Specialized Returns and Taxpayers · Retirement plans
Prohibited transactions
tax year · reviewed 2026-08-21 · Draft for I. Ohu review
The prohibited transaction rules are not a general anti-abuse standard. They are a list of six transaction types that are forbidden between a plan and a defined class of people, whether or not the terms are fair and whether or not the plan comes out ahead. Fairness is not a defence, and the Code makes that explicit by supplying a separate list of exemptions for the transactions it is willing to tolerate.
The rule
The six categories (IRC § 4975(c)(1)). a prohibited transaction is any direct or indirect sale, exchange or lease of property between a plan and a disqualified person; lending of money or any other extension of credit between them; furnishing of goods, services or facilities between them; transfer to, or use by or for the benefit of, a disqualified person of plan income or assets; an act by a fiduciary dealing with plan income or assets in the fiduciary’s own interest or for the fiduciary’s own account; or receipt of consideration for a fiduciary’s own personal account from any party dealing with the plan in connection with a transaction involving plan income or assets (IRC § 4975(c)(1))TY2026 Note what unites them. Each requires a plan on one side and a disqualified person on the other, except the last two, which reach a fiduciary’s self-dealing without any counterparty at all.
Who is disqualified. a disqualified person is a fiduciary; a person providing services to the plan; an employer any of whose employees are covered; an employee organisation any of whose members are covered; a direct or indirect owner of 50 percent or more of the voting power or value of such an employer’s stock, of its capital or profits interest, or of its beneficial interest; a member of the family of any of those individuals; and a corporation, partnership, trust or estate 50 percent or more of which is owned by them, along with officers, directors, 10 percent or more shareholders and highly compensated employees of such an entity (IRC § 4975(e)(2))TY2026 The list is wide enough to catch almost everyone close to a small plan: the employer, the owner, the plan’s accountant and its investment adviser are all in it by definition.
But the family definition is narrow. family for this purpose means an individual’s spouse, ancestor, lineal descendant and any spouse of a lineal descendant — notably not siblings (IRC § 4975(e)(6))TY2026 Siblings are absent, which is a genuine difference from the IRC § 267(c)(4) family definition used elsewhere in the Code and a favourite examination point.
The tax. the initial tax is 15 percent of the amount involved for each year or part of a year in the taxable period, payable by any disqualified person who participates in the transaction other than a fiduciary acting only as such (IRC § 4975(a))TY2026 where the transaction is not corrected within the taxable period, a further tax of 100 percent of the amount involved is imposed on the same persons (IRC § 4975(b))TY2026 where more than one person is liable with respect to one prohibited transaction, all are jointly and severally liable (IRC § 4975(f)(1))TY2026 The initial tax compounds: it is charged for each year or part of a year in the taxable period, so a transaction left uncorrected for four calendar years draws the initial tax four times before the additional tax is even considered.
When the clock stops. the taxable period begins on the date the prohibited transaction occurs and ends on the earliest of the mailing of a notice of deficiency for the initial tax, the assessment of that tax, or the completion of correction (IRC § 4975(f)(2))TY2026
How much is involved. the 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, except that for the services and shared-office exemptions only the excess compensation counts; for the initial tax, value is measured on the date of the transaction, and for the additional tax it is the highest value during the taxable period (IRC § 4975(f)(4))TY2026 The measure is the gross amount, not the profit and not the loss to the plan. A sale of property between a plan and a disqualified person has an amount involved equal to the whole consideration even if the price was exactly right.
