Most of us want to help family members – especially with issues in our realm of experience. But helping family members with their IRAs creates a problem under the “prohibited transaction” rules of the Internal Revenue Code (the “Code”). (Similar issues arise in connection with retirement plan accounts under the ERISA rules, but as we discuss later, the consequences aren’t quite as severe. Thus, our focus in this article is on IRAs.)
In our experience, this problem is not well-known and will come as an unpleasant surprise to many. To help you make sense of this, we are getting a little deeper into the legal weeds than we usually do.
One of the prohibitions under the Code is the “self-dealing” rule under section 4975. This rule says that:
a fiduciary may not use the authority, control, or responsibility which makes such person a fiduciary to cause a plan to pay an additional fee to such fiduciary (or to a person in which such fiduciary has an interest which may affect the exercise of such fiduciary’s best judgment as a fiduciary) to provide a service.
The rule goes on to identify “a person in which such fiduciary has an interest” as including a “member of the family” of the fiduciary. The Code defines a family member as the fiduciary’s “spouse, ancestor (e.g., parent or grandparent), lineal descendant (e.g., child, grandchild), and any spouse of a lineal descendant.”
Why is all this important? The reason is that most guidance indicates that an IRA owner is a fiduciary with respect to his or her own IRA. Based on this, if, for example, a mother asks her son, who is an advisor at a broker-dealer, to manage her IRA, any compensation paid to the son would be a prohibited transaction. That is, the mother is causing a family member – a person in whom she presumably has an interest that could affect her fiduciary judgment – to receive compensation. The consequences are harsh.
Normally, a prohibited transaction results in the imposition of an excise tax and the requirement to “correct” the transaction, which would mean that the compensation paid to the advisor’s firm would have to be put back into the plan, and that a 15 percent excise tax would be owed. But in the case of the IRA owner engaging in a prohibited transaction, there is a special rule.
To understand this special rule, we start with two basic propositions. The Code says that “[a]ny individual retirement account is exempt from taxation under this subtitle unless such account has ceased to be an individual retirement account by reason of paragraph (2)…” It also provides that “any amount paid or distributed out of an individual retirement plan shall be included in gross income by the… distributee…”
When the IRA owner engages in a prohibited transaction, the result is as follows:
If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year.
And as a result,
In any case in which any account ceases to be an individual retirement account by reason of [the prohibited transaction] as of the first day of any taxable year, [the account is treated] as if there were a distribution on such first day in an amount equal to the fair market value (on such first day) of all assets in the account (on such first day).
To put this into simple terms, if the IRA owner is considered the fiduciary of his IRA and engages in a prohibited transaction, he or she must take the full value of the IRA into income in the year in which the transaction takes place. In other words, the IRA is no longer tax-exempt because (in our example) a mom was taking advice from her son and paying him for that advice.
The bottom line is this: advisors (and their firms) should not provide advice to family members about transferring their IRAs or about investing their IRA assets… unless they forgo compensation for the advice.