IRC 4975: Prohibited Transactions, Penalties, and Exemptions

Section 4975 of the Internal Revenue Code bans certain dealings between a tax-advantaged retirement or health account and the people closest to it, and it enforces that ban through a stiff excise tax. IRC 4975 prohibited transactions include any direct or indirect sale, loan, service arrangement, or use of plan assets involving a “disqualified person,” and the penalty is a 15 percent tax for each year the problem goes unfixed, climbing to 100 percent if it is never corrected. For IRA and HSA owners the stakes are different and often worse: the entire account can lose its tax-favored status and become taxable income in a single year.

Which Accounts the Rule Covers

The statute reaches further than most people expect. It covers employer-sponsored qualified plans such as 401(k)s, profit-sharing plans, and defined benefit pensions, and it also applies to Traditional and Roth IRAs, SEP-IRAs, SIMPLE IRAs, Archer MSAs, health savings accounts, and Coverdell education savings accounts.¹ If you hold a self-directed IRA with real estate inside it, or an HSA you use as an investment account, every transaction between you and that account is governed by the same rules that apply to billion-dollar pension funds.

Who Counts as a Disqualified Person

A disqualified person is anyone whose relationship with the account creates a potential conflict of interest. The category is broad, and plenty of people fall into it without noticing.

Fiduciaries come first: anyone with decision-making authority over the plan or its investments, and anyone paid to provide services to it, such as accountants, administrators, or legal advisors. The employer sponsoring a plan is a disqualified person, as is any individual who directly or indirectly owns 50 percent or more of that employer’s stock, partnership interest, or beneficial trust interest. Officers, directors, 10 percent shareholders, and highly compensated employees earning at least 10 percent of the employer’s yearly wages also qualify, along with partners or joint venturers holding a 10 percent or greater interest in a related entity.² The IRA holder is effectively a disqualified person with respect to their own IRA.

Family is swept in too. Spouses, parents, grandparents, children, grandchildren, and the spouse of any child or grandchild are all disqualified by relationship.¹ A corporation, partnership, trust, or estate is disqualified if 50 percent or more of its ownership is held by any combination of the people above. Siblings, cousins, aunts, and uncles are not on the list; the rule stops at the vertical line of ancestors and descendants plus spouses.

What Transactions Are Prohibited

A prohibited transaction is any direct or indirect dealing between the account and a disqualified person that falls into one of the banned categories below. The word “indirect” does real work. You do not have to personally sign the check; if the economic benefit flows between the account and someone it should not, the transaction is prohibited no matter how many entities sit in between.

Selling, exchanging, or leasing property between the plan and a disqualified person, even at fair market value.¹
Lending money or extending credit in either direction, including a personal guarantee of a loan made to the plan.
Furnishing goods, services, or facilities between the plan and a disqualified person, unless a specific exemption applies.
Transferring plan assets to a disqualified person or letting a disqualified person use them. This is the broadest category and catches arrangements that do not fit neatly elsewhere.
Fiduciary self-dealing: a fiduciary cannot make plan investment decisions that benefit themselves personally or accept compensation from a party whose interests conflict with the plan’s.¹

Where Self-Directed IRA Owners Get Caught

Self-directed IRAs holding real estate are where these rules most often go wrong. The IRS treats all of the following as prohibited: buying property for personal use (now or later) with IRA funds, selling your own property to the IRA, borrowing from the IRA, and pledging IRA assets as security for a personal loan.³

The one that surprises people most is “sweat equity.” If your IRA owns a rental and you fix the roof, paint the walls, or manage tenants yourself, you have furnished services to the plan. Saving the IRA money by doing the work does not help; the labor itself is a benefit flowing between you and the account. Renting the IRA-owned property to your child, or paying IRA expenses from your personal checking account and reimbursing yourself, creates the same problem. Expenses must come directly from the IRA, and dealings must run through unrelated third parties.

Exemptions That Keep a Transaction Legal

Not every dealing between a plan and a disqualified person is automatically prohibited. The statute carves out exemptions for arrangements that serve the plan without creating a real conflict.

Participant Loans from Employer Plans

A 401(k) or similar employer plan can lend to a participant who is also a disqualified person, provided the loan is available to all participants on a reasonably equivalent basis, is not offered to highly compensated employees on better terms, charges a reasonable interest rate, is adequately secured, and follows the plan document’s written loan provisions.² The maximum is the lesser of $50,000 or 50 percent of the vested balance, and repayment is generally required within five years with at least quarterly payments.⁴

IRAs, SEP-IRAs, and SIMPLE IRAs cannot offer participant loans at all. Any loan from these accounts is a prohibited transaction, full stop.⁴

Reasonable Compensation for Services

A disqualified person can be paid reasonable compensation for services the plan actually needs, such as legal, accounting, or administrative work. “Reasonable” is the key: if compensation exceeds fair market rates, only the excess is treated as a prohibited transaction.² A disqualified person may also receive any benefit they are entitled to as a plan participant on the same terms that apply to everyone else.

Penalties in Employer Plans: The Two-Tier Excise Tax

When a prohibited transaction happens in an employer-sponsored plan, the disqualified person who participated owes the excise tax. The plan itself does not pay.

