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Prohibited Transactions Can Come Back to Haunt You

Two individuals wanted to purchase a business together. They set up self-directed IRAs and a corporation to hold the business. The self-directed IRAs purchased the shares of the new company, which then purchased an ongoing business. The purchase of the business was partly funded with loans that were personally guaranteed by the two individuals.

The IRAs were later converted to Roth IRAs. Eventually the Roth IRAs sold the stock held in the business at a profit. IRS got wind of all of this and sent the individuals tax notices for tax on the gains realized from the sale of the stock and for accuracy related penalties. The individuals took the case to tax court.

The ultimate decision of the tax court was not good for the IRA owners. The judge found that the tax code prohibits a direct or indirect extension of credit between IRA assets and a disqualified person. He found that the loan guarantees were an indirect extension of credit by the individuals to the IRAs through the business the IRA owned.

The court found that once the prohibited transaction occurred, the IRA was no longer qualified and that the prohibited transaction continues to exist until the loan is paid. When the IRAs were converted to Roth IRAs, the Roth IRAs were not qualified because the IRAs were not qualified. Therefore, the gain on the sale of the stock was taxable in the year it occurred.

When prohibited transactions occur in an IRA, the repercussions may not be felt until many years later. If the consequences from the prohibited transaction are not properly reported to IRS, there is no statute of limitations. IRS can come back at any time and assess penalties due to the prohibited transaction. In this case, the individuals were also hit with accuracy related penalties.

Any time you want to do something out of the box with an IRA, you have to be very sure that you know what you are doing in order to stay out of trouble. The prohibited transaction rules are nothing to laugh at.

-By Beverly DeVeny and Jared Trexler


It's beyond me why people try and get fancy with their retirement funds. With the availability of 3x ETFs (multiplying the gain or loss by 3 times) and inverse ETFS, one can play the market or any market segment as widely as they want in any direction they want.

@Bob Richards This isn't about getting fancy. If you are an entrepreneur and you are starting/buying a business you need to put all your capital to work. If most of that capital is in an IRA the option used above is the only way to tap into that capital. The only other option is it take it out and pay the penalty.

It needs to be as easy as possible for small businessmen to tap into their capital, even if that capital is in an IRA. I know several people who have done this without the prohibited transaction.

This is not about investing but funding a small business. Talking about ETFs is missing the point.

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Thursday's Slott Report Mailbag

Consumers: Send in Your Questions to [email protected]

You recently said that a 401(k) distribution would add to your MAGI (modified adjusted gross income) for the purpose of determining if you are subject to the 3.8% healthcare surtax. What about Roth IRA distributions? Would they also count towards your total MAGI income for surtax purposes?


IRA distributions are exempt from the 3.8% surtax, but taxable distributions from IRAs can push income over the threshold amount, causing other investment income to be subject to the surtax. Because Roth IRA distributions are generally tax-free, they don’t count towards your total MAGI.