Tax and financial advice from the Silicon Valley expert.

How to remedy a prohibited transaction violation for Roths, IRAs, or retirement accounts

The penalties for prohibited transactions are severe.

For regular and Roth IRAs, the penalty is retroactive disqualification of the the account, which is treated as distributed at the beginning of the year of violation. If the owner of the account is under age 59 1/2, the penalty for early distribution will also apply.

For other qualified retirement plans, like 401(k) plans, a 15% penalty applies until the prohibited transaction is fixed. A 100% excise tax can also apply if the prohibited transaction isn’t fixed within 90 days of receiving an IRS notice. Prohibited transactions are reported on Form 5330.

(See the blog post, “What kinds of transactions can you do with your Roth or IRA account” at

With more taxpayers setting up entities owned by self-directed IRA, Roth and retirement accounts, such as corporations, partnerships, LLCs and single-member LLCs, “foot faults” of prohibited transactions are becoming more common.

Given the severe penalties, the taxpayer should probably set up a separate retirement account for any investment for which there is a possibility that a prohibited transaction could happen.

There is a procedure to “cure” a prohibited transaction, but it isn’t easy. The procedure is to apply for an administrative exemption from the prohibited transaction provisions of ERISA. The Department of Labor issued updated regulations on how to apply for an exemption, 2011ARD 207-1, on October 27, 2011. The procedure for applying for an individual exemption is explained at the Department of Labor web site at

The application is made to the Department of Labor and the exemption can be retroactive. If an exemption is granted, the penalties won’t apply.

In order to receive a retroactive exemption, the applicant will have to demonstrate that safeguards were in place at the time in which the parties entered into the transaction. An applicant for a retroactive exemption must have acted in good faith by taking reasonable and appropriate steps to protect the plan from abuse and unnecessary risk at the time of the transaction. Since the violation happened, this may be a difficult requirement to satisfy.

The Department of Labor will not ordinarily consider an application for a transaction that is the subject of an investigation under the reporting, disclosure and fiduciary responsibility provisions of ERISA (the federal pension laws).

Since tax returns and penalty forms may be required to be filed if the exemption isn’t granted, the application should be submitted as soon as possible after the violation is discovered to give the Department of Labor time to give a response.

Given the complex technical requirements and the critical consequences of failing to have the exemption granted, it would be wise to hire a pension attorney to make the application. The legal fees will be substantial, so this procedure probably won’t make economic sense for small accounts.

Tax and financial advice from the Silicon Valley expert.