Disqualified Persons: Prohibited Transactions, Self-Dealing, Penalties

Prohibited transactions and disqualified persons are the two halves of one rule: the IRS bars certain financial dealings between a tax-advantaged account and the people closest to it, and it defines who those people are by statute. For retirement plans and IRAs, the rules live in IRC Section 4975. For private foundations, they live in Sections 4941 and 4946. Fair market value is not a defense. Good intentions are not a defense. If a disqualified person is on one side and the account is on the other, the transaction is prohibited, and the penalties run from steep excise taxes to complete loss of the account’s tax-exempt status.

Who Counts as a Disqualified Person

The label sounds like it should mean someone shady. It doesn’t. It means someone connected closely enough to a plan or foundation that their dealings with it are presumed to compromise its tax-advantaged purpose. The exact list depends on which regime you’re in.

Retirement Plans and IRAs

Under IRC Section 4975, disqualified persons start with fiduciaries: anyone with discretionary authority over the plan’s management or assets, and anyone who provides investment advice for a fee.¹ For an IRA, the account owner is treated as the plan creator and is a fiduciary by default. Custodians, administrators, and other service providers to the plan are also on the list.

Family members can’t be used as a workaround. The statute reaches spouses, ancestors (parents and grandparents), lineal descendants (children and grandchildren), and the spouses of those descendants.¹ Siblings are not listed. Your brother buying property from your IRA doesn’t trigger a prohibited transaction on that basis alone, though other facts might still create one.

Business entities become disqualified persons when 50% or more of the ownership is held by other disqualified persons. That threshold applies to voting power in a corporation, profits interest in a partnership, or beneficial interest in a trust or estate.¹ Officers, directors, 10%-or-greater shareholders, and highly compensated employees of an employer sponsoring the plan are also disqualified, along with 10%-or-greater partners in such entities.² Ownership is measured with constructive-ownership rules, so shares held through entities get attributed up to their individual owners in proportion to their interest.³

Private Foundations

Section 4946 uses a different starting point for foundations. The core categories are substantial contributors to the foundation and foundation managers, meaning officers, directors, and trustees.⁴ Anyone owning more than 20% of a corporation, partnership, or trust that is itself a substantial contributor also qualifies.

The family definition is slightly wider than for retirement plans: spouses, ancestors, children, grandchildren, great-grandchildren, and the spouses of children, grandchildren, and great-grandchildren. Siblings are excluded here as well. The entity-ownership threshold is 35%, lower than the 50% used for retirement plans.⁴ Government officials are disqualified persons for foundations, but only for purposes of the self-dealing rules.

The Six Prohibited Transactions Under Section 4975

Section 4975(c)(1) lists six categories of forbidden conduct. A transaction that would be perfectly reasonable between strangers becomes illegal the moment a disqualified person sits across the table from the plan.

Selling, exchanging, or leasing property. You cannot sell your rental house to your IRA, and your IRA cannot lease office space to your business. The prohibition runs both directions.²
Lending money or extending credit. An IRA cannot lend money to the account owner, and the account owner cannot personally guarantee a loan taken by the IRA. Using IRA assets as collateral for a personal loan lands here too.¹
Furnishing goods, services, or facilities between the plan and a disqualified person, subject to a narrow exception for services necessary to operate the plan.¹
Transferring plan income or assets to a disqualified person, or letting a disqualified person use them. This is the broadest catch-all and reaches things as simple as staying overnight at a vacation property your IRA owns.⁵
Fiduciary self-dealing: a fiduciary dealing with plan assets for their own interest or account.¹
Kickbacks: a fiduciary receiving payment from any party in connection with a plan transaction.¹

The last two don’t require a counterpart transaction. A fiduciary who steers plan investments into a company where they hold a personal stake has dealt with plan assets in their own interest, whether or not the investment made money. The conflict is the violation. Same with kickbacks: any payment, commission, or gift a fiduciary receives from a party doing business with the plan is prohibited regardless of whether the underlying deal was good for the plan.

The personal-guarantee issue catches self-directed IRA investors constantly. If your IRA borrows to buy real estate, the loan has to be non-recourse, meaning the lender’s only remedy on default is the property itself. The instant you sign a personal guarantee, you’ve extended credit between yourself and your IRA, and that can disqualify the entire account.

Self-Dealing for Private Foundations

Private foundations face a parallel set of restrictions under IRC Section 4941. The categories overlap heavily with the retirement-plan list: selling or leasing property, lending money, furnishing goods or services, paying compensation, transferring income or assets, and making certain payments to government officials.⁶ The important difference is that most of the statutory exemptions available to retirement plans don’t apply to foundations, and the penalty rates are considerably harsher.

What It Costs You

The penalty structure depends on whether the account is an IRA, an employer plan, or a private foundation. The differences matter, and the IRA rule is the one that surprises people most.

