IRC Section 4975: Prohibited Transaction Rules for IRAs

IRC Section 4975 sets the federal rules on prohibited transactions for IRAs: it forbids an IRA from buying, selling, lending, leasing, or exchanging value with the account owner, close family, or entities they control, and it applies to traditional, Roth, SEP, and SIMPLE IRAs alike. Cross the line and the entire IRA loses its tax-advantaged status as of the first day of the year, with the full balance treated as a taxable distribution to the owner. The rules bite hardest on self-directed IRAs, where the owner picks the investments and has real opportunities to transact with the wrong person.

Who Counts as a Disqualified Person

Section 4975 only reaches transactions between the IRA and a “disqualified person.” Section 4975(e)(2) defines that category broadly enough to catch most people with a financial connection to the account.¹ The IRA owner is the primary disqualified person. So is anyone acting as a fiduciary or service provider to the account, including custodians, investment advisors, and anyone with discretionary authority over its assets.

Family is defined narrowly by statute: the owner’s spouse, ancestors (parents, grandparents), lineal descendants (children, grandchildren), and the spouses of those lineal descendants.¹ Siblings, step-parents, aunts, uncles, and cousins are not disqualified persons under Section 4975. An IRA can transact with the owner’s brother, though the deal still has to reflect fair market value and serve a legitimate purpose.

Entities are pulled in through ownership. A corporation, partnership, trust, or estate is a disqualified person if disqualified persons together hold 50% or more of the voting power, share value, capital interest, profits interest, or beneficial interest.¹ Officers, directors, and 10%-or-more shareholders or partners of a connected employer or entity are also included. If you control a company and also own an IRA, the two are barred from doing business with each other once those thresholds are met.

The Six Prohibited Transactions

Section 4975(c)(1) lists six categories, and each covers direct dealings and indirect arrangements designed to reach the same result through intermediaries.¹

Any sale, exchange, or lease of property between the IRA and a disqualified person. You cannot sell your rental property to your IRA, and your IRA cannot sell an asset to your spouse.
Lending money or extending credit between the IRA and a disqualified person, in either direction. Using IRA assets to secure a personal loan falls here as well.
Furnishing goods, services, or facilities between the IRA and a disqualified person. If you are a contractor, the IRA cannot pay you to renovate a property it owns.
Transferring IRA income or assets to a disqualified person, or letting a disqualified person use them. Staying in a house your IRA owns, even for a night, violates this rule.
Fiduciary self-dealing: anyone with authority over the account using that authority for personal financial benefit.
A fiduciary receiving consideration from a third party in connection with a transaction involving the account’s assets, including referral fees and commissions.

The word “indirect” in the statute does real work. A chain of transactions built to reach a prohibited result through friends or unrelated entities can be collapsed and treated as though the IRA dealt directly with the disqualified person.

Where Self-Directed IRA Owners Slip

Self-directed IRAs allow real estate, private companies, and other alternative assets. That flexibility creates the traps.

The most common one is personal use of IRA property. If your IRA owns a vacation home, you cannot stay in it. If it owns farmland, you cannot work the land. The IRS treats any personal use as a transfer of assets for the owner’s benefit, prohibited under Section 4975(c)(1)(D).²

Checkbook-control IRA LLCs raise the risk further. The IRA owns an LLC, and the owner manages the LLC and writes checks from its account. The structure itself is not automatically prohibited, but the owner who manages the LLC is a fiduciary under Section 4975(e)(3) and therefore a disqualified person. Any compensation taken from the LLC for management work is a prohibited transaction. In Ellis v. Commissioner, the Tax Court held that a taxpayer’s IRA was disqualified after the owner drew a salary from an LLC the IRA owned, resulting in income tax on the full account value plus a 10% early distribution penalty and accuracy-related penalties.

Sweat equity is another trap. You cannot personally renovate a fixer-upper the IRA bought, and you cannot bring in your spouse, children, or parents to do it either. Every hour a disqualified person contributes to an IRA-held asset is furnishing services, prohibited whether or not the person is paid.

What Happens to the IRA Owner

This is where the IRA rules diverge sharply from those for employer-sponsored plans. When an IRA owner or beneficiary engages in a prohibited transaction, the account loses its tax-advantaged status as of the first day of that tax year under Section 408(e)(2).³ The entire IRA, not just the piece involved in the transaction, is treated as distributed to the owner at fair market value on that first day of the year.²

That full deemed distribution goes into gross income for the year. On a $500,000 IRA, the tax hit can push the owner into the top federal bracket. If the owner is under 59½, the 10% additional tax on early distributions typically applies on top of that.⁴

One point that gets stated wrong often: the IRA owner does not also owe the Section 4975 excise taxes when the account is disqualified. Section 4975(c)(3) explicitly exempts the IRA owner and beneficiaries from the excise tax when the IRA loses its status.¹ The disqualification is the owner’s penalty.

