No, No, No, No…Prohibited Transactions When Selling a Small Business Held by a Self-Directed IRA

Self-directed Individual Retirement Accounts (“IRAs”) offer an individual the ability to invest his or her retirement funds in nontraditional assets such as privately held small businesses. When it comes time for the owner of a self-directed IRA to sell the business held by his or her IRA, there are a number of rules that must be followed in order to avoid the IRS disregarding the tax-exempt status of the IRA. This article discusses some of the rules an owner of an IRA must strictly follow when selling a closely held business in order to avoid triggering the prohibited transaction rules and disastrous tax consequences.

Introduction to the Rules Governing Self-Directed IRAs

The IRS defines traditional IRAs as “tax-advantaged personal savings plan[s] where contributions may be tax deductible.” Generally, the earnings and gains on assets in a traditional IRA are not taxed until funds are withdrawn from the account. Under Section 408(a) of the Internal Revenue Code, “the term ‘individual retirement account’ means a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries…” Traditional IRAs are controlled by money managers who invest in firm-approved stocks, bonds, mutual funds, or exchange-traded funds. Self-directed IRAs, on the other hand, are managed by the account owner. In other words, what makes an IRA “self-directed” is not its legal framework but rather that the trustee holding the IRA allows alternative assets and delegates “maximum control” to the account owner.

The Internal Revenue Code explains that IRAs are exempt from taxes unless the account owner engages in a “prohibited transaction” as outlined in Section 4975. See IRC Section 408(e)(2)(A). If the owner engages in one of these prohibited transactions in their IRA, the account is stripped of its status as an IRA as of the first day of such a taxable year. The implication of losing status of an IRA is that the account’s value is taxable as gross income and, in many cases, subject to a ten-percent early withdrawal penalty. Section 408 prohibits IRAs from investing in certain classes of assets such as insurance contracts and collectibles. The IRS enumerates a list of prohibited transactions in Section 4975(c)(1).

For purposes of this section, the term “prohibited transaction” means any direct or indirect

1) sale or exchange, or leasing, of any property between a plan and a disqualified person;

2) Lending of money or other extension of credit between a plan and a disqualified person; See Thiessen v. Commissioner, 146 T.C. 100, 106, 108 (2016)(quoting Janpol v. Commissioner, 101 T.C. 518, 527 (1993)(reasoning that a person who guarantees repayment of a loan extended by a third party to a debtor – in this case the petitioners’ LLC – is, although indirectly, extending credit to a debtor in violation of Section 4975(c)(1)(B)).

3) Furnishing of goods, services, or facilities between a plan and a disqualified person; See IRC Section 4975(c)(1)(C). Suppose a self-directed IRA owner directs the custodian to purchase real property that he plans to renovate through his or her own efforts; the IRA owner’s performance of work will likely constitute a furnishing service between a plan and a disqualified person.

4) Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;

5) Act by a disqualified person who is a fiduciary whereby he deals with the income and assets or for his own account; See IRC Section 4975(c)(1)(C). Suppose a self-directed IRA owner directs the custodian to purchase real property that he plans to renovate through his or her own efforts; the IRA owner’s performance of work will likely constitute a furnishing service between a plan and a disqualified person.

or

6) Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

An IRA ceases to be an IRA of the person for whose benefit the IRA is established (IRA owner) or his or her beneficiary engages in a prohibited transaction with respect to the IRA. See IRC Section 408(e)(2)(A). A “fiduciary” includes any person who “exercises any discretionary authority or discretionary control respecting management of such a plan or exercises any authority or control respecting management or disposition of its assets.” IRC Section 4975(e)(3)(A).

Many investors have suffered the severe consequences of noncompliance with the prohibited transaction rules discussed above. For example, in Thiessen v. Commissioner, 146 T.C. No. 7 2016, the Tax Court held that a loan guarantee was a prohibited transaction because it was an indirect extension of credit. If an IRA engages in a prohibited transaction and is deemed to have been distributed, the IRS will calculate the taxpayer’s gross income as their actual income, plus the fair market value of the IRA. The IRS may also assess a 10 percent early withdrawal penalty.

Unrelated Business Taxable Income

Unrelated Business Taxable Income (“UBTI”) is income by a tax-exempt entity that is not related to the exempt purpose of the tax-exempt entity. An IRA is considered a tax-exempt entity, meaning that it generally does not pay taxes on interest, dividends, or capital gains within the account. As a tax-exempt organization, an IRA is subject to the tax-exempt rules stated in the Internal Revenue Code. Since 1950, exempt organizations have been taxed on unrelated business taxable income, which is defined as gross income (less directly connected expenses) derived from an unrelated trade or business. See IRC Section 512(a). If the property producing such income is acquired with borrowed funds, however, the debt-financed property rules of Internal Revenue Code Section 514 treat all or part of the income as unrelated business taxable income with the result that it is subject to tax.

