What is IRA Section 4975 (Self-Directed IRAs)?

Report: Understanding Section 4975 and Its Impact on Self-Directed IRAs

Date: October 26, 2023
Prepared For: General Audience
Subject: The Prohibited Transaction Rules of IRC Section 4975

1.0 Executive Summary

Section 4975 of the Internal Revenue Code establishes a strict regulatory framework to prevent self-dealing and protect the assets of qualified retirement plans, including Self-Directed IRAs. It imposes severe financial penalties on “prohibited transactions”—specific types of improper dealings between the plan and “disqualified persons.” For IRA owners, the consequences of a violation are particularly catastrophic, as it can lead to the entire account being deemed distributed and becoming immediately taxable. Understanding these rules is critical for anyone utilizing a Self-Directed IRA to make alternative investments.

2.0 Introduction: The Purpose of Section 4975

Section 4975 functions as a protective guardrail for the tax-advantaged “highway” of retirement savings. Its primary purpose is to ensure that plan assets are used solely for the benefit of the retirement account and its beneficiaries, not for the personal, immediate gain of those who control or are connected to the plan. The statute achieves this by imposing an excise tax on prohibited transactions.

Scope: The rules apply to a wide range of plans, including:

• Trusts described in section 401(a) (e.g., 401(k)s, Profit-Sharing Plans)
• Individual Retirement Accounts (IRAs) and Self-Directed IRAs
• Individual Retirement Annuities
• Archer MSAs, Health Savings Accounts (HSAs), and Coverdell ESAs

3.0 Penalties for Prohibited Transactions

The tax structure is a two-tiered penalty system designed to first penalize and then force correction.

3.1 Initial Tier 1 Tax (Subsection (a))

• Rate: 15% of the “amount involved” in the prohibited transaction.
• Duration: This tax is applied for each year (or part thereof) in the “taxable period,” which is the time from the date the transaction occurs until it is fully corrected.

3.2 Additional Tier 2 Tax (Subsection (b))

• Trigger: This tax is imposed if the transaction is not corrected within the taxable period.
• Rate: 100% of the amount involved. This severe penalty makes it financially ruinous to leave a prohibited transaction uncorrected.

3.3 The Concept of “Correction”
“Correction” means undoing the transaction to the extent possible and returning the plan to a financial position at least as good as it would have been if the disqualified person had acted under the highest fiduciary standards.

3.4 Special Catastrophic Consequence for IRAs
For an Individual Retirement Account (IRA), engaging in a prohibited transaction has a unique and severe outcome:

• The entire IRA is treated as distributed on the first day of the tax year in which the transaction occurred.
• The entire account balance becomes immediately taxable as ordinary income.
• If the owner is under age 59½, they will also be subject to an additional 10% early distribution penalty.

This consequence is separate from and can be in addition to the excise taxes described above.

4.0 Definition of a Prohibited Transaction

A “prohibited transaction” is any direct or indirect transaction between a plan and a “disqualified person.” Key prohibited actions include:

• Sale, Exchange, or Lease: Selling, exchanging, or leasing property between the plan and a disqualified person.
• Lending Money or Credit: Lending money or extending credit between the plan and a disqualified person.
• Furnishing Goods/Services: Furnishing goods, services, or facilities between the plan and a disqualified person.
• Transfer or Use for Benefit: Transferring plan assets to, or using them for the benefit of, a disqualified person.
• Fiduciary Self-Dealing: A fiduciary using the plan’s income or assets in their own interest or for their own account.
• Kickbacks: A fiduciary receiving consideration (a kickback, fee, or commission) for their own account from any party dealing with the plan in connection with a transaction involving plan income or assets.

5.0 Key Definitions: Disqualified Person and Fiduciary

The restrictions hinge on identifying the parties involved.

5.1 Disqualified Person
This is a broadly defined group that includes:

• A fiduciary of the plan.
• A person providing services to the plan.
• An employer any of whose employees are covered by the plan.
• An owner (direct or indirect) of 50% or more of an employer or entity service provider.
• Family members of the above (spouse, ancestor, lineal descendant, or spouse of a lineal descendant).

