direct Personal Benefit Indirect Personal Benefit Disqualified Person 10

What Is a Plan? 401(a) plans Traditional IRA Roth IRA (i.e., pension, profit sharing, including 401(k) and stock bonus plans) HSAs & MSAs SIMPLE IRA Coverdell ESA 11

Who Is a Disqualified Person? Fiduciary or service provider including Plan participants IRA owners Trustees/custodians Employer maintaining the plan Employee organizations that have members covered under the plan 12

Who Is a Disqualified Person? 50% owner of a company Family member of plan participant or IRA owner 50% owner by a family member A company s officers, directors, 10% or more shareowners, or highly compensated employees 10% or more owner of a company 13

What Transactions Are Prohibited? Sale, exchange, or leasing of any property between a plan and a disqualified person Lending of money or other extension of credit Furnishing of goods, services, or facilities 14

What Transactions Are Prohibited? Use of, for the benefit of, or transfer of the income or assets of the plan Act dealing with the income or assets of the plan in own interest Receipt of any consideration for personal account dealing with the plan involving the plan s income or assets 15

Prohibited Transactions: Direct or Indirect? Removing a disqualified person from direct involvement is not a solution Enlisting a third party to execute the transaction does not insulate the parties from a prohibited transaction 16

Applying the Prohibited Transaction Restrictions

Applying the Prohibited Transaction Restrictions An employer working with a custodian or trustee, or a third party, that confines the plan to common or conventional investments, is more likely to stay out of danger. A self-trusteed plan, particularly with no rank-and-file employees, is commonly the target market for boutique service providers that deal in unconventional investments, which may be gray areas for prohibited transaction exposure. Taxpayers inclined to push the envelope work with nonbank trustees willing to get involved with and hold unconventional investments. 18

Sale or Exchange of Assets Example Rhoda s Traditional IRA holds $100,000 in cash. Rhoda s husband, Joe, owns a local salvage business. Rhoda directs the trustee of her IRA to purchase a $50,000 interest in the business. Rhoda s IRA purchased an interest in property already owned by her husband outside of the IRA a disqualified person which is impermissible. 19

Lending of Money Example #1 Martin s 401(k) plan account holds approximately $300,000 in cash. Martin s daughter, Debbie, is shopping around for a car loan. Martin lends his daughter $10,000 from his 401(k) account in exchange for a 60-month promissory note that bears a reasonable rate of interest. Debbie, a lineal descendant of Martin, is a disqualified person, making this a prohibited transaction. On the other hand, lending money to a total stranger might be permissible. 20

Lending of Money Example #2 Brenda s Roth IRA holds $500,000 in cash. Brenda wants the IRA to purchase a new business, but the IRA does not have enough cash to purchase the business outright. Brenda consults with a financial organization that can loan the difference to the IRA. Brenda personally guarantees the debt. Because a personal guarantee is an extension of credit, a prohibited transaction has occurred. 21

Furnishing of Goods, Services or Facilities Example #1 Mae s IRA purchases 1,000 shares of stock in a golf course so that she may receive a lifetime country club membership. As a disqualified person providing Mae with a free membership would be a prohibited transaction. 22

Furnishing of Goods, Services, or Facilities Example #2 Gary s IRA purchases a piece of commercial real estate from an unrelated third party. Thereafter, the IRA permits Gary s dental practice to operate out of the property for free. The furnishing of facilities between a plan and a disqualified person (Gary) is prohibited. 23

Furnishing of Goods, Services, or Facilities Example #3 Benny personally makes repairs on a rental property that is owned by his IRA. The furnishing of services between a plan and disqualified person (Benny) is prohibited. 24

Transfer to or Use of Plan Assets Example #1 Jack is a real estate agent. One of Jack s clients is selling an apartment building in an up-and-coming neighborhood, and Jack represents the client as the listing agent. Jack uses his IRA assets to purchase the apartment building and earns a commission as the real estate agent on the sale. The IRA assets are used for the benefit of a disqualified person (Jack), which is a prohibited transaction. 25

Transfer to or Use of Plan Assets Example #2 Joe s Traditional IRA holds property. Joe s son, Donny, lives on the property during the summer months when he s not at college. This plan asset cannot be used by Donny, who is a lineal descendant of Joe, and is, therefore, a disqualified person (Donny). 26

Fiduciary Dealing With Assets in His Own Interest Example #1 Carlton uses $80,000 of his IRA assets to lend money to a limited liability company that he controls and manages. Carlton, as the IRA owner, is a disqualified person and a fiduciary. IRC Sec. 4975(c)(1)(E) prohibits Carlton from dealing with the income or assets of the IRA for his own interest. 27

Fiduciary Dealing With Assets in Her Own Interest Example #2 Sally used her 401(k) plan assets to lend money to two companies in which she was the largest, but not controlling, stockholder. The companies have 30 and 55 other stockholders, respectively. The loans were at market rate and each company s assets were secured. The transactions were used by Sally, for her benefit, using plan assets. Thus, the transactions are prohibited. 28

Receipt of Consideration for Personal Account Example #1 Alice sells her printing business, Stationary Plus, LLC, to her Traditional IRA. In exchange, the IRA pays Alice $250,000. A prohibited transaction occurs upon Alice s receipt of consideration for the sale of her business to the IRA. 29

Receipt of Consideration for Personal Account Example #2 Stationary Plus, LLC, which is now owned by Alice s Traditional IRA, hires Alice as a saleswoman on the weekends. Alice makes a commission on any of her sales and also receives an hourly wage paid by Stationary Plus, LLC. A prohibited transaction occurs upon Alice s receipt of wages or commissions from Stationary Plus, LLC. 30