An exempt organization is taxed on unrelated business taxable income which is defined as gross income (less directly connected expenses) derived from an unrelated trade or business. An unrelated trade or business is defined as: (a) any trade or business; (b) that is regularly carried on; and (c) is not substantially related, aside from the need of the organization for funds, to the organization’s exempt purpose.

In most instances, investment activities of exempt organizations would be regularly carried on and not substantially related to the organization’s exempt purpose, thus meeting the second and third prongs of the definition of an unrelated trade or business. It is less clear whether the conduct of investment activities constitutes a trade or business. The regulations of the Internal Revenue Code provide that, in general, the term “trade or business” has the same meaning it has in Section 162 of the Internal Revenue Code and generally includes any activity carried on for the production of income from the sale of goods or the performance of services. The Supreme Court held in Higgins v. Commissioner, 312, 217 (1941) that an individual’s management of his own investments was not a trade or business even though the individual’s activities were extensive enough to require an office and a staff. Congress ultimately overruled Higgins and enacted Section 212 of the Internal Revenue Code. Section 212 of the Internal Revenue Code allows individuals to deduct “ordinary and necessary” expenses for producing income, managing income-producing property, or handling tax-related matters.

Certain types of income, commonly referred to as “passive income,” are excluded from UBTI. See IRC Section 512(b). These include dividends, interest, payments with respect to securities loans, amounts received or accrued as consideration for entering into agreements to make loans, annuities, royalties, rents from real property and personal property leased with the real property if the rent attributable to the personal property is 50 percent or less of the total and the rent does not depend on income or profits derived from the leased property, and capital gains and losses. See IRC Section 512(b)(5). In addition to passive income, royalties are excluded in computing the unrelated business taxable of a tax-exempt entity. A “royalty” has been defined as any payment received in consideration for the use of a valuable intangible property right, whether or not payment is based on the use made of the intangible property. However, payments for services provided in connection with the granting of these types of rights are not royalties and are generally taxable as unrelated business income.

The UBTI for self-directed IRAs are taxed at progressive trust tax rates, which can reach up to 37% for income over $16,000 (as of 2026). If an IRA generates over $1,000 in annual gross income from unrelated business income, it can be subject to UBTI tax at a rate of 37%. As discussed above, deductions are permitted for expenses that are “directly connected” with the carrying on of the unrelated trade or business, and net operating losses are allowed to be carried forward and backward (with certain limitations). Losses from one unrelated business activity are not able to offset gains in another; profit and losses are determined per activity.

Below, please see Illustration 1 which provides an example as to how UBTI can be assessed against a self-directed IRA holder.

Illustration 1.

Jill invested $500,000 from her IRA into an LLC custom jewelry company. The investment gave Jill a 25 percent interest in an LLC. The LLC had three other owners, not related to Jill, and none of the other investors were co-owners with her in any other business entities. Jill was not involved in the LLC’s day-to-day operations and did not otherwise personally benefit from the investment. The LLC recorded a significant profit on its annual Form 1065, U.S. Partnership Income Tax Return. In turn, each investor, including Jill’s self-directed IRA was issued yearly Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., which showed ordinary income. The Internal Revenue Code imposes a tax on income earned by a tax-exempt organization in a trade or business that is unrelated to the organization’s exempt purpose. This type of tax liability is known as UBTI and it became a large tax liability for Jill.

It should be understood that most IRA investments do not trigger current tax consequences, not because all income an IRA earns grows tax free, but because the types of income that an IRA typically earns are exempt from UBTI tax rules. For example, IRAs that invest in publicly traded securities (e.g., stocks, bonds, and mutual funds) do not owe current tax because gains from the sale of C corporation stock dividends, and interest income are exempt from UBTI. For this reason, most IRA investors are unaware that an IRA can require a tax return (Form 990-T Exempt Organization Business Income Tax Return) and pay taxes. Income from a business that is regularly carried on (whether directly or indirectly) can result in UBTI and filing requirements.

