Prohibited Transactions -- What If I Make A Mistake?
We have reviewed disallowed investments, prohibited transactions and disqualified persons as it relates to investment transactions taken by Retirement Plans (RP). Some of these are easy concepts to grab onto and some are not. That is why you should make sure that you fully investigate what all is involved in a potential self-directed IRA or 401(k) investment. Always seek advise from qualified individuals on what is and is not permissible.
Now, what happens is you make a mistake with either a "traditional" or self-directed RP? Does the IRS care? What kind of penalties could they place on you? Well, we all know that the IRS wants all tax that is owed to them and will take appropriate action if they feel as if the RP has not paid its fair share of the applicable tax. So, what are these penalties?
IRS regulations spell out the penalties quite succinctly in IRS Code 408. It states that the disqualified person who takes part in a prohibited transaction:
1) Must correct the transaction and must pay an excise tax which is based on the amount involved in the transaction;
2) Must pay an initial excise tax that is 15% of the amount involved in EACH tax year (or partial tax year);
IF the transaction is not satisfactorily corrected within this taxable period, the IRS notes that:
"an additional tax of 100% of the amount involved is imposed. Both taxes are payable by ANY disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax."
Yes, you did read that right. If it is not satisfactorily resolved for that first tax year (or partial tax year thereof), the tax is 100%! Now, does one think it is important to make sure they are understanding what they can and cannot invest RP assets into?
How doe the IRS define what the "amount" is that is involved in a prohibited transaction? Well, it is the GREATER of:
1) the money and fair market value of any property given; and
2) the money and fair market value of any property received.
If services are performed, the amount involved is any excess compensation given or received.
How does the IRS define the "taxable period"? For purposes of this provision, the taxable period starts on the date of the transaction and ends on the earliest of the following:
1) the day the IRS mails a notice of deficiency for the tax;
2) the day the IRS assesses the tax; and
3) the day the correction of the transaction is completed.
In the next blog, we will review if and how a prohibited transaction can be corrected. I have a feeling this isn't going to be pretty :)
John R. Park is President of PGI SelfDirected (www.pgiselfdirected.com) and co-founding Partner of Fulcrum Investment Network (www.fulcruminvestmentnetwork.com)
