Click that link above to read the opinion in its entirety, but here’s my summary in its most basic form:

Your plan can partner with disqualified persons in certain situations, BUT there are many possibilities for a prohibited transaction in operating the partnership.

A prohibited transaction is when a retirement plan transacts with a disqualified person. The DOL Opinion says that co-investment/partnering is not, by itself, creating a transaction between the plan and disqualified person. The opinion goes on to say that there are many other actions that could then constitute a transaction between the two, and thus a prohibited transaction. Here are a couple of notable items:

1. A prohibited transaction would occur if the entity (such as an LLC) that the plan invests in was a disqualified person at the time of the investment.
2. If the co-investment is made, even if it is not a prohibited transaction, if the interests of the plan & its accountholder diverge (with respect to the partnership) at a later time, a prohibited transaction may occur if uncorrected.
3. If disqualified persons could not have participated in the proposed investment activity without the plan’s participation, then the inclusion of the plan’s funds would be a prohibited transaction.
4. If the co-investment is made, even if it is not a prohibited transaction, anything in the future (involved in the partnership’s operation) that would create a transaction between a plan and disqualified person would be a prohibited transaction. For instance, if the partnership needed additional capital at a later time, the plan and disqualified persons could not buy or sell membership units or stock to or from each other or the partnership itself in order to raise capital for the partnership.

Many self directed IRA/401k promoters regurgitate this opinion letter to say “yes, a retirement plan can partner with disqualified persons.” In reality, the answer is “yes, a retirement plan could possibly partner with disqualified persons under certain circumstances.”

All in all, I encourage investors to stay away from partnering their IRA with disqualified persons.

A PT happens when a plan enters into a transaction with a disqualified person. In our previous post, we covered how to make a list of disqualified persons for a specific plan. This included determining whether a partnership, LLC, corporation (or other entity) is a DQP itself because of significant ownership by other DQPs.

A prohibited transaction occurs when all three factors are present: a DQP, a plan, and a transaction between the two. So, from the previous post we know how to determine if an entity is considered to be a DQP itself. But how do we know if an entity is considered to be a plan?

Plan asset look-through

…is the term DOL uses (The U.S. Department of Labor, DOL, is the government entity that solely has the authority and responsibility to interpret prohibited transactions code). If a situation does have plan asset look-through it means that you look through an entity to the plan and consider the assets of the entity to be the assets of the plan itself. This also means that when you do have plan asset look-through, that entity is treated as if it is the plan itself for PT purposes. That would mean that that entity could not transact with a disqualified person.

When is there plan asset look-through?

The first hard and fast rule is that when an entity is owned 100% by a plan, there is plan asset look-through. So if your Solo 401(k) was 100% owner of an LLC (or any other type of entity) then that LLC would be seen as if it were the plan itself for purposes of PT determination.

The second rule is that when a plan owns 25% or more of an entity, there is plan asset look-through. I know you have a scrunched up face right now because the second rule seemingly makes the first rule unnecessary. This second rule isn’t hard and fast like the first rule. This rule does not apply if you have an “operating company”.

What is an operating company?

This is where the fun starts.

An operating company is one that primarily makes or sells a product or service other than the investment of money.

A real estate operating company is one where at least 50% of its assets (valued at cost) are invested into managed real estate or real estate development, provided that the entity is directly engaged in the management or development activities.

So, back to plan asset look-through… If you have an operating company, the there is only look through if a plan owns 100% of the operating company. If you don’t have an operating company, there is look through if the plan owns 25% or more of the company.

At first glance you may think “wow, there are some major benefits to investing in an operating company”. I partially disagree. Firstly, your plan is intended for passive investment. An operating company suggests that its owners are engaging in a business activity which might subject the plan to UBIT tax (35% tax on almost all of the income from the entity rather than just the income attributable to leveraged) and it might even create a PT if the accountholder/participant is engaged in the management or development activities. You see, a plan can’t operate a business, so if it owns something that is a business, the reality is that the plan’s accountholder or participant is operating the business, and that is a no-no.

Secondly, the only benefit to intentionally creating an operating company for the purposes of skirting the plan asset rule would be if you intend to involve a DQP with your plan. That intent alone starts you off on the wrong foot.

To simplify, an entity is a plan if significantly (25% or more) owned by a plan. An entity is a DQP if it is significantly (50% or more) owned by other DQPs.