Pledging IRA Assets as Collateral

Using the IRA as security for a loan is treated under a different provision with a narrower consequence. Under Section 408(e)(4), only the portion pledged is treated as distributed, not the whole account.³ Pledge $50,000 of a $500,000 IRA and only $50,000 is a distribution; the other $450,000 keeps its status.

Excise Taxes on Other Disqualified Persons

The IRA owner faces disqualification instead of the excise taxes, but other disqualified persons who took part in the transaction, such as a fiduciary, service provider, or a related entity, remain fully subject to Section 4975.

The initial tax is 15% of the “amount involved” for each year or part-year the transaction stays uncorrected. If it is not corrected within the taxable period, an additional 100% tax on the amount involved applies.⁵

“Amount involved” is the greater of the money and fair market value of property given, or the money and fair market value of property received. For the 15% initial tax, fair market value is measured on the date of the transaction. For the 100% tax, it is the highest fair market value during the taxable period, which can be much larger if the asset has appreciated.¹ Disqualified persons subject to the tax report and pay it on Form 5330.⁶

Correcting a Prohibited Transaction

A disqualified person facing the excise tax can avoid the 100% second-tier tax by correcting the transaction. Correction means undoing it to the extent possible without leaving the plan in a worse financial position than if the highest fiduciary standards had been followed from the start.⁷ In practice, that usually means reversing the sale, returning the property, or repaying borrowed funds with reasonable interest.

The taxable period runs from the date of the prohibited transaction and ends on whichever comes first: the day the IRS mails a notice of deficiency for the 100% tax, the day the IRS assesses that tax, or the day the correction is completed.⁷ Waiting for a notice before acting shrinks that window, so the practical incentive is to fix the problem first and report only the 15% tax on Form 5330.

For the IRA owner, correction works differently. Because the consequence is disqualification under Section 408(e)(2) rather than an excise tax, unwinding the deal does not undo the deemed distribution. Once the IRA loses its status, the tax damage is done. The IRS Voluntary Correction Program (EPCRS) is built for employer-sponsored plans and generally is not available to repair an IRA prohibited transaction.

Statutory Exemptions

Section 4975(d) carves out specific transactions that would otherwise be prohibited, so that plans can carry out ordinary operations.⁵ The most relevant one for IRAs is reasonable compensation for services. The IRA can pay a custodian, attorney, or accountant who is technically a disqualified person, provided the fee reflects the market rate for the work. Overpaying a related service provider converts an exempt transaction into a prohibited one, because the excess is the amount involved for excise tax purposes.

Other statutory exemptions cover bank deposits at reasonable interest when the bank is a plan fiduciary, participant loans (largely a 401(k) issue rather than an IRA one), and certain insurance contract purchases for employer plans. IRAs remain separately barred from holding life insurance regardless of the insurance exemption.

DOL Administrative Exemptions

When no statutory exemption fits, the Department of Labor can grant an individual administrative exemption under ERISA Section 408(a) and IRC Section 4975(c)(2). The DOL must find that the exemption is administratively feasible, in the interests of the plan and its participants, and protective of participants’ rights.⁸ Applications are detailed, and retroactive relief is rare and unavailable if the plan lost money on the deal. Most individual IRA owners never go this route because of cost and complexity, but it exists when the stakes are large enough.

Investments an IRA Cannot Hold at All

Separate from the Section 4975 transaction rules, federal law limits what an IRA can hold. Section 408(a)(3) flatly bars IRA trust funds from being invested in life insurance contracts.⁹

Section 408(m) treats an IRA’s purchase of a “collectible” as an immediate taxable distribution equal to the cost of the item. Collectibles include artwork, rugs, antiques, gems, stamps, coins, alcoholic beverages, and certain metals.¹⁰ An owner under 59½ owes the 10% early distribution tax on top of ordinary income tax.

Narrow exceptions exist for precious metals. Certain gold, silver, and platinum coins described in federal coinage statutes, coins issued under any state’s laws, and gold, silver, platinum, or palladium bullion meeting minimum fineness standards can be held, but only if a bank or approved trustee has physical possession.¹⁰ Taking personal custody of IRA bullion defeats the exception.

1
Office of the Law Revision Counsel. 26 U.S. Code 4975 – Tax on Prohibited Transactions
2
Internal Revenue Service. Retirement Topics – Prohibited Transactions
3
Office of the Law Revision Counsel. 26 USC 408 – Individual Retirement Accounts
4
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
5
Office of the Law Revision Counsel. 26 USC 4975 – Tax on Prohibited Transactions
6
Internal Revenue Service. Instructions for Form 5330
7
Internal Revenue Service. Retirement Topics – Tax on Prohibited Transactions
8
Federal Register. Procedures Governing the Filing and Processing of Prohibited Transaction Exemption Applications
9
Office of the Law Revision Counsel. 26 U.S. Code 408 – Individual Retirement Accounts
10
Internal Revenue Service. Investments in Collectibles in Individually Directed Qualified Plan Accounts