For a Self-Directed IRA, the IRA owner is almost always a fiduciary, making them and their close family members disqualified persons.

5.2 Fiduciary
A fiduciary is any person who:

• Exercises any discretionary authority or control over the management of the plan assets or its administration.
• Renders investment advice for a fee or other compensation with respect to any plan money or property.
• Has any discretionary authority in the plan’s administration.

6.0 Statutory Exemptions

The law provides specific exemptions for necessary transactions that do not jeopardize the plan, provided strict conditions are met. Key exemptions include:

• Plan Loans to Participants: Loans to participants or beneficiaries, provided they are available to all on a reasonably equivalent basis, are adequately secured, and bear a reasonable rate of interest.
• Necessary Services: Contracts for necessary services (legal, accounting, custodial) with a disqualified person, provided the compensation is no more than “reasonable.”
• Receipt of Plan Benefits: A disqualified person receiving benefits they are entitled to as a plan participant or beneficiary.
• Administrative Exemptions: The Secretary of the Treasury may grant additional conditional or unconditional exemptions.

7.0 Analogy and Conclusion

Analogy: Section 4975 acts as a guardrail system on the tax-advantaged highway of retirement savings. “Disqualified persons” are vehicles forbidden from crossing this guardrail. A minor touch results in an initial fine (15% tax). A failure to reverse course and correct the error leads to a catastrophic penalty (100% tax and potential plan disqualification).

Conclusion: The rules under Section 4975 are intentionally strict to preserve the integrity of retirement funds. For owners of Self-Directed IRAs, who have broader investment choices, the risk of inadvertently engaging in a prohibited transaction with a disqualified person (often themselves or a family member) is significantly higher. Extreme caution and consultation with a qualified tax or legal professional specializing in retirement plans are essential before entering into any transaction that could be construed as self-dealing.

 

Report: Understanding Section 4975 and Its Impact on Self-Directed IRAs

Date: October 26, 2023
Prepared For: General Audience
Subject: The Prohibited Transaction Rules of IRC Section 4975

1.0 Executive Summary

Section 4975 of the Internal Revenue Code establishes a strict regulatory framework to prevent self-dealing and protect the assets of qualified retirement plans, including Self-Directed IRAs. It imposes severe financial penalties on “prohibited transactions”—specific types of improper dealings between the plan and “disqualified persons.” For IRA owners, the consequences of a violation are particularly catastrophic, as it can lead to the entire account being deemed distributed and becoming immediately taxable. Understanding these rules is critical for anyone utilizing a Self-Directed IRA to make alternative investments.

2.0 Introduction: The Purpose of Section 4975

Section 4975 functions as a protective guardrail for the tax-advantaged “highway” of retirement savings. Its primary purpose is to ensure that plan assets are used solely for the benefit of the retirement account and its beneficiaries, not for the personal, immediate gain of those who control or are connected to the plan. The statute achieves this by imposing an excise tax on prohibited transactions.

Scope: The rules apply to a wide range of plans, including:

• Trusts described in section 401(a) (e.g., 401(k)s, Profit-Sharing Plans)
• Individual Retirement Accounts (IRAs) and Self-Directed IRAs
• Individual Retirement Annuities
• Archer MSAs, Health Savings Accounts (HSAs), and Coverdell ESAs

Official IRS Resources:

• IRS Code Section 4975 (via IRS.gov): The official text of the statute. (Note: The IRS often provides the Code in PDF form through Revenue Rulings or other publications. For a direct, searchable version, see the Office of the Law Revision Counsel link below).
• 26 U.S. Code § 4975 – Tax on prohibited transactions: From the Office of the Law Revision Counsel, U.S. House of Representatives. This is the official U.S. Code version.

3.0 Penalties for Prohibited Transactions

The tax structure is a two-tiered penalty system designed to first penalize and then force correction.

