Prohibited Transaction

Cornelius Ashgrove directs the self-directed traditional IRA he owns to purchase a vacation cottage from himself at an independently appraised fair market price, and he pays the IRA a market rent whenever he uses it. He tells his IAR that the appraisal and the rent make the arrangement acceptable. Which statement is correct?

1. A.The arrangement is permitted, because an independent appraisal establishes fair market value and he pays market rent for any personal use.Incorrect. The prohibition covers the category of dealing between an IRA and a disqualified person; a fair price does not cure it.
2. B.The purchase is permitted but the personal use is not, so only the rental portion is a prohibited transaction.Incorrect. BOTH the sale of property between the owner and his IRA and the personal use of IRA property are prohibited transactions.
3. C.The transaction is merely subject to an excise tax that can be corrected by unwinding the purchase before year end.Incorrect. The correction-and-excise-tax framework does not save an IRA owner here; the account itself loses its status.
4. D.This is a prohibited transaction with a disqualified person, so the account ceases to be an IRA as of the first day of that year and the ENTIRE balance is treated as distributed and taxable.Correct. The IRA owner is a disqualified person, and owner-initiated prohibited transactions disqualify the whole account retroactively to the start of the year.

Why: The IRA owner is a DISQUALIFIED PERSON with respect to his own IRA. Any direct or indirect sale, exchange or leasing of property between an IRA and a disqualified person is a prohibited transaction, and so is the use of IRA assets by a disqualified person for personal benefit. Paying a fair price and a market rent does not cure the defect, because the rule prohibits the category of dealing itself rather than merely unfair dealing. The consequence for an IRA is unusually harsh. Where the owner is the one who engaged in the transaction, the account ceases to be an IRA as of the first day of that taxable year, and the ENTIRE account is treated as distributed at that point. The full value becomes taxable ordinary income and, if the owner is under 59 and a half, the 10% additional tax on early distributions can apply to the whole amount, not merely to the cottage.

Corbin Securities learns that a customer, age 48, has pledged the entire balance of his self-directed traditional IRA as collateral for a personal bank loan. He has withdrawn nothing from the account. What is the federal tax consequence?

1. A.The pledged portion is treated as distributed in the year of the pledge - taxable as ordinary income and, because he is under 59 1/2, generally subject to the 10 percent early distribution penalty.Correct. Using an IRA as loan security is a deemed distribution of the pledged portion, with the early-distribution penalty layered on for an owner under 59 1/2.
2. B.There is no tax consequence as long as the loan is repaid within 60 days of the pledge.Wrong. The 60-day window belongs to rollovers. There is no 60-day cure for pledging an IRA as collateral.
3. C.The pledge is permitted, because an IRA may secure a loan so long as the owner withdraws nothing from the account.Wrong. Pledging an IRA is exactly what the rule prohibits, and the absence of an actual withdrawal is what makes the result surprising.
4. D.Tax is triggered only if the bank actually forecloses and takes the pledged assets.Wrong. The deemed distribution occurs at the moment of the pledge. Foreclosure is irrelevant to the timing.

Why: Using an IRA - or any portion of it - as security for a loan is treated as a DISTRIBUTION of the pledged portion in the year of the pledge, even though no money has left the account. The deemed distribution is includible in ordinary income, and because the owner is under 59 1/2 and no statutory exception applies, the 10 percent early distribution penalty applies on top of the income tax. The bank never has to foreclose for this result to occur; the pledge itself triggers it.

The trustee of the Brantley Manufacturing 401(k) plan is approached by Brantley's majority shareholder, who offers to sell a warehouse he owns personally to the plan. He supplies a current independent appraisal and offers the property at exactly the appraised fair market value. Under ERISA, how should the trustee treat the offer?

1. A.The purchase is permitted because an independent appraisal establishes that the plan pays no more than fair market value.Wrong. A fair price does not cure a per se prohibited transaction between a plan and a party in interest.
2. B.The purchase is permitted as long as the trustee documents that real estate fits the plan's investment policy.Wrong. Meeting the prudence standard does not override the flat prohibition on property sales with a party in interest.
3. C.The purchase is a prohibited transaction because the shareholder is a party in interest and ERISA bars sales of property between a plan and a party in interest regardless of price, absent an exemption.Correct. This is a per se prohibited transaction; only a statutory or administrative exemption could permit it.
4. D.The purchase is prohibited only if the plan pays more than the appraised value.Wrong. Overpaying would add a breach of the prudence duty, but the transaction is already prohibited at any price.

Why: ERISA flatly prohibits certain transactions between a plan and a party in interest, a category that includes the employer, its owners, plan fiduciaries and service providers. Among the barred transactions are the sale, exchange or lease of property between the plan and a party in interest. The prohibition is structural: it applies even when the price is demonstrably fair, because Congress chose a bright line over case-by-case scrutiny. Only a statutory exemption or a Department of Labor exemption can permit the deal.

Noor Haddadi holds units of a publicly traded master limited partnership inside her self-directed traditional IRA. The partnership passes through her share of income from its pipeline operating business on a Schedule K-1. What is the tax consequence?

1. A.Holding the MLP is a prohibited transaction that disqualifies the entire IRAMLP units are a permitted IRA asset. Prohibited transactions involve self-dealing and disallowed assets such as collectibles.
2. B.The income is taxable to Noor personally in the current year on her Form 1040The tax, if any, is imposed on the IRA and paid from IRA assets, not reported on her personal return.
3. C.All of the partnership income is tax-deferred inside the IRA until distribution, like interest or dividendsOperating business income passed through by a partnership is UBTI and is not sheltered by the IRA.
4. D.The IRA itself may owe tax on unrelated business taxable income above the annual exclusion amount, reported on Form 990-T by the custodian and paid from IRA assetsCorrect. UBTI is taxed inside the IRA even though the account is otherwise tax-deferred.

Why: A tax-exempt retirement account is not sheltered from tax on unrelated business taxable income. Income a partnership generates from an active trade or business flows through to the IRA as UBTI, and once the IRA's UBTI for the year exceeds the annual exclusion amount, the IRA itself owes tax. The custodian files Form 990-T for the account and pays the tax out of IRA assets, reducing the balance. Holding an MLP in an IRA is legal, so no prohibited transaction arises and the account is not disqualified.