Correction. correction means undoing the transaction to the extent possible and in any case placing the plan in a financial position no worse than it would occupy had the disqualified person acted under the highest fiduciary standards (IRC § 4975(f)(5))TY2026
A trap in the definition of sale. a transfer of real or personal property by a disqualified person to a plan is treated as a sale or exchange if the property is subject to a mortgage or similar lien that the plan assumes, or that a disqualified person placed on the property within the 10-year period ending on the date of transfer (IRC § 4975(f)(3))TY2026
What is permitted. a plan loan to a participant or beneficiary who is a disqualified person is exempt if it is available to all participants and beneficiaries on a reasonably equivalent basis, is not made available to highly compensated employees in a greater amount than to other employees, is made in accordance with specific plan provisions, bears a reasonable rate of interest, and is adequately secured (IRC § 4975(d)(1))TY2026 a contract or reasonable arrangement with a disqualified person for office space, or for legal, accounting or other services necessary to establish or operate the plan, is exempt if no more than reasonable compensation is paid (IRC § 4975(d)(2))TY2026 These are narrow, conditional and exhaustive on their own terms; there is no general “arm’s length” exemption. the Secretary must maintain an exemption procedure and may grant conditional or unconditional exemptions after consulting the Secretary of Labor, only on findings that the exemption is administratively feasible, in the interests of the plan and its participants and beneficiaries, and protective of their rights, with notice to interested persons and publication in the Federal Register (IRC § 4975(c)(2))TY2026
And what is not permitted even then. the statutory exemptions, including the participant loan exemption, do not apply to a transaction with an owner-employee as defined in IRC § 401(c)(3), or with related persons and entities — which is why a sole proprietor or more-than-10-percent partner cannot borrow from the plan (IRC § 4975(f)(6))TY2026
The IRA rule is different in kind. where the individual for whose benefit an individual retirement account is established, or that individual’s beneficiary, engages in a transaction prohibited by IRC § 4975 with respect to the account, the account ceases to be an individual retirement account as of the first day of that taxable year and is treated as distributing all its assets — so the whole balance is taxed at once rather than an excise tax being imposed (IRC § 408(e)(2))TY2026 There is no excise tax and no correction period. The account is deemed to distribute everything on the first day of the year, which means ordinary income on the whole balance and, for an owner under 59½, the additional tax under IRC § 72(t) on top.
Current figures
| Item | 2026 |
|---|---|
| The six categories | a prohibited transaction is any direct or indirect sale, exchange or lease of property between a plan and a disqualified person; lending of money or any other extension of credit between them; furnishing of goods, services or facilities between them; transfer to, or use by or for the benefit of, a disqualified person of plan income or assets; an act by a fiduciary dealing with plan income or assets in the fiduciary’s own interest or for the fiduciary’s own account; or receipt of consideration for a fiduciary’s own personal account from any party dealing with the plan in connection with a transaction involving plan income or assets (IRC § 4975(c)(1))TY2026 |
| Disqualified person | a disqualified person is a fiduciary; a person providing services to the plan; an employer any of whose employees are covered; an employee organisation any of whose members are covered; a direct or indirect owner of 50 percent or more of the voting power or value of such an employer’s stock, of its capital or profits interest, or of its beneficial interest; a member of the family of any of those individuals; and a corporation, partnership, trust or estate 50 percent or more of which is owned by them, along with officers, directors, 10 percent or more shareholders and highly compensated employees of such an entity (IRC § 4975(e)(2))TY2026 |
| Family | family for this purpose means an individual’s spouse, ancestor, lineal descendant and any spouse of a lineal descendant — notably not siblings (IRC § 4975(e)(6))TY2026 |
| Initial tax | the initial tax is 15 percent of the amount involved for each year or part of a year in the taxable period, payable by any disqualified person who participates in the transaction other than a fiduciary acting only as such (IRC § 4975(a))TY2026 |
| Additional tax | where the transaction is not corrected within the taxable period, a further tax of 100 percent of the amount involved is imposed on the same persons (IRC § 4975(b))TY2026 |
| Amount involved | the 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, except that for the services and shared-office exemptions only the excess compensation counts; for the initial tax, value is measured on the date of the transaction, and for the additional tax it is the highest value during the taxable period (IRC § 4975(f)(4))TY2026 |