Receipt of Consideration for Personal Account Example #3 21st Century Bank is giving away tablets (valued at $100) to anyone who opens a new IRA with a $3,000 deposit. This is a prohibited transaction because consideration is provided for opening the account. The prohibited transaction exemption that might have applied here (PTE 1993-1 which deals with gifts rather than services) does not apply because the tablet is valued at more than $10. 31

Real Estate Investments and Prohibited Transaction Issues Generally a long-term investment 32

Ways to Invest in Real Estate Share Direct ownership REIT 33

Real Estate Investment Concerns vs. Tax Benefits Valuations Expenses Management of real estate 34

Real Estate Investment Concerns vs. Tax Benefits Prohibited transactions Environmental concerns Unrelated business taxable income (UBTI) 35

Not uncommon in the IRA world When Does UBTI Come Into Play With a Real Estate Purchase? Occurs if property is purchased in an IRA and property is partially financed with debt (a mortgage) Rental income goes into the IRA and all expenses must be paid from the IRA No personal use of the property and IRA owner may not make property repairs Liquidity considerations Annual valuations for Form 5498 reporting 36

UBTI and Real Estate Purchase Concerns Example Jenny buys a $200,000 rental property with her IRA. The average value of her mortgage for 2018 is $100,000. Jenny received $20,000 in rental income in 2018. Because her average debt was 50% of the property purchase amount, 50% of the rental income ($10,000) is taken into consideration when calculating her UBTI for the year. 37

UBTI and Real Estate Purchase Concerns Tax is paid by the IRA Tax rates for trusts and estates apply UBTI generated income is currently taxable to the extent it exceeds $1,000 for the year IRA trustee/custodian files Form 990-T to pay the tax 38

Prohibited Transaction Prevention, Penalties, and Correction

Prohibited Transaction Prevention, Penalties and Correction Take the time to understand the nature of prohibited transactions and how they tend to arise Avoid making any kind of prohibited transaction determination Advise clients to seek their own competent tax, legal, and accounting professionals 40

Prohibited Transaction Prevention, Penalties and Correction Refuse to permit client s suspected prohibited transaction Resign as trustee or custodian Obtain specific written direction and/or hold harmless agreement 41

Prohibited Transaction Penalties Qualified plan penalties and IRA penalties differ 42

IRA Penalties for Prohibited Transactions IRC Sec. 4975 prohibited transaction January 1 1099-R 5 IRA deemed distributed as of the first day of the year in which prohibited transaction occurred if prohibited transaction committed by IRA owner or beneficiary Enter code 5 on IRS Form 1099-R to report distribution 43

IRA Penalties for Prohibited Transactions IRC Sec. 4975 prohibited transaction 1099-R 1 or 7 Pledging IRA as security for a loan: only that portion of IRA pledged as security is deemed distributed Enter code 1 or code 7 on Form 1099-R to report distribution 44

QRP Penalties for Prohibited Transactions 5530 Initial penalty tax on disqualified person = 15% of amount involved Additional penalty tax on disqualified person = 100% of amount involved Potential plan disqualification Disqualified person should file Form 5330 to report payment of penalty tax 45

Self-Correcting Certain Prohibited Transactions Breaching party (fiduciary) is responsible for making the plan whole PPA allows individuals to self-correct certain transactions within 14 days No self-correction for real estate transactions, or where individual knew or should have known transaction was prohibited May involve disgorging profits even if plan was not harmed 46

Prohibited Transaction Exemptions

Prohibited Transaction Exemptions Statutory Exemptions DOL Class Exemptions Individual Exemptions Prohibited Transaction Exemptions Advisory Opinions 48

Loans (if detailed requirements met) Statutory Exemptions Providing office space or legal, accounting, and other necessary services for reasonable compensation Deposits in bank accounts or life insurance where the bank or insurance company is the employer Providing ancillary services to a plan by bank trustees 49

Prohibited Transaction Class Exemptions PTE 2004-16 Fiduciaries may designate themselves an IRA provider to receive automatic rollovers of mandatory distributions PTE 1997-11 Broker-dealers may provide free or low-cost brokerage services to IRA and owner-only plans 50

Prohibited Transaction Class Exemptions PTE 1980-26 Employers may lend money or extend credit to their QRPs PTE 1993-1 1993-2 1993-33 Trustees may provide free bank services in connection with opening or maintaining an IRA 51

Prohibited Transaction Class Exemptions PTE 2006-04 Allowed sale of property held by plan to a disqualified person PTE 2006-05 Allowed a loan to the plan from the union (a disqualified person) to finance the building of a training facility 52

Advisory Opinions: Insight Into DOL Interpretations

DOL response to a specific factual scenario requested by an individual or organization Advisory Opinions Like PLRs, AOs can be relied on only by the entity requesting the ruling Certain patterns may emerge in the rulings, giving some insight into the DOL s perspective Usually just a handful are issued each year, so AOs are scrutinized more heavily than PLRs 54

Advisory Opinion AO 2003-02A Financial organizations that serve in a trust capacity to a retirement plan can offer overdraft protection (extension of credit) to the plan if an event (e.g., delayed settlement of a securities transaction) would otherwise result in account overdrafts. 55

IRA Incentives

IRA Incentives Direct payment to IRA owner Direct deposit into IRA as earnings or dividends Direct deposit into IRA as regular contribution 57

IRA Incentives The $10/$20 exemption PLR 201317017 1099-MISC 1099-DIV 1099-INT 58

Questions?

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