Let’s use an example. XYZ Corp is 35% owned by Rachel’s IRA. Rachel’s mother owns 60% of ABC, LLC. Rachel and her mom are thinking of directing XYZ to lease a property it owns to ABC, LLC. Because of the significant ownership on both sides, this is what it looks like:

ABC, LLC		XYZ Corp
Owned 60% by Rachel’s mother		Owned 35% by Rachel’s IRA

…and it is a prohibited transaction. Some people even go to the extent of officially requesting a PT exception from DOL in order to execute a transaction such as this. To me, this is silly. DOL would only consider granting such an exception if the lease were for market value to ensure that a DQP isn’t getting special use of plan assets or vice versa. If the proposed lease were for market value, then ABC, LLC shouldn’t have a problem finding another leasee who isn’t a DQP. With the same logic, XYZ Corp shouldn’t have a problem finding another leasor who isn’t a plan. All things considered, this type of transaction should just be avoided completely.

Finding out if a proposed transaction is possibly a PT should follow this simple process:

1. Is there a plan? (follow the plan asset look-through rules) If yes, continue to next question…
2. Is there a disqualified person? (refer to the DQP list you made) If yes, continue to next question…
3. Is there a transaction between the two? If yes, you probably have a PT; don’t follow through with it.

I would follow that actual order so that you can reach your answer as quick as possible. There’s no harm in walking away from a transaction because it might be prohibited, but inversely if you are pretty sure something is not a PT, but there is a DQP involved somewhere/somehow… check with a qualified attorney before proceeding.

Following that step by step process to attain the peace of mind that your transactions are building your wealth rather than risking it to hefty tax penalties.

The more involved rule is known as “no self dealing” and is described in Internal Revenue Code section 4975. This rule basically says that for each retirement plan/account, there is a list of “disqualified persons” with whom that plan cannot do business. These DQPs include:

1. The accountholder/participant and any other fiduciary (person who makes investment decisions for the plan)
2. Companies who provide services
3. A member of the family of #1 or #2 above (family defined as spouse [husband/wife], ancestor [parents, grandparents, etc], lineal descendants [children, grandchildren, etc], and spouses of lineal descents)
4. A corporation (or other entity) that is 50% or more owned (directly or indirectly) by #1, #2, or #3 above
5. An officer, director, 10% or more owner, or highly compensated employee of #4 above.
6. A 10% or more (in capital of profits) partner or joint venturer of #4 above

Every self directed IRA/401(k) investor should make this DQP list before making any investments.

Too many people seem to think of the list as only “the accountholder and his family”. As you can see it is a bit more involved than that. This doesn’t require calculus, but you should actually write out the list step by step to ensure that it is complete. This list can actually get quite extensive if you, your family member, or anyone who provides services to your plan has ownership in several companies.

So, what is a prohibited transaction?

In a nutshell, when a DQP transacts with a plan it is a prohibited transaction (abbr “PT”). The trick here is what is considered to be a “transaction”. This is generally defined in IRC 4975 as when one of the following happens between a plan and DQP directly or indirectly:

• sale, exchange or lease of property
• lending of money or extension of credit
• furnishing of goods, services, or facilities

So I consider that to be the general rule. There are a couple of special rules and they consider a PT to also include:

• When plan assets are transferred to, used by or creating benefit to a DQP
• When the accountholder/participant directs his plan in his own interests (to benefit him now instead of through a proper distribution)
• When the accountholder/participant receives compensation from anybody in connection with plan income or assets

The reason I call these last three items “special rules” is because they transcend the 50% rule in determining when corporations are DQPs. In other words, if XYZ Corp is owned 49% by the accountholder’s mother then XYZ Corp isn’t techinically a DQP. Buuuuuut, if the plan then transacts with XYZ Corp it is obvious that the transaction might violate one of these special rules simply because you can’t ignore that the mother’s position in XYZ Corp was probably considered in the decision to direct the plan into that transaction.

All in all, a little common sense goes a long way. The intent of IRC 4975 is to obviously keep the plan out of transactions connected to people that the #1 & #2 DQPs might be able to control or use as a strawperson. So, clever concoctions that aim to evade prohibited transactions rules by a technicality often times still violate the last 3 special rules. It all comes down to intent, and this is something that DOL (the Department of Labor – the government agency that solely bears the responsibility and authority to interpret prohibited transaction expemtions) concludes based on assembling a fact pattern.

So the “directly or indirectly” part of the rule allows them to let some common sense override the technical rules. It also means that if a plan invests into an entity (Corp, LLC, etc) and that entity invests with disqualified person, it may still be a PT. More on that (plan asset rule) in a later post.

In summary, every self directed IRA/401(k) investor should make a disqualified person list before doing any transactions that involve the plan. Overlooking this is on par with a teenager not making and reviewing a budget because he thinks he can learn from and apply the concepts without actually doing the budget. Once this list is made, prohibited transactions can easily be avoided as long as the plan is never involved in any deals connected to anyone on the DQP list.