IRA Beneficiary for Prohibited Transactions

[Guest l52094]

My question is in regard to Section 408(e)(2) of the Internal Revenue Code which concerns prohibited transactions with IRAs. Under Section 408(e)(2), it states that an IRA will become disqualified if the owner/creator or his or her beneficiary engages in a prohibited transaction with the IRA. My specific question is, when does a person become a "beneficiary" for this purpose (when named, when the creator/owner dies, or when benefits begin to be paid to the beneficiary)?

Treasury Regulation 1.408-2(b)(8) provides a definition for the term "beneficiary." Does such definition apply to 408(e)(2) and help to answer the question above?

Thank you for your help!

[Appleby]

For this purpose, the beneficiary is affected by the rules only when he/she has the authority to effect such a transaction, which is upon the death of the IRA owner.

[Guest l52094]

Appleby, thankyou for your reply. Do you know of any legal authority or IRS guidance that states that person becomes a beneficiary for 408(e)(2) purposes upon the IRA owners death? I cannot find any.

[mbozek]

The 401(a) (9) regs do not determine when a person become a beneficiary after the death of the owner because that is a matter of contract between the owner and custodian. IRAs are non probate property which are inherited by operation of state law by the beneficiary upon the death of the owner. You need to read the IRA custodial account. Every custodial account I have ever reviewed provides that the beneficary receives all the rights of ownership upon the death of the owner including the right to direct investments and take distributions.

[Appleby]

I think the reliance may be more on logic than a reference to a specific cite?

You asked in your first post if the definition of beneficiary, as provided under 1.408-2(b)(8) would apply here. The answer is a qualified yes?because the beneficiaries as defined under 1.408-2(b)(8) can be changed during the IRA holder's lifetime, for the purpose of your question, such beneficiary would be affected only if he/she is the death beneficiary (i.e. the designated beneficiary/ies who remain after the death of the IRA owner)

This may be somewhat meandering ...but let's see?

Given that the " account ceases to be an individual retirement account as of the first day of such taxable year ",a prohibited transaction occurs IRC § 408(e)(2)(A), the question would then be "Who is the owner of the IRA when the taxability is determined? ?..I.e. to whom would the distribution be taxable? Given that any distribution that occurs after the death of the IRA holder is reportable to the beneficiary (Ref Instructions for filing IRS Form

1099-R) , this is where it gets murky for me ? who is the distribution reportable/taxable to? The deceased or the beneficiary? If the deceased was alive as at the first day of the year, then the language suggests that 1099-R will be issued in his/her name and SS#. If not, then the 1099-R will be issued in the name of the deceased. What is the prohibited transaction occurred after the death of the IRA owner, but after the beginning of the year???? Not sure!

You could also refer to the IRA plan document for some guidance As provided in IRS form 5305, the IRA Custodian/Trustee may use Article Vlll for any additional provisions. Article Vlll is where you will generally find rights, features and benefits provided by the Custodian. One such is the identity of the party who will assume the responsibilities (including directing investments ? prohibited or not) of the IRA owner upon his/her death. The document will generally provide that the beneficiary assumes ownership of the assets upon the death of the IRA owner?This sort of leads into IRC § 408(e)(2)(A) which provides that "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." Excluding POAs and the like, the beneficiary does not have the authority to engage in any transaction relating to the IRA, until the IRA assets becomes his/her, which is upon the death of the IRA holder.

Maybe we will get more comments?

[Guest P A Weick]

Is this an answer: Section 4975 of the Code defines what a prohibited transaction is. Certain activities between the IRA and a "disqualfied person" are prohibited. A disqualified person is, among others, members of the IRA owner's family; trusts, corporations and partnerships controlled by the IRA owner; and the IRA owner's estate. This covers all the beneficiary designations I have ever seen, excepting charities. So probably a beneficiary could during the owner's lifetime commit a prohibited transaction, such as a son selling property to the IRA or the trustee of a grantor trust borrowing moneys from the owner's IRA.

[Appleby]

I can see your point Weick… when the son ( or any disqualified person) is the beneficiary, your explanation rings true. Bear in mind though that an IRA owner can name anyone/any entity as the beneficiary...so what then if the beneficiary is not a disqualified person, such as a friend? Wouldn’t the sale then be an arms-length transaction, if it occurs while the IRA owner is still alive?

[Guest l52094]

Thank you Appleby and Weick for your replies. I appreciate you comments.

In my opinion, Code Section 4975 is helpful and relevant, but does not answer the question. That is because a prohibited transaction between an IRA and a "disqualified person," as defined under 4975(e), results in a penalty of an excise tax imposed on the disqualified person.

However, under Code Section 408(e)(2), if the prohibited transaction is between an IRA and the owner or his or her "beneficiary," the penalty is disqualification of the IRA as of the first day of the taxable year of such transaction. Therefore, the determination of whether a person is a "beneficary" under 408(e)(2) and/or a "disqualified person" under 4975 is critical.

Say, for example, that an IRA owner with investment direction rights names his son as his beneficary and then directs the custodian to lend funds from the owner's IRA to his son. We know that a prohibited transaction occurs between the IRA and the son as a "disqualified person" under 4975. However, it is unclear whether the son is a "beneficiary" within the meaning of Code Section 408(e)(2) [the son is the named beneficary but the IRA owner is still alive]. If the son is a "beneficary" under 408(e)(2) in addition to being a disqualified person under 4975, the IRA is disqualified. Thus, the answer to this question is critical.

Thank you for any further help.

[Guest P A Weick]

Given the downside here, the disqualification of the IRA, perhaps the best answer would be to seek an advisory opinion from DOL. My gut reaction is that you cannot have a prohibited transaction occur unless the person involved first is a disqualifed person. Then if they are the beneficiary the consequences of disqualification occur. I think that is how a court would read the language in Section 408(e)(2) which speaks of an individual or his/her beneficiary engaging in a transaction prohibited by Section 4975. But I would never mistake my gut for the responsible agency's position.

Also another thought. In my examples I assumed (but did not state) that the owner did not direct the transaction - we do trusteed IRAs where we often have full discretion over investments. In the example the originator of this thread gives a father IRA owner directs a loan to his beneficiary son from his IRA. The father here, in my view, commits a prohibited transaction indirectly by directing a loan to a person attributed to him. So whether the beneficiary can commit a prohibited transaction during the owner's lifetime may not be relevant in that circumstance.

As to a friend as beneficiary, as long as the friend is not among the disqualifed folk, I would think the transaction arms length. But again I could see the regulators taking a contrary position and would suggest a ruling for safety's sake before pursuing the transaction.