11.2 Prohibited Transactions under IRC 4975 and Disqualified Persons

Statutory Framework and Congressional Intent of IRC § 4975

When Congress passed the Employee Retirement Income Security Act of 1974 (ERISA), it established a rigid statutory barrier designed to prevent individuals with authority over retirement plans from exploiting plan assets for personal enrichment. Internal Revenue Code (IRC) Section 4975 codifies these protections by establishing a strict liability framework governing Prohibited Transactions across qualified retirement plans, Individual Retirement Accounts (Traditional, Roth, SEP, and SIMPLE IRAs), Health Savings Accounts (HSAs), and Coverdell Education Savings Accounts (ESAs).

Unlike general trust law, which evaluates transactions under an equitable "prudent person" standard, IRC § 4975 establishes per se statutory prohibitions. If a transaction falls within one of the forbidden categories between an IRA and a statutory "disqualified person," it is unlawful regardless of whether the transaction was executed at fair market value, produced superior investment gains, or was conducted in complete good faith (Ellis v. Commissioner, 787 F.3d 1213).

Statutory Definition of "Disqualified Persons" (IRC § 4975(e)(2))

A prohibited transaction requires two elements: an IRA and a Disqualified Person. Under IRC § 4975(e)(2), Congress defined disqualified persons to include any individual or entity occupying a position of influence, control, or close relationship to the retirement plan:

1. Fiduciaries (IRC § 4975(e)(2)(A)): Any person who exercises discretionary authority or discretionary control over the management or administration of the IRA, exercises any authority over the disposition of its assets, or renders investment advice for a fee or other compensation. In an IRA, the IRA owner, the designated beneficiary, the trustee, and the custodian are fiduciaries;
2. Service Providers (IRC § 4975(e)(2)(B)): Any person or entity providing services to the plan, such as an external third-party administrator (TPA), recordkeeper, broker-dealer, or legal counsel;
3. Employers and Employee Organizations (IRC § 4975(e)(2)(C)–(D)): An employer whose employees are covered by the plan (critical for SEP and SIMPLE IRAs) or an employee organization whose members participate;
4. 50% Controlled Entities (IRC § 4975(e)(2)(G)): Any corporation, partnership, trust, or estate where 50% or more of the combined voting power, total value of shares, capital/profits interest, or beneficial interest is owned directly or indirectly by fiduciaries, service providers, employers, or family members;
5. Officers, Directors, and 10% Owners (IRC § 4975(e)(2)(H)): An officer, director (or person with similar responsibilities), a 10% or more shareholder, or a highly compensated employee (earning 10% or more of the yearly wages) of an employer, employee organization, or 50% controlled entity;
6. 10% Partners or Joint Venturers (IRC § 4975(e)(2)(I)): A 10% or more partner or joint venturer in a partnership or joint venture described above;
7. Family Members (IRC § 4975(e)(2)(F)): Specific relatives of a fiduciary, service provider, employer, or 50% owner, as strictly defined by statute.

The Statutory Family Tree (IRC § 4975(e)(6)): Lineal vs. Lateral Relatives

The statutory boundary defining which family members are disqualified persons is one of the most frequently tested concepts on the CISP examination. Under IRC § 4975(e)(6), Congress explicitly limited disqualified family members to:

• The Spouse of the individual;
• Ancestors: Parents, grandparents, and great-grandparents;
• Lineal Descendants: Children, grandchildren, and great-grandchildren (including legally adopted children);
• Spouses of Lineal Descendants: Sons-in-law, daughters-in-law, and spouses of grandchildren.

The Lateral Relative Carve-Out

Candidates must observe who is omitted from the statutory definition. Under IRC § 4975(e)(6), lateral relatives are NOT disqualified persons:

• Brothers and Sisters (Siblings): An IRA owner's brother or sister is not a statutory disqualified person. An IRA may legally purchase real estate from, sell stock to, or co-invest with the account owner's sibling;
• Collateral Descendants and Ancestors: Aunts, uncles, nieces, nephews, and first cousins are not disqualified persons;
• Spouses of Ancestors and Siblings: Step-parents (unless adopting the individual) and brothers-in-law or sisters-in-law are not disqualified persons.

The Fiduciary Self-Dealing Warning: While a direct transaction with a sibling is not a per se prohibited transaction under IRC § 4975(c)(1)(A)–(C), fiduciaries must beware of the indirect benefit rule under Section 4975(c)(1)(D) or (E). If an IRA owner directs their IRA to buy real estate from a brother to provide cash to bail out the brother's failing business where the owner is a creditor, the transaction violates the self-dealing provisions because it benefits the IRA owner personally.

The Six Statutory Prohibited Transactions (IRC § 4975(c)(1))

Internal Revenue Code Section 4975(c)(1) enumerates six distinct categories of forbidden conduct:

1. Sale, Exchange, or Leasing of Property (IRC § 4975(c)(1)(A))

The direct or indirect sale, exchange, or leasing of any property between an IRA and a disqualified person is strictly barred.

• Selling Personal Assets: An IRA owner cannot sell shares of stock, real estate, or private notes from their personal investment portfolio to their IRA;
• Buying IRA Assets: An IRA owner cannot purchase property out of their IRA;
• Leasing Transactions: An IRA-owned commercial building cannot be leased to the IRA owner, the owner's spouse, parents, children, or son-in-law, nor to a corporation where disqualified persons own 50% or more of the stock. Even if the lease is negotiated at full fair market rental value, the transaction is illegal.