3.1 Initial Tier 1 Tax (Subsection (a))

• Rate: 15% of the “amount involved” in the prohibited transaction.
• Duration: This tax is applied for each year (or part thereof) in the “taxable period,” which is the time from the date the transaction occurs until it is fully corrected.

3.2 Additional Tier 2 Tax (Subsection (b))

• Trigger: This tax is imposed if the transaction is not corrected within the taxable period.
• Rate: 100% of the amount involved. This severe penalty makes it financially ruinous to leave a prohibited transaction uncorrected.

3.3 The Concept of “Correction”
“Correction” means undoing the transaction to the extent possible and returning the plan to a financial position at least as good as it would have been if the disqualified person had acted under the highest fiduciary standards.

3.4 Special Catastrophic Consequence for IRAs
For an Individual Retirement Account (IRA), engaging in a prohibited transaction has a unique and severe outcome:

• The entire IRA is treated as distributed on the first day of the tax year in which the transaction occurred.
• The entire account balance becomes immediately taxable as ordinary income.
• If the owner is under age 59½, they will also be subject to an additional 10% early distribution penalty.

This consequence is separate from and can be in addition to the excise taxes described above.

Official IRS Resources:

• IRS Publication 590-B, Distributions from IRAs: Discusses the tax treatment of IRA distributions, including the consequence of a prohibited transaction. See the section on “Prohibited Transactions.”
• IRS Tax Topic 557 – Tax on Prohibited Transactions: A brief overview of the tax implications for prohibited transactions in any qualified plan.

4.0 Definition of a Prohibited Transaction

A “prohibited transaction” is any direct or indirect transaction between a plan and a “disqualified person.” Key prohibited actions include:

• Sale, Exchange, or Lease: Selling, exchanging, or leasing property between the plan and a disqualified person.
• Lending Money or Credit: Lending money or extending credit between the plan and a disqualified person.
• Furnishing Goods/Services: Furnishing goods, services, or facilities between the plan and a disqualified person.
• Transfer or Use for Benefit: Transferring plan assets to, or using them for the benefit of, a disqualified person.
• Fiduciary Self-Dealing: A fiduciary using the plan’s income or assets in their own interest or for their own account.
• Kickbacks: A fiduciary receiving consideration (a kickback, fee, or commission) for their own account from any party dealing with the plan in connection with a transaction involving plan income or assets.

Official IRS Resources:

• IRS Retirement Plans FAQs on Prohibited Transactions: A helpful question-and-answer resource that provides practical examples and explanations.

5.0 Key Definitions: Disqualified Person and Fiduciary

The restrictions hinge on identifying the parties involved.

5.1 Disqualified Person
This is a broadly defined group that includes:

• A fiduciary of the plan.
• A person providing services to the plan.
• An employer any of whose employees are covered by the plan.
• An owner (direct or indirect) of 50% or more of an employer or entity service provider.
• Family members of the above (spouse, ancestor, lineal descendant, or spouse of a lineal descendant).

For a Self-Directed IRA, the IRA owner is almost always a fiduciary, making them and their close family members disqualified persons.

5.2 Fiduciary
A fiduciary is any person who:

• Exercises any discretionary authority or control over the management of the plan assets or its administration.
• Renders investment advice for a fee or other compensation with respect to any plan money or property.
• Has any discretionary authority in the plan’s administration.

6.0 Statutory Exemptions

The law provides specific exemptions for necessary transactions that do not jeopardize the plan, provided strict conditions are met. Key exemptions include:

• Plan Loans to Participants: Loans to participants or beneficiaries, provided they are available to all on a reasonably equivalent basis, are adequately secured, and bear a reasonable rate of interest.
• Necessary Services: Contracts for necessary services (legal, accounting, custodial) with a disqualified person, provided the compensation is no more than “reasonable.”
• Receipt of Plan Benefits: A disqualified person receiving benefits they are entitled to as a plan participant or beneficiary.
• Administrative Exemptions: The Secretary of the Treasury may grant additional conditional or unconditional exemptions.