In this case, since the LLC Jill invested into conducted a regularly conducted business, the self-directed IRA had a tax consequence. To make matters worse, in Jill’s case, the self-directed IRA was taxed at trust rates. This resulted in Jill’s self-directed IRA realizing a far greater tax liability compared to an individual who is taxed at ordinary marginal tax rates. Jill may be shocked to discover that her self-directed IRA is subject to taxes on the LLC’s yearly profits, but also that the tax rate on income over $16,000 is a whopping 37 percent. To add insult to injury, there was an additional net investment income tax of 3.8 percent assessed on the trust income over $16,000.

Unrelated Debt Financed Income

The exclusion for passive income is not available for income derived from debt-financed property. Section 514(a)(1) of the Internal Revenue Code requires an exempt organization to include UDFI a percentage of income derived from “debt-financed property” equal to the “average acquisition indebtedness” for the taxable year over the average amount of the adjusted basis for the taxable year. A like percentage of deduction is allowed in computing UDFI. See IRC Section 514(a)(2). The straight-line method of depreciation must be used. See IRC Section 514(c)(3). Debt-financed property is defined in Section 514(b)(1) as any property held to produce income with respect to which there is an acquisition indebtedness at any time during the taxable year or, if the property is disposed of during the taxable year, at any time during the 12-month period ending on the disposition. The statute contains several exceptions to the definition of debt-financed property, which have the collective effect of limiting its application to investment income. Specifically, the following are excepted from the definition of debt-financed property: (a) any property substantially all of the use of which is substantially related to the organization’s exempt purpose; (b) any property the income from which is included in UDFI without regard to the debt-financed property rules, except that gain from the sale or disposition of such property is not excluded under Section 512(b)(5); (c) any property to the extent income is excluded under Section 512(b)(7) relating to government research, Section 512(h)(9) relating to college, university, and hospital research, and Section 512(b)(9) relating to fundamental research the results of which are made freely available to the public; (d) any property used in any trade or business described in Section 513(a)(1) relating to work performed by volunteers, Section 513(a)(2) relating to convenience of members, etc., and Section 513(a)(3) relating to selling of merchandise received as gifts; and (e) neighborhood land acquired with the intent of using it for exempt purposes within 10 years.

Acquisition indebtedness is defined as the unpaid amount of (a) indebtedness incurred by the organization in acquiring or improving debt-financed property; (b) indebtedness incurred before the acquisition or improvement of the debt-financed property if such indebtedness would not have been incurred but for such acquisition or improvement; and (c) indebtedness incurred after the acquisition or improvement of the debt-financed property if such indebtedness incurred after the acquisition or improvement of the debt-financed property if such indebtedness would not have been incurred but for such acquisition or improvement and, the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement. See IRC Section 514(c).

The statute excludes from the definition of acquisition indebtedness a number of transactions that relate to non-investment transactions common to exempt organizations. These include: (a) a 10-year exception if mortgaged property is acquired by bequest or devise and certain conditions are met; (b) liens for taxes and assessments that attach before the payment date; (c) extension, renewal, or refinancing of an obligation evidencing a pre-existing indebtedness; (d) indebtedness inherent in performing an organization’s exempt purpose such as indebtedness incurred by a credit union accepting deposits from its members; (e) charitable gift annuities; and (f) certain federal financing for low-and-moderate-income persons. The statute also excludes from the definition of acquisition indebtedness securities loans and real property acquired by pensions trusts and schools, colleges, and universities.

If none of the statutory exceptions is applicable, then, to determine whether there is acquisition indebtedness, one must first determine whether there is indebtedness and then determine the indebtedness is traceable to the acquisition or improvement of income-producing property.

Below, please see Illustration 2 which provides an example as to how UDFI can be assessed against a self-directed IRA plan holder.

Illustration 2.

Mark had $1.5 million in his 401(k). Mark decided to invest the $1.5 million in a self-directed IRA. Mark’s goal for his self-directed IRA was to invest in residential real estate through an LLC. Mark found a real estate investment group that frequently organized partnerships and promised “passive” investment (no direct involvement by Mark). The real estate partnership collected capital contributions from 20 investors and used the cash plus debt to purchase an apartment building. The apartment building was held as a rental property, with net income distributed to the investors, including Mark’s self-directed IRA LLC.

As stated above, it is possible for a self-directed IRA to invest in a broad range of investments. Thus, real estate partnerships are acceptable self-directed IRA investments is technically correct. However, this does not answer the question of whether there are more difficult legal or tax issues. For example, “rent from real property” is normally exempt from UBTI, and thus currently not taxable when earned by a self-directed IRA or self-directed IRA LLC. However, income from debt-financed property (whether held directly or indirectly by the self-directed IRA or self-directed IRA LLC) is partially taxable under the rules because the income generated from the investment is not earned by investment of the self-directed IRA capital, but rather by financing.