| Correction | correction means undoing the transaction to the extent possible and in any case placing the plan in a financial position no worse than it would occupy had the disqualified person acted under the highest fiduciary standards (IRC § 4975(f)(5))TY2026 |
| Participant loan exemption | a plan loan to a participant or beneficiary who is a disqualified person is exempt if it is available to all participants and beneficiaries on a reasonably equivalent basis, is not made available to highly compensated employees in a greater amount than to other employees, is made in accordance with specific plan provisions, bears a reasonable rate of interest, and is adequately secured (IRC § 4975(d)(1))TY2026 |
| Owner-employee restriction | the statutory exemptions, including the participant loan exemption, do not apply to a transaction with an owner-employee as defined in IRC § 401(c)(3), or with related persons and entities — which is why a sole proprietor or more-than-10-percent partner cannot borrow from the plan (IRC § 4975(f)(6))TY2026 |
| IRA consequence | where the individual for whose benefit an individual retirement account is established, or that individual’s beneficiary, engages in a transaction prohibited by IRC § 4975 with respect to the account, the account ceases to be an individual retirement account as of the first day of that taxable year and is treated as distributing all its assets — so the whole balance is taxed at once rather than an excise tax being imposed (IRC § 408(e)(2))TY2026 |
How it works in practice
Identify the disqualified person before analysing the transaction, because most of the difficulty is there rather than in the six categories. In a closely held business the owner is a disqualified person as an employer under IRC § 4975(e)(2)(C), as a 50 percent owner under subparagraph (E), and usually as a fiduciary under subparagraph (A) as well. Their spouse, parents, children and children’s spouses are all disqualified through the family rule. Their brother is not, and neither is their brother’s company unless some other test catches it.
Then ask whether the transaction is on the list, and resist the instinct to reason about fairness. A plan buying an office building from the sponsor at an independently appraised price is a sale between a plan and a disqualified person and is prohibited, full stop. A plan lending money to the sponsor at a commercial rate on good security is an extension of credit and is prohibited. The only route to permission is a statutory exemption in IRC § 4975(d) or an administrative exemption granted under the IRC § 4975(c)(2) procedure, and the latter takes months.
For an IRA, treat the analysis as binary and terminal. There is no excise tax to compute and no correction that restores the account, because IRC § 408(e)(2) deems the whole balance distributed as of the first day of the taxable year in which the transaction occurred — not the date of the transaction. A prohibited transaction in November therefore taxes the balance as it stood the previous January.
When a prohibited transaction has already happened in a qualified plan, correct it before the taxable period closes, and understand what closes it. Correction is one of three closing events; the other two are the mailing of a notice of deficiency and the assessment of the initial tax. An examination that reaches assessment stops the clock but leaves the 100 percent additional tax available, so speed of correction matters more than the elegance of the argument.
The building the plan wanted to buy
A dental practice’s profit-sharing plan has $900,000 in cash. The owner-dentist proposes that the plan buy the practice’s office building from him personally. He obtains two independent appraisals, both at $840,000, and proposes that the plan pay exactly that. The plan would then lease the building back to the practice at a market rent, also independently determined.
Two prohibited transactions, not one. The purchase is a sale of property between a plan and a disqualified person under IRC § 4975(c)(1)(A); the leaseback is a lease of property between the same parties under the same subparagraph, and is also a use of plan assets for the benefit of a disqualified person under subparagraph (D). The appraisals are irrelevant — the statute prohibits the transaction, not an unfair price. The amount involved for the purchase is $840,000, so the initial tax is $126,000 for each year or part of a year in the taxable period, and the additional tax on failure to correct would be $840,000. The route to doing this lawfully is an administrative exemption, applied for in advance.
The sister-in-law's consultancy
A manufacturer’s 401(k) needs a new third-party administrator. The owner’s sister runs an administration firm and quotes a competitive fee. Separately, the owner’s brother-in-law — his wife’s brother — offers investment advisory services to the plan at a market rate.