Official IRS Resources:

• IRS Prohibited Transaction Exemptions Page: Provides information and links to rulings on specific exemptions granted by the Department of Labor (DOL), which the IRS respects under the coordinated regulatory framework.

7.0 Analogy and Conclusion

Analogy: Section 4975 acts as a guardrail system on the tax-advantaged highway of retirement savings. “Disqualified persons” are vehicles forbidden from crossing this guardrail. A minor touch results in an initial fine (15% tax). A failure to reverse course and correct the error leads to a catastrophic penalty (100% tax and potential plan disqualification).

Conclusion: The rules under Section 4975 are intentionally strict to preserve the integrity of retirement funds. For owners of Self-Directed IRAs, who have broader investment choices, the risk of inadvertently engaging in a prohibited transaction with a disqualified person (often themselves or a family member) is significantly higher. Extreme caution and consultation with a qualified tax or legal professional specializing in retirement plans are essential before entering into any transaction that could be construed as self-dealing.

Additional Key IRS Resource:

• IRS Publication 590-A, Contribution to IRAs: While focused on contributions, this publication also contains vital information about what constitutes an IRA and the general rules governing them, providing essential context for the prohibited transaction rules.

Glossary: Key Terms for Section 4975 & Self-Directed IRAs

A

• Additional Tax (100% Tax): A severe financial penalty imposed under Section 4975(b) if a prohibited transaction is not “corrected” within the taxable period. This tax is equal to 100% of the amount involved in the transaction.

C

• Correction: The act of undoing a prohibited transaction to the extent possible. The goal is to return the retirement plan to the same financial position it would have been in if the disqualified person had acted under the highest fiduciary standards.
• Coverdell Education Savings Account (ESA): A tax-advantaged savings account designed to pay for qualified education expenses. It is subject to the prohibited transaction rules of Section 4975.

D

• Disqualified Person: A broadly defined group of individuals and entities who are prohibited from engaging in transactions with a retirement plan. This includes the plan’s fiduciary, service providers, the employer, any 50% or more owner, and members of their families (spouse, ancestor, lineal descendant).

E

• Excise Tax: A tax levied on a specific activity or transaction, in this case, on prohibited transactions involving retirement plans.
• Exemption: A statutory or administrative exception to the prohibited transaction rules, allowing certain necessary or low-risk transactions (e.g., reasonable loans to participants or payments for necessary services) to occur without penalty.

F

• Fiduciary: Any person who exercises discretionary authority or control over the management of a plan’s assets, renders investment advice for a fee, or has discretionary authority in the plan’s administration. For most Self-Directed IRAs, the account owner is a fiduciary.

I

• Initial Tax (15% Tax): The first-tier penalty imposed under Section 4975(a) on a disqualified person for engaging in a prohibited transaction. It is equal to 15% of the amount involved for each year the transaction remains uncorrected.
• Internal Revenue Code (IRC): The official body of federal tax law in the United States. Section 4975 is part of this code.
• IRA (Individual Retirement Account): A tax-advantaged investing tool individuals use to earmark funds for retirement savings. Engaging in a prohibited transaction can cause the entire IRA to be distributed, making it taxable.

P

• Prohibited Transaction: Any direct or indirect transaction between a retirement plan and a disqualified person. Specific examples include sales, leases, loans, and the furnishing of goods or services between the plan and the disqualified person.

S

• Section 4975: The section of the Internal Revenue Code that imposes an excise tax on prohibited transactions between a qualified retirement plan and a disqualified person. Its purpose is to prevent self-dealing and protect plan assets.
• Self-Directed IRA: A type of IRA that allows for a broader range of investments (e.g., real estate, private equity) beyond typical stocks and bonds. The same prohibited transaction rules apply, often creating a higher risk of inadvertent violations due to the nature of the investments.

