Prohibited Transaction

A prohibited transaction is a transaction between a retirement plan or account and a person the law treats as too closely connected to it to deal with the plan at arm's length. Internal Revenue Code Section 4975 imposes an excise tax on such transactions involving qualified plans, individual retirement accounts and annuities, health savings accounts, Archer MSAs, and Coverdell education savings accounts. Section 406 of the Employee Retirement Income Security Act of 1974, codified at 29 U.S.C. Section 1106, states a parallel prohibition aimed at plan fiduciaries. Neither rule asks whether the deal was a good one. The theory is that a retirement account is meant to be an arm's-length investment vehicle, so whole categories of self-dealing are closed off rather than policed case by case.

The six categories in the tax code. Section 4975(c)(1) defines a prohibited transaction as any direct or indirect sale, exchange, or lease of property between a plan and a disqualified person; lending of money or other extension of credit between them; furnishing of goods, services, or facilities between them; transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; any act by a disqualified person who is a fiduciary dealing with plan income or assets in his own interest or for his own account; and receipt of consideration for his own personal account by a fiduciary from any party dealing with the plan in connection with a transaction involving plan assets. Who counts as a disqualified person is defined at Section 4975(e)(2) and runs wider than most people expect, reaching fiduciaries, service providers, employers whose employees are covered, 50-percent owners of those entities, and a defined family group. The self-directed IRA page works through which relatives are and are not caught, which is the part that most often surprises an account owner.

The ERISA half uses different words for a similar idea, and adds one of its own. ERISA Section 406(a)(1) is written as a duty on the fiduciary rather than a tax on the counterparty: a fiduciary "shall not cause the plan to engage in a transaction, if he knows or should know" that it is one of five listed dealings with a "party in interest". Four of those five track the tax-code list; the fifth concerns acquiring employer securities or employer real property in violation of ERISA's own limits. Section 406(b) then adds three self-dealing prohibitions with no ordinary consumer analogue in the tax code: a fiduciary may not deal with plan assets in his own interest or for his own account, may not act on behalf of a party whose interests are adverse to the plan or its participants, and may not receive consideration for his own personal account from anyone dealing with the plan. The vocabulary difference is not cosmetic. "Party in interest" and "disqualified person" are separately defined terms in separately administered statutes, and a document that uses one is telling you which regime it is speaking about.

Two regimes, two completely different consequences, and this is the practical heart of the subject. Under Section 4975(a) the initial tax is 15 percent of the amount involved, imposed for each year or part of a year in the taxable period and paid by the disqualified person who took part, not by the plan. If the transaction is not corrected within the taxable period, Section 4975(b) adds a tax "equal to 100 percent of the amount involved". Neither tax falls on the plan itself, so an employer plan generally survives the event even though the wrongdoer is penalized heavily.

An IRA owner is treated entirely differently. Section 4975(c)(3) switches the excise tax off for the individual whose benefit the account was established for, where the account instead ceases to be an IRA, and Section 408(e)(2)(A) supplies that consequence: if during any taxable year the individual or the beneficiary "engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year." Section 408(e)(2)(B) then treats the account as having distributed everything in it at that day's fair market value. One transaction can therefore empty the entire account for tax purposes, not just the offending investment.

A neighboring rule that is easy to confuse and works the other way. Using an IRA as security for a loan is dealt with by Section 408(e)(4), which treats only "the portion so used" as distributed. Pledging part of an account costs the pledged part; a prohibited transaction costs the whole account. The two sit within a few lines of each other and are routinely described as though they were the same rule.

Exemptions exist, and they are the reason ordinary plan administration is possible. Both statutes carry lists of statutory exemptions, and both give the government authority to grant further ones. Section 4975(c)(2) sets out an exemption procedure requiring consultation with the Secretary of Labor, notice to interested persons, and publication in the Federal Register, and it requires findings that the exemption is administratively feasible, in the interests of the plan and its participants, and protective of their rights. The ERISA prohibitions in Section 406 open with the words "Except as provided in section 1108", which is where its own exemptions live. The exemption most consumers meet without knowing it is the one that allows a plan to pay a service provider for necessary services at reasonable compensation; the recordkeeper page explains what happens when the conditions attached to it are not met.

A different statute, an identical heading. Section 206 of the Investment Advisers Act of 1940, at 15 U.S.C. Section 80b-6, is headed "Prohibited transactions by investment advisers" and is that Act's antifraud provision, reaching conduct such as defrauding a client or trading as principal with a client without written disclosure and consent. It has nothing to do with the retirement rules on this page, and a search result quoting that heading is answering a different question.

Two hypothetical examples, chosen to show why the same act carries such different consequences depending on the account.

A plan case. Suppose a business owner whose company sponsors a retirement plan leases warehouse space to the plan, and the amount involved is $100,000 for the year. The owner is a disqualified person, and a lease of property between a plan and a disqualified person is prohibited on its face. The initial tax under Section 4975(a) is 15 percent of the amount involved, or $15,000, imposed for the year and payable by the owner rather than by the plan. If the arrangement is unwound within the taxable period, that is where it ends. If it is not, Section 4975(b) imposes an additional tax equal to 100 percent of the amount involved, a further $100,000.

An IRA case. Suppose instead an individual aged 52 with a $400,000 IRA borrows from the account. Because the actor is the owner, the excise tax does not apply. The account stops being an IRA as of the first day of that taxable year and is treated as distributing everything, so the entire $400,000 fair market value becomes taxable income. At an assumed 24 percent marginal rate that is $96,000 of income tax, and because the owner is under 59 and a half the 10 percent additional tax on early distributions adds $40,000, for $136,000 on a transaction involving a fraction of the balance. Had the same owner instead pledged $50,000 of the account as security for a bank loan, Section 408(e)(4) would have treated only that $50,000 as distributed.

The correction step is worth understanding before it is needed. In the plan case the initial 15 percent tax is survivable and the 100 percent tax is generally not, so the whole question is whether the transaction is undone inside the statutory window. In the IRA case there is no equivalent second chance, because the account's status is lost as of the first day of the year rather than at the moment of the transaction.

Pros

• A categorical rule is knowable in advance, so a plan fiduciary or account owner can screen a transaction without valuing it or litigating its fairness.
• Because the tax falls on the disqualified person and not on the plan, an employer plan's participants are generally not punished for a fiduciary's act.
• The statutory and administrative exemptions leave room for ordinary administration, including paying service providers reasonable compensation.

Cons

• Good faith is irrelevant. A fair price, an appraisal, and an honest motive do not save a transaction inside a prohibited category.
• For an IRA the penalty is wildly out of proportion to the act, because the entire account is deemed distributed rather than the offending amount.
• The definition of a disqualified person is broad and counterintuitive, so a dealing that feels obviously arm's-length can still be caught.
• The two statutes use different terms for overlapping ideas, which makes reading guidance written for one regime and applying it to the other genuinely risky.
• Correction has a deadline, and missing it adds a second tax of 100 percent of the amount involved on top of the 15 percent already imposed.