The sister is a disqualified person: she is a lineal descendant of the owner’s parents, but that is not why. She is caught because she is about to become a person providing services to the plan under IRC § 4975(e)(2)(B). So the arrangement is a furnishing of services between the plan and a disqualified person — and it is nonetheless permitted, because IRC § 4975(d)(2) exempts a reasonable arrangement for services necessary to operate the plan where no more than reasonable compensation is paid. The brother-in-law is in exactly the same position for the same reason. Note the sequence: the service provider becomes a disqualified person by providing the service, and the exemption is what makes ordinary plan administration possible at all. What neither of them may do is receive anything beyond reasonable compensation, because the amount involved would then be the excess.
The IRA that bought a holiday let
An individual directs her self-directed IRA to buy a coastal cottage for $310,000 in March 2026, intending to rent it out. In August she and her family stay in it for a fortnight without paying rent. Her IRA balance was $340,000 on 1 January 2026 and $355,000 in August. She is 51.
The fortnight’s use is a use of plan assets for the benefit of a disqualified person under IRC § 4975(c)(1)(D) — she is the beneficiary of the account and a fiduciary of it. Because this is an IRA, IRC § 4975 does not produce an excise tax. IRC § 408(e)(2) instead provides that the account ceased to be an individual retirement account as of the first day of her 2026 taxable year and is treated as having distributed all its assets then. So the $340,000 balance as of 1 January is ordinary income for 2026, and because she is under 59½ the IRC § 72(t) additional tax applies to it as well. Nothing she does now restores the account.
A fair price is not a defence. IRC § 4975(c)(1) prohibits categories of transaction, not unfair ones. Appraisals, market rates and independent valuations are relevant to the amount involved and to some exemptions, and are irrelevant to whether the transaction is prohibited.
The family definition excludes siblings. IRC § 4975(e)(6) reaches a spouse, ancestors, lineal descendants and the spouses of lineal descendants. A brother or sister is not a disqualified person by family relationship. Compare IRC § 267(c)(4), which names brothers and sisters first — the two definitions are genuinely different and the exam tests the difference.
The participant loan exemption does not reach owner-employees. IRC § 4975(f)(6) withdraws the IRC § 4975(d) exemptions for transactions with an owner-employee as defined in IRC § 401(c)(3). A sole proprietor or a more-than-10-percent partner therefore cannot take a plan loan, however carefully the plan document is drafted. A more-than-5-percent shareholder of an S corporation is treated the same way.
For an IRA the deemed distribution is dated 1 January, not the transaction date. IRC § 408(e)(2) disqualifies the account “as of the first day of such taxable year.” The measure is the balance at the start of the year, which can be larger than the amount involved in the transaction and can exceed the balance at the moment of the breach.
How this has changed
The framework is old and stable — IRC § 4975 came from the Employee Retirement Income Security Act of 1974 and its structure has not been rebuilt since. What has moved is the rate. The initial tax was 5 percent until the Taxpayer Relief Act of 1997 raised it to 10 percent, and the Pension Protection Act of 2006 raised it again to the present 15 percent. Any calculation carried forward from older material understates the tax by a factor of three.
The Pension Protection Act also added the statutory exemptions now at IRC § 4975(d)(20) and following, covering block trading, electronic communication networks, service provider transactions and cross-trading. These made ordinary institutional plan investment administrable and are the main reason the exemption list is now long and technical rather than short.
SECURE 2.0 § 322 changed the IRA consequence in one narrow respect for years beginning after 29 December 2022: where an individual maintains multiple IRAs, a prohibited transaction with respect to one no longer disqualifies the others. Before that change the aggregation rules could take out an entire retirement position over a single transaction in one account.