In this case, the yearly income that is allocated to Mark’s self-directed LLC is partially subject to tax under the UDFI rules. Income received from debt-financed property may be subject to the UDFI rules. Because the property placed in the self-directed IRA was financed and subject to the UBTI and/or UDFI rules, the self-directed IRA was required to file Form 990-T, annually. This was the case whether or not UDFI taxes were required to be paid. Failure to pay the UDFI taxes and file Form 990-T could subject Mark’s self-directed IRA to significant penalties and interest.

Items In Sales Contract or Asset Purchase Agreement that May Trigger the Prohibited Transaction Rules

Anytime an IRA sells a business, the parties will enter into a sales or asset purchase agreement. It is incredibly important to carefully review the sales or asset purchase agreement to determine if the contract will trigger the prohibited transaction rules. Below are a number of terms, provisions, or covenants in a contract to purchase a business that will trigger the prohibited transaction rules and could result in an IRA losing its tax exempt status.

Restrictive Covenants

Contracts that govern the sale of businesses or business assets often contain a restrictive covenant. A restrictive covenant is a clause in a legal contract that prohibits a party from taking specific actions or doing certain things. Restrictive covenants prohibiting the sellers of business from competing are often placed in acquisition contracts. If the owner of a self-directed IRA personally executes a non-compete agreement as a condition of an IRA’s asset acquisition, the guarantee is similar to the Thiessen case discussed above. Under Section 4975 of the Internal Revenue Code, a prohibited transaction occurs if there is any direct or indirect self-dealing, or if a disqualified person receives a personal benefit from an IRA investment. A non-compete covenant creates distinct risks depending on who is signing it. Section 4975 prohibits an IRA owner from signing a non-compete covenant.

Indemnification Clause

Contracts for the sale of assets or a business also often contain indemnification clauses. An indemnification clause is a contractual provision where one party agrees to cover the financial losses, damages, or legal costs of the other party if specific events occur. An indemnification provision related to Section 4975 of the Internal Revenue Code is a contractual provision used to allocate financial responsibility and risk in the event that a transaction is deemed a prohibited transaction involving an IRA. An indemnification clause added to acquisition of a business contract may be classified as a prohibited transaction under Section 4975. The Department of Labor has issued an Advisory Opinion 2011-09A in this area. Advisory Opinion 2011-09A provides a warning that if an IRA owner signs a personal indemnification agreement to cover a broker’s trading losses within their IRA, the indemnification itself could potentially be seen as an impermissible “extension of credit” between the owner and the IRA plan. Under the broad wording in Advisory Opinion 2011-09A, it is possible, the indemnification stated in an acquisition agreement or asset purchase agreement can be classified as prohibited transaction.

No Personal Guarantees of the IRA Owner

In Thiessen, the taxpayers transferred $432,000 to their IRAs and then directed the IRAs to purchase all of the shares of stock in a new corporation. The contract called for a purchase price of $600,000 consisting of $60,000 of a deposit, a $200,000 Note, and a $340,000 balance of cash from the IRA. The $200,000 note was guaranteed by the IRA account owners. The IRA account owners’ guarantee of the note triggered the Section 4975 prohibited transaction rules and resulted in the disqualification of the IRA. IRA account holders cannot guarantee notes on behalf of their IRA.

The Consideration Received from the Business Must Revert to the IRA Directly

Once the IRA owners sell the business held by the IRA, the sales proceeds must be transferred directly back to the self-directed IRA custodian account rather than the IRA account holder.

Watch the Tax Consequences

IRA account holders must understand that the sale of a business held in an IRA may trigger UBTI and/or UDFI. These tax consequences should be considered by IRA account holders prior to the sale of an IRA asset. Sometimes, IRA account holders can minimize UBTI and/or UDFI tax consequences with the use of a C corporation blocker structure.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding regarding the taxation of an asset from a self-directed IRA and the sale of a business asset held by a self-directed IRA. Self-directed IRA owners should consult with a tax attorney well before the sale of an IRA asset to properly plan the transaction and the tax consequences of the IRA asset sale.

Anthony Diosdi is a tax attorney at Diosdi & Liu, LLP. He has significant experience defending private clients before the IRS in difficult and complex tax disputes. Anthony counsels clients through examinations and liability disputes and, when necessary, takes disputed issues to court. Anthony has advised a significant number of individuals who hold self-directed IRAs that contain cryptocurrency, pre-IPO shares, unlisted shares, and late-stage private equity, domestic and foreign corporations.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.