T

• Taxable Period: The period starting when the prohibited transaction occurs and ending when it is corrected. The 15% initial tax is imposed for each year (or part of a year) within this period.

 

To-Do List: Managing Your Self-Directed IRA & Avoiding Prohibited Transactions

A Checklist for Compliance and Prudent Investing

Phase 1: Before You Invest – Education & Foundation

• ✔️ Understand the Golden Rule: Internalize that your IRA is a separate entity. You cannot do business with yourself, your close family, or entities you control.
• ✔️ Identify Your “Disqualified Persons” List: Write down a definitive list of all individuals and entities that are off-limits for your IRA. This includes you, your spouse, your parents, your children and their spouses, and any businesses you control (≥50% ownership).
• ✔️ Consult a Professional: Schedule a meeting with a qualified professional (tax attorney, CPA, or financial advisor) who has specific expertise in Self-Directed IRAs and ERISA law. Do not rely solely on a custodian’s advice.
• ✔️ Review IRS Resources: Bookmark key IRS webpages, such as the Retirement Plans FAQs on Prohibited Transactions and Publication 590-A.

Phase 2: During the Investment – Diligence & Execution

• ✔️ Perform a “Disqualified Person” Check: For every potential investment, explicitly confirm that no seller, partner, tenant, or service provider is on your disqualified persons list.
• ✔️ Use Only IRA Assets: Ensure all funds for the purchase, related expenses, and maintenance come directly from your IRA. Do not pay for anything out-of-pocket.
• ✔️ Document Everything: Keep impeccable records of all transactions, approvals, and fee structures. The paper trail is your best defense in an audit.
• ✔️ Avoid “Sweetheart” Deals: Ensure all transactions are conducted at arm’s length and for fair market value. Your IRA should not give you (or a disqualified person) a personal benefit.

Phase 3: Ongoing Management – Vigilance & Administration

• ✔️ Pay All Expenses from the IRA: Property taxes, insurance, maintenance, and management fees for an IRA-owned asset must be paid by the IRA itself. If the IRA cannot pay, the asset may need to be sold or risk being distributed.
• ✔️ Deposit All Income into the IRA: All income (e.g., rent, dividends, interest) generated by the IRA’s investment must flow directly back into the IRA account.
• ✔️ Never Provide Services Personally: You cannot be the handyman, property manager, or lawyer for your IRA’s assets. Your IRA must hire and pay unrelated third parties for all services.
• ✔️ Conduct an Annual Compliance Review: Once a year, formally review your IRA’s investments and transactions against your “Disqualified Persons” list and the rules of Section 4975.

Phase 4: Red Flags – Immediate “Do Not Do” List

• ❌ DO NOT use your IRA to buy a property for your personal use, your child’s use, or your business’s use.
• ❌ DO NOT loan your IRA’s money to a disqualified person.
• ❌ DO NOT personally guarantee a loan for your IRA. (This is a complex area; seek expert advice).
• ❌ DO NOT receive any compensation (e.g., a fee, commission) for managing your IRA’s investments.
• ❌ DO NOT let your IRA invest in an entity (LLC, LP) where disqualified persons are also investors.

Disclaimer: This checklist is for educational purposes and is not a substitute for professional legal, tax, or financial advice. The rules governing Self-Directed IRAs are complex and carry severe penalties for non-compliance. Always consult with a qualified expert before making any investment decisions.

Here is a table distinguishing disqualified from non-disqualified persons, followed by illustrative example stories.

Disqualified Person vs. Non-Disqualified Person

This table defines who you, as the IRA fiduciary, are prohibited from transacting with.

