A Self-Directed IRA allows you to make alternative asset investments with your retirement funds. In other words, it gives you more options than just traditional investments such as stocks and bonds. However, there are IRS regulations surrounding Self-Directed IRAs, including rules around disqualified persons. As a result, your IRA cannot perform transactions with these individuals, and in some cases, organizations.

Self-Directed IRA Disqualified Person Rules Background

The prohibited transaction rules under Internal Revenue Code Section 4975 were enacted as part of the Employee Retirement Income Security Act of 1974 (ERISA) and reflect Congress’s intent to protect retirement assets from self-dealing and abuse.

Prior to ERISA, Congress was concerned that retirement account owners, plan fiduciaries, and related parties could use tax-advantaged retirement funds for personal benefit rather than for their intended purpose of providing retirement security. As a result, Congress established the disqualified person rules to create clear boundaries between a retirement account and those individuals who have sufficient influence or control over it.

The legislative history makes clear that the objective was not to restrict legitimate investment activity, but rather to prevent transactions that could result in conflicts of interest, divided loyalties, or the misuse of retirement assets for current personal gain. By prohibiting transactions between a retirement account and certain related parties, including the account owner, certain family members, fiduciaries, and entities they control, Congress sought to ensure that retirement assets are managed exclusively for the benefit of the retirement account and remain preserved for their intended long-term purpose: funding retirement.

Who Are Disqualified Persons?

The IRS restricts certain transactions between the IRA and a disqualified person. This comes from a congressional assumption that certain transactions between certain parties are inherently suspicious. As a result, they are not allowed.

The definition generally includes you (the IRA holder), your lineal descendants, and entities in which the IRA holder holds a controlling equity or management interest.

Here is who the IRS considers to be disqualified:

• A fiduciary (the IRA holder, participant, or person having authority over making IRA investments)
• Someone who provides services to the plan (trustee or custodian)
• A family member of the IRA holder, trustee, or custodian (parents, grandparents, children, grandchildren, spouses of the fiduciary’s children, etc.)
• Entities of which a disqualified person owns 50% or more

Note: The disqualified person rules apply to lineal descendants only. Brothers, sisters, aunts, uncles, cousins, step-brothers, step-sisters, and friends are not lineal descendants and are therefore NOT treated as disqualified persons.

An In-Depth Look at Disqualified Persons

You can do a great deal with a Self-Directed IRA, but it is important not to trigger a prohibited transaction, which can lead to significant penalties. In order to avoid triggering a prohibited transaction, make sure you know who the IRS considers a disqualified person. The list above covers the key categories, but it is worth understanding the boundaries in more detail.

Brothers, sisters, aunts, uncles, cousins, step-brothers, step-sisters, and friends are not treated as disqualified persons under the IRS rules. This means transactions between your IRA and these individuals are generally permitted, provided they do not otherwise fall into one of the disqualified categories above.

Application of the Prohibited Transaction Rules

In order to determine whether a transaction is a prohibited transaction, it is important to examine all parties within the transaction, not simply the IRA owner.

Pursuant to Internal Revenue Code Section 4975, a Self-Directed IRA cannot engage in certain types of transactions. You can understand the types of prohibited transactions by dividing them into three categories:

• Direct Prohibited Transactions
• Self-Dealing Prohibited Transactions
• Conflict of Interest Prohibited Transactions

The Best Way to Prevent a Prohibited Transaction

When making an investment with a Self-Directed IRA, it is advisable not to engage in any transaction with a disqualified person. There is an abundance of case law that clearly states that an IRA holder cannot engage in a transaction that directly or indirectly benefits a disqualified person.

Below are a few examples of common prohibited transactions involving disqualified persons.

• Direct or Indirect Lending of Money Between an IRA and a Disqualified Person Example: Jen lends her husband $20,000 from her IRA.
• Direct or Indirect Furnishing of Goods, Services, or Facilities Between an IRA and a Disqualified Person Example: Joel buys a home with his IRA funds and personally fixes it up.
• The Direct or Indirect Transfer to a Disqualified Person to Pay Mortgage or Credit Card Bills Example: Tim is in a financial jam and takes $3,000 from his IRA to pay his mortgage and credit card bill.
• Receipt of Any Consideration by a Disqualified Person Who Is a Fiduciary Example: Derrick uses his IRA funds to loan money to a company he manages and controls but holds a small ownership interest in.