2. Lending of Money or Extension of Credit (IRC § 4975(c)(1)(B))

The direct or indirect lending of money or extension of credit between an IRA and a disqualified person is completely prohibited.

• IRA Participant Loans: Unlike qualified 401(k) plans governed by IRC § 72(p), an IRA owner cannot borrow money from their IRA under any circumstances. IRAs do not permit participant loans;
• Lending to Disqualified Persons: An IRA cannot extend a mortgage or personal loan to the owner, their children, or an entity controlled by them;
• Personal Loan Guarantees: If an IRA borrows money from a commercial bank to acquire real estate, the loan must be strictly non-recourse. If the IRA owner or any disqualified person signs a personal guarantee, pledges personal assets, or agrees to cover debt shortfalls, the guarantee constitutes an illegal extension of credit to the IRA (Peek v. Commissioner, 140 T.C. 216 (2013)).

3. Furnishing Goods, Services, or Facilities (IRC § 4975(c)(1)(C))

The direct or indirect furnishing of goods, services, or facilities between an IRA and a disqualified person is prohibited.

• Sweat Equity: An IRA owner who purchases a rental property cannot perform repairs, paint walls, replace plumbing, or perform landscaping on the property. Providing physical labor constitutes an impermissible furnishing of services;
• Professional Services: An IRA owner who is a licensed real estate broker, general contractor, or attorney cannot charge or receive fees from their IRA for listing or managing IRA property;
• Uncompensated Services: Even performing uncompensated property management or renovation work violates this rule, as the contribution of personal labor artificially enhances plan asset value outside statutory contribution ceilings.

4. Transfer to or Use of Plan Assets by a Disqualified Person (IRC § 4975(c)(1)(D))

The transfer to, or use by or for the benefit of, a disqualified person of the income or assets of an IRA is prohibited.

• Personal Use of Real Estate: An IRA owner, their spouse, parents, or children cannot stay in an IRA-owned vacation home, condominium, or farm, even for a single weekend, and even if they pay full fair market rental value;
• Compensating Bank Balances: An IRA owner cannot deposit IRA cash into a commercial bank to fulfill compensating balance requirements or qualify for favorable interest rates on personal or business loans.

5. Fiduciary Self-Dealing (IRC § 4975(c)(1)(E))

An act by a fiduciary whereby they deal with the income or assets of the IRA in their own interest or for their own account.

• Directing an IRA to invest in a private startup where the fiduciary personally holds equity, serves as an executive, or receives personal performance compensation;
• Allocating IRA assets to purchase property adjacent to the fiduciary's personal residence to artificially enhance personal land values.

6. Receipt of Kickbacks or Personal Consideration (IRC § 4975(c)(1)(F))

The receipt of any consideration for their own personal account by any fiduciary from any party dealing with the IRA in connection with a transaction involving the income or assets of the plan.

• An investment adviser, trustee, or custodian accepting referral fees, rebates, private gifts, or side commissions from an investment sponsor or property seller in exchange for directing IRA capital into that vehicle.

Disqualified Persons Classification Matrix

Bank Administrative Scenario: SDIRA Asset Review and Compliance Interception

A commercial bank's trust department provides custodial services for self-directed IRAs. An IRA owner holding $750,000 in a self-directed Traditional IRA submits documentation to acquire a four-unit residential rental apartment complex for $500,000.

During routine onboarding and due diligence review, the bank's CISP compliance administrator reviews the supporting contracts and uncovers the following operational facts:

1. The current property owner selling the apartment complex is the IRA owner's brother;
2. The IRA will pay $200,000 in cash and fund the remaining $300,000 through a mortgage loan from an independent regional bank, which requires the IRA owner to execute a personal guarantee;
3. The property management agreement designates the IRA owner's daughter-in-law as the property manager, paying her a standard 8% monthly gross rental fee;
4. Unit 1 is currently leased to the IRA owner's first cousin at fair market rent.

The CISP administrator conducts a statutory compliance audit under IRC § 4975 and determines:

• The Seller (Brother): Permissible. Under IRC § 4975(e)(6), siblings are lateral relatives and are not disqualified persons. The purchase from the brother does not violate IRC § 4975(c)(1)(A), provided an independent appraisal validates that the purchase price matches fair market value.
• The Tenant (Cousin): Permissible. A first cousin is a lateral relative and not a disqualified person under IRC § 4975(e)(6). Leasing to the cousin is lawful.
• The Personal Guarantee: PROHIBITED. Under IRC § 4975(c)(1)(B), an IRA owner providing a personal loan guarantee commits an illegal extension of credit to the IRA (Peek v. Commissioner). The administrator notifies the client that the transaction cannot close unless the lender removes the personal guarantee and issues a 100% non-recourse note.
• The Property Manager (Daughter-in-Law): PROHIBITED. Under IRC § 4975(e)(6), the spouse of a lineal descendant is a disqualified person. Compensating the daughter-in-law to furnish property management services constitutes an illegal furnishing of services under IRC § 4975(c)(1)(C). The administrator requires the IRA to retain an independent third-party management company.

By intercepting the personal guarantee and the daughter-in-law's contract prior to closing, the bank's compliance officer prevents catastrophic prohibited transactions that would have resulted in complete account disqualification.