Feature	Disqualified Person (PROHIBITED)	Non-Disqualified Person (ALLOWED)
Definition	A person or entity legally defined in IRC §4975(e)(2) that is strictly prohibited from engaging in transactions with your Self-Directed IRA.	Any individual or entity that does not meet the definition of a disqualified person.
Who is Included	– You (the IRA Owner) – Your Spouse – Your Parents – Your Children & their Spouses – Your Fiduciary Appointees – Any Entity You ≥50% Own (e.g., your business)	– You (in your personal capacity) – Friends – Siblings – Aunts/Uncles/Cousins – Arm’s Length Business Partners – Any Entity You <50% Own
Relationship to IRA	Has a close, pre-existing personal or controlling relationship with the IRA owner, creating a high risk of self-dealing.	Has an arm’s-length relationship with the IRA owner; transactions are conducted on standard market terms.
Allowed to Transact with IRA?	NO. Any direct or indirect transaction is a “Prohibited Transaction.”	YES. The IRA can freely engage in transactions with them, provided they are for the sole benefit of the IRA and at fair market value.
Example Transaction	Your IRA cannot buy a rental property from your father.	Your IRA can buy a rental property from your friend’s father.
Key Principle	Conflict of Interest. The law assumes the transaction may benefit the person, not the IRA.	Arm’s Length. The law assumes the transaction is for the exclusive benefit of the IRA’s retirement savings.

Example Stories: Prohibited vs. Permitted

Story 1: The Rental Property Purchase

• Disqualified Person (PROHIBITED):
  • Scenario: Sarah has a Self-Directed IRA with $200,000. Her mother, Linda, wants to sell a condo she owns. To help her mother get a quick sale and because it’s a good property, Sarah directs her IRA to buy the condo from Linda for $200,000.
  • The Problem: Linda is a disqualified person (lineal ancestor of the IRA owner).
  • The Violation: The sale of property between the IRA and a disqualified person is a direct prohibited transaction.
  • The Consequence: The entire balance of Sarah’s IRA ($200,000) is deemed distributed as of January 1st of that year. It becomes immediately taxable income, and if she is under 59½, she also owes a 10% early withdrawal penalty. The IRS will also assess excise taxes on the transaction.
• Non-Disqualified Person (ALLOWED):
  • Scenario: Sarah has a Self-Directed IRA with $200,000. Her college roommate’s father, Mr. Davis, whom she knows socially but has no business ties with, is selling a condo. After independent due diligence, Sarah directs her IRA to buy the condo from Mr. Davis for its fair market value of $200,000.
  • The Analysis: Mr. Davis is a non-disqualified person (no family relation, not a fiduciary).
  • The Outcome: The transaction is permitted. The IRA owns the condo. All rental income flows back into the IRA, and all expenses (taxes, repairs) are paid by the IRA. The investment grows tax-deferred for Sarah’s retirement.

Story 2: Fixing Up an Investment Property

• Disqualified Person (PROHIBITED):
  • Scenario: Mark’s IRA purchases a fixer-upper property. To save money and because he’s a skilled carpenter, Mark decides to do the renovation work himself on the weekends. He does not pay himself for this labor.
  • The Problem: Mark is a disqualified person (the IRA owner and fiduciary). By providing a service (sweat equity) to the plan, he is furnishing goods, services, or facilities between the plan and a disqualified person.
  • The Violation: This “sweat equity” is a prohibited transaction. The IRS views this as you contributing labor to enhance an asset owned by your retirement plan, which is a form of self-dealing.
  • The Consequence: Same as above—potential disqualification of the entire IRA.
• Non-Disqualified Person (ALLOWED):
  • Scenario: Mark’s IRA purchases a fixer-upper property. He hires a licensed, unrelated general contractor to manage the renovation. The contractor hires plumbers, electricians, and carpenters at market rates, and all invoices are paid directly from Mark’s IRA.
  • The Analysis: The general contractor and all subcontractors are non-disqualified persons.
  • The Outcome: The transaction is permitted. The IRA pays for necessary services at a reasonable cost, and the asset is improved for the exclusive benefit of the retirement plan.

Key Takeaway: The rules are designed to create a clear, bright line between your personal life and your retirement assets. When in doubt, the safest course is to assume a person is disqualified and seek professional advice before proceeding.