IRAs Lose Tax-Exempt Status Entirely

Under IRC Section 408(e)(2), if an IRA owner or beneficiary engages in a prohibited transaction, the account ceases to be an IRA as of the first day of that taxable year. The IRS then treats the entire fair market value of the account as distributed on that date.⁷ The full balance becomes ordinary income. If the owner is under 59½, an additional 10% early-withdrawal tax applies on top of that.⁸

One small silver lining: when an IRA is disqualified this way, the 15% excise tax on the transaction itself doesn’t apply, because the account is no longer an IRA.¹ Cold comfort. On a $500,000 self-directed IRA, a single prohibited transaction at fair market value can generate a federal tax bill north of $200,000.

Employer Plans Pay Excise Taxes

For an employer-sponsored retirement plan, the plan survives, but the disqualified person owes tax. The initial excise tax is 15% of the “amount involved” for each year or partial year in the taxable period. The amount involved is the greater of what was given or received, valued as of the transaction date.¹ The disqualified person pays, not the plan. If the transaction isn’t corrected within the taxable period, an additional tax of 100% of the amount involved applies.⁹

Foundations Face the Steepest Rates

The initial tax on foundation self-dealing is 10% of the amount involved for each year the transaction remains uncorrected, plus 5% on any foundation manager who knowingly participated. Fail to correct in time and the additional tax jumps to 200% on the self-dealer and 50% on a manager who refused to agree to the correction.¹⁰ The 200% figure is among the most punitive rates anywhere in the Internal Revenue Code.

What’s Still Allowed

Not every interaction between a plan and a disqualified person is off-limits. Section 4975(d) carves out statutory exemptions, and the Department of Labor issues class exemptions on top of those. The most commonly used statutory exemptions include reasonable compensation for services necessary to operate the plan, participant loans that meet the statutory conditions, interest-bearing bank deposits held by a bank fiduciary at its own institution when an independent fiduciary approved the arrangement, and plan benefits paid to a disqualified person who is also a participant, as long as those benefits are calculated the same way as for everyone else.²

The “necessary services” exemption is narrower than it reads. Services must be genuinely needed for plan operation, and compensation cannot exceed what an unrelated party would charge. A fiduciary who also happens to be a plumber cannot bill the plan for fixing pipes at a plan-owned building and call it necessary services when any licensed plumber could do the job.

The DOL’s class exemptions (called PTEs) cover categories of otherwise-prohibited transactions common in the financial industry, including transactions managed by qualified professional asset managers independent of the parties, certain securities-lending arrangements, and compensation to investment-advice fiduciaries. PTE 2002-51 provides excise tax relief for eligible transactions corrected through the DOL’s Voluntary Fiduciary Correction Program.¹¹

Reporting and Fixing a Violation

Once a prohibited transaction has happened, both reporting and correction are mandatory, and delay only makes the numbers worse. The initial tax accrues for each year the transaction remains uncorrected.

For retirement plans and IRAs, the disqualified person reports the transaction and calculates excise taxes on IRS Form 5330.⁹ Private foundations and their disqualified persons use Form 4720.⁶ Both forms require specific detail on transaction dates, amounts, and the parties involved.

Correction means undoing the transaction to the extent possible so the plan or foundation ends up in the same financial position it would have been in had the transaction never happened. That may mean selling property back, repaying borrowed funds with interest, or reversing an improper payment. Timely correction is the only way to avoid the additional tax, which is where the real financial damage sits.

The Voluntary Fiduciary Correction Program

The Department of Labor’s Voluntary Fiduciary Correction Program (VFCP) gives plan fiduciaries and sponsors a structured path to fix certain prohibited transactions before an enforcement action starts. The program covers 19 categories of eligible transactions, including purchases and sales involving parties in interest, below-market-rate loans, delinquent participant contributions, and payment of excessive compensation.¹² Applicants identify the violation, follow the prescribed correction process, restore any losses with interest, and file supporting documentation with the appropriate regional office. Transactions corrected through the VFCP can qualify for excise tax relief under PTE 2002-51, which is a significant incentive because self-correction outside the program still leaves the excise tax liability in place.

The IRS’s Employee Plans Compliance Resolution System (EPCRS) is a separate program that addresses operational and amendment failures rather than prohibited transactions. For self-dealing and other prohibited transactions with disqualified persons, VFCP is the right door.¹³

1
Office of the Law Revision Counsel. 26 USC 4975 Tax on Prohibited Transactions
2
Office of the Law Revision Counsel. 26 USC 4975 Tax on Prohibited Transactions
3
eCFR. 26 CFR 1.267(c)-1 Constructive Ownership of Stock
4
Office of the Law Revision Counsel. 26 USC 4946 Definitions and Special Rules
5
Internal Revenue Service. Retirement Topics – Prohibited Transactions
6
Internal Revenue Service. Instructions for Form 4720
7
Office of the Law Revision Counsel. 26 USC 408 Individual Retirement Accounts
8
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
9
Internal Revenue Service. Instructions for Form 5330
10
Office of the Law Revision Counsel. 26 USC 4941 Taxes on Self-Dealing
11
U.S. Department of Labor. Class Exemptions
12
U.S. Department of Labor. Fact Sheet – Voluntary Fiduciary Correction Program
13
Internal Revenue Service. Summary of Plan Correction Programs