The Department of Labor, not the Service, administers the parallel ERISA § 406 prohibitions and grants most individual exemptions. The two regimes overlap almost entirely on substance and diverge on remedy, which is why a plan-side answer often involves a Department of Labor programme while the tax-side answer is Form 5330.
Exam focus
Know the six categories well enough to spot which one a fact pattern describes, and know that a fair price does not save any of them. Expect at least one question whose facts are scrupulously even-handed precisely to test that point.
Know the disqualified person list and the narrow family definition. The sibling point is the single most reliable distractor in this topic.
Know the two rates — 15 percent initial, charged for each year in the taxable period, and 100 percent additional on failure to correct — and know that the amount involved is the gross amount rather than any profit. Know that the IRA consequence is disqualification of the account under IRC § 408(e)(2) rather than an excise tax, and that it is dated to the first day of the year.
Check yourself
1. A plan sells land to the sponsor’s chief executive, who is also a plan fiduciary, for $40,000 more than an independent appraisal supports. What is the amount involved?
Answer: The gross consideration, not the $40,000 overpayment. IRC § 4975(f)(4) defines the amount involved as the greater of the money and fair market value of property given or received, and only for the services and office space exemptions is it limited to excess compensation. So the initial tax is 15 percent of the full sale price for each year or part of a year in the taxable period.
2. A sole proprietor sponsors a profit-sharing plan with a properly drafted loan provision. He borrows $20,000 from the plan on commercial terms, adequately secured. Is that a prohibited transaction?
Answer: Yes. The loan is an extension of credit between a plan and a disqualified person under IRC § 4975(c)(1)(B). The IRC § 4975(d)(1) participant loan exemption would ordinarily apply, but IRC § 4975(f)(6) withdraws the IRC § 4975(d) exemptions for transactions with an owner-employee as defined in IRC § 401(c)(3), and a sole proprietor is one. The plan terms cannot cure it.
3. A plan’s trustee arranges for the plan to buy an interest in a partnership, and receives a finder’s fee from the partnership’s promoter. The plan’s investment is sound. Has anything gone wrong?
Answer: Yes. IRC § 4975(c)(1)(F) prohibits receipt of consideration for a fiduciary’s own personal account from any party dealing with the plan in connection with a transaction involving plan assets. No counterparty analysis is needed and the quality of the investment is irrelevant. Subparagraph (E) is likely engaged too, as an act by a fiduciary dealing with plan assets in his own interest.
4. An individual’s brother sells a parcel of land to her IRA at fair value. Has a prohibited transaction occurred?
Answer: Not by reason of the family relationship. IRC § 4975(e)(6) defines family as a spouse, ancestor, lineal descendant and the spouse of a lineal descendant; a brother is not included. The transaction would still be prohibited if the brother is a disqualified person on some other basis — as a fiduciary, a service provider, or through an entity test — so the analysis does not end there, but the sibling relationship alone does not disqualify him.
5. A prohibited transaction occurs in a qualified plan in June 2023 and remains uncorrected when the Service assesses the initial tax in September 2026. How many times is the initial tax charged?
Answer: Four. IRC § 4975(a) charges 15 percent of the amount involved for each year, or part of a year, in the taxable period, and IRC § 4975(f)(2) runs that period from the date of the transaction to the earliest of the notice of deficiency, the assessment, or correction. Part of 2023, all of 2024 and 2025, and part of 2026 is four years or parts of years — 60 percent of the amount involved before the 100 percent additional tax is considered.
Change log
- Initial draft. Sets out the six categories of prohibited transaction in IRC § 4975(c)(1), the disqualified person definition in IRC § 4975(e)(2) with the narrow family definition of IRC § 4975(e)(6) that omits siblings, the 15 percent initial and 100 percent additional taxes with joint and several liability, the amount involved and correction definitions, the statutory exemptions of IRC § 4975(d) and their withdrawal for owner-employees under IRC § 4975(f)(6), and the wholly different IRA consequence under IRC § 408(e)(2).