The 15 Percent Annual Tax

The initial penalty is 15 percent of the “amount involved” for each year or partial year within the taxable period. The amount involved is the greater of the money or fair market value of property given or received, measured as of the date of the transaction. The taxable period begins on the date of the violation and ends on the earliest of three events: the IRS mails a notice of deficiency for the Tier 1 tax, the IRS assesses the tax, or the disqualified person corrects the transaction.¹

The 15 percent charge stacks. An improper loan made on July 1 and not corrected until three full calendar years later generates three separate 15 percent charges, each reported on a separate Form 5330. For ongoing transactions like loans, the amount outstanding during each year is the amount involved for that year.⁵

The 100 Percent Tax

If the transaction is still uncorrected when the taxable period closes, the IRS adds a tax equal to 100 percent of the amount involved. For this second tier, the amount involved is measured at the highest fair market value during the entire taxable period, so if the property appreciated while the violation ran, the penalty grows with it.²

Penalties for IRA and HSA Owners: Full Disqualification

IRA and HSA owners face a different penalty, and it is often harsher. When the owner or beneficiary engages in a prohibited transaction, the account loses its tax-advantaged status as of the first day of the tax year in which the violation occurred.⁶ The entire fair market value on that date is treated as a distribution and included in the owner’s gross income. Health savings accounts follow a similar disqualification rule.⁷

In exchange, the IRA owner is exempt from the Section 4975 excise tax on the transaction once the account is disqualified.² The math is still brutal. A $300,000 self-directed IRA that gets disqualified because the owner personally renovated an IRA-owned property produces $300,000 of taxable income in the year of the violation. If the owner is under 59½, the deemed distribution is also likely subject to the 10 percent early distribution penalty. In a 24 percent bracket that works out to roughly $72,000 in income tax plus around $30,000 in early distribution penalties, more than $100,000 of total tax in a single year.

The retroactive timing makes it worse. Because the account is treated as distributed on the first day of the tax year, a violation that happens in December still disqualifies the account for the full year, and any growth during those months is included in the deemed distribution.

Fixing a Violation

For an employer-sponsored plan, correcting the transaction before the taxable period closes is the only way to avoid the 100 percent Tier 2 tax. Correction means undoing the transaction to the extent possible and putting the plan in a financial position no worse than if the disqualified person had followed the highest fiduciary standards.² In practice that means returning property, repaying improper loans with interest, refunding excessive fees, and compensating the plan for investment gains it missed while the assets were diverted.

Even after correction, the 15 percent Tier 1 tax is still owed for each year the violation was outstanding. It is reported and paid using IRS Form 5330, which is due by the last day of the seventh month after the end of the filer’s tax year.⁵ For a calendar-year taxpayer that is July 31.⁸

For IRA owners, correction is far less useful. The account is disqualified retroactively the moment the violation occurs, and there is no statutory mechanism to undo the disqualification and restore the IRA’s tax-exempt status the way there is for excise tax liability on an employer plan.

The DOL Voluntary Fiduciary Correction Program

Plan fiduciaries who discover a prohibited transaction in an ERISA-covered plan may be able to use the Department of Labor’s Voluntary Fiduciary Correction Program to resolve the violation and obtain relief from certain penalties. Eligibility requires that neither the plan nor the applicant is currently under investigation by the DOL, IRS, or another government agency in connection with the plan.⁹ The most common correction processed through the program involves employers who failed to forward employee contributions or loan repayments to the plan within the required time.¹⁰ A completed VFCP filing can qualify the transaction for a class exemption from the excise tax.

How Long the IRS Has

The IRS has three years to assess the Section 4975 excise tax if the prohibited transaction was disclosed on the plan’s Form 5500, and six years if it was not.¹¹ The clock starts when the Form 5500 is filed. Hiding the transaction doubles the government’s window, so disclosure works in the filer’s favor even when the facts are unflattering.

How Section 4975 Overlaps with ERISA

Employer-sponsored plans covered by ERISA face a second layer of oversight under ERISA Title I, Section 406. The two statutes overlap heavily but are not identical. ERISA’s rules target fiduciary conduct and require that the fiduciary knew or should have known the transaction was improper. IRC 4975 is a strict-liability tax provision: it applies to any disqualified person who participated, regardless of intent.

The practical result is that an employer plan can trigger penalties under both statutes at the same time. The DOL enforces ERISA and can pursue fiduciaries for plan losses; the IRS independently assesses the excise tax under Section 4975. IRAs are not covered by ERISA at all, so for IRA owners, Section 4975 and the disqualification rules under Section 408 are the only enforcement mechanisms in play.

1
Office of the Law Revision Counsel. 26 USC 4975 Tax on Prohibited Transactions
2
Office of the Law Revision Counsel. 26 U.S. Code 4975 – Tax on Prohibited Transactions
3
Internal Revenue Service. Retirement Topics – Prohibited Transactions
4
Internal Revenue Service. Retirement Topics – Plan Loans
5
Internal Revenue Service. Instructions for Form 5330 (Rev. December 2025)
6
Office of the Law Revision Counsel. 26 U.S. Code 408 – Individual Retirement Accounts
7
Office of the Law Revision Counsel. 26 U.S. Code 223 – Health Savings Accounts
8
Internal Revenue Service. Retirement Topics – Tax on Prohibited Transactions
9
U.S. Department of Labor Employee Benefits Security Administration. Voluntary Fiduciary Correction Program
10
Federal Register. Prohibited Transaction Exemption (PTE) 2002-51 Amendment
11
Internal Revenue Service. Statute of Limitations Processes and Procedures