Tax Facts

3992 / What are the penalties for engaging in a prohibited transaction?



A first tier tax equal to 15 percent of the amount involved is imposed on each prohibited transaction for each year or part thereof from the time the transaction occurs until the earliest of the date: (1) it is corrected, (2) a deficiency notice is mailed, or (3) the tax is assessed.1 An employer fined under this provision for failing to make timely 401(k) transfer deferrals was assessed the 15 percent penalty only on the amount of interest the employer would have paid for a bank loan for the same amount, not 15 percent of the amount of the late deposit.2

All disqualified persons who participate in the prohibited transaction, other than a fiduciary acting only as a fiduciary, are jointly and severally liable for the full amount of the tax. A trustee was held liable for the tax even though the trustee did not vote to approve the payment that was determined to be a prohibited transaction; the Seventh Circuit Court of Appeals determined that the trustee had benefited from the payments and thus had participated in the transaction.3

An act of self-dealing involving the use of money or property (for example, the leasing of property) may be treated as giving rise to multiple transactions – one on the day the transaction occurs and separate ones on the first day of each taxable year within the above period – and, thus, may result in multiple penalties.4

Second Tier Tax


If a transaction is not corrected within the above period, there is a second tier tax of 100 percent of the amount involved. This tax will be abated if the transaction is corrected within 90 days after the notice of deficiency with respect to the additional tax is mailed. This 90-day period may be extended in certain circumstances.

To be corrected, the transaction must be undone to the extent possible, but, in any event, so as to place the plan in a financial position no worse than it would have been in had the disqualified person acted under the highest fiduciary standards.5

A prohibited transaction was held to be self-correcting, and thus not subject to the second tier tax (or to the first tier tax in subsequent tax years), where the extraordinary success of the investment was such that to undo the transaction would have put the plan in a worse position than if the disqualified persons had acted under the highest fiduciary standards. Essentially, the transaction involved a sale of mineral rights that were producing over a million dollars a year in royalties to an ESOP by the employees of the employer in return for a private annuity.6 The Tax Court considers this case to be an anomaly and has stated that, in general, prohibited transactions cannot be self-correcting.7

If the owner of an individual retirement account, or the owner’s beneficiary, engages in a prohibited transaction and, as a result, the account ceases to be an individual retirement account, the tax does not apply ( Q 3649). Similar rules apply to beneficiaries of health and Archer medical savings accounts ( Q 390 to Q 422) and to beneficiaries of and contributors to education savings accounts.8

The IRS has the authority to impose tax penalties as a result of prohibited transactions, even when the Department of Labor has entered into a consent judgment concerning the plan.9

Other Consequences


In addition to the potential tax penalties discussed above, there can be other consequences to a prohibited transaction. IRAs cease to qualify as IRAs as of the first day of the taxable year in which the prohibited transaction occurs and the account is treated as distributing all of its assets on that date.10

A self-directed IRA purchased land and contributed it and cash to a partnership with an LLC solely owned by the IRA owner and his wife that owned the adjacent property. It allowed the IRA owner to use the IRA assets for his personal benefit. Because the IRA owner was a fiduciary with regard to the IRA, this was a prohibited transaction and immediately terminated the IRA’s exempt status. As a result, the IRA assets were not protected when the IRA owner filed for bankruptcy.11






1.  IRC § 4975(a); IRC § 4975(f)(2).

2.  Rev. Rul. 2006-38, 2006-29 IRB 80.

3O’Malley v. Comm., 972 F.2d 150 (7th Cir. 1992).

4.  Treas. Reg. § 141.4975-13. See Lambos v. Comm., 88 TC 1440 (1987).

5.  IRC §§ 4975(b), 4961.

6Zabolotny v. Comm., 7 F.3d 774 (8th Cir. 1993), nonacq. 1994-1 CB 1.

7Morrissey v. Comm., TC Memo 1998-443.

8.  IRC § 4975(c)(3).

9Baizer v. Comm., 204 F.3d 1231 (9th Cir. 2000).

10.  IRC § 408(e)(2).

11In Re Kellerman, 115 AFTR 2d 2015-1944 (Bktcy. Ct. AR 2015).


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