It occurs when a disqualified person (for example, the consequence of a prohibited transaction) is the disqualification of that IRA (owner of an IRA involved) and the distribution of the entire account. In addition to the explanation of the details behind the last sentence, that's what you need to know in a few words. Self-employment essentially means that neither you nor any other “disqualified” person can use your IRA to obtain a personal benefit other than the one you receive as a by-product of growing your IRA. People who ignore the rules or want to get more out of transactions than the law allows may jeopardize their retirement savings by exposing their retirement accounts to taxes and penalties as a result of creating a “prohibited transaction.” Again, in general terms, prohibited transactions involve any attempt to gain personal benefit as a by-product of your IRA or pension plan transactions.
This is also known as the “exclusive benefits rule”. Regardless of the amount involved in the prohibited transaction, the entire account is considered distributed and the owner of the IRA is subject to applicable taxes on the amount distributed. Finally, taxes apply to all income and profits earned by the IRA after the prohibited transaction has been made. The decision in the Swanson case supports the idea that the mere creation of a company by the IRA alone or, by reasonable extension, between an IRA and unrelated parties (or, in fact, related parties) is not a prohibited transaction.
However, there are some types of investments and some transactions that are prohibited for all IRAs, including self-directed IRAs, that you should be aware of to avoid jeopardizing the status of your IRA and exposing it and you to taxes and penalties. If the owner of an IRA made a prohibited transaction, the IRA is considered distributed as of January 1 of the year the transaction took place. The IRS doesn't have a list of “approved investments” for self-managed IRAs, but what it does have is a list of types of investments, transactions, and prohibited situations where you don't want your IRA to participate. Swanson, that the initial and total capitalization through the incorporation of a company by an IRA is not a prohibited transaction, but that, from then on, that company would be a disqualified person.
In general, a prohibited IRA transaction is any misuse of an IRA account or annuity by the owner of the IRA, its beneficiary, or any disqualified person. This type of preconceived quid pro quo (a preconceived reciprocal agreement) is called a phased or linked transaction by the IRS, because it is nothing more than a plan to avoid a transaction that would otherwise be prohibited and therefore amounts to a prohibited transaction and will be treated as such. A prohibited transaction may call into question the status of your tax-deferred account, which could result in the disqualification of your self-managed IRA account and have serious tax consequences. Examples of investments prohibited in an IRA include collectibles (such as works of art, stamps, carpets, antiques, and gems), certain currencies, and life insurance.
If the aggregated ownership of the plan and IRA of any class of equity in an entity is 25% or more, the entity's assets are considered assets of the IRA or investment plan for the purposes of prohibited transaction rules, unless an exception applies. In essence, prohibited transactions don't limit WHAT an IRA can invest in, but rather WHO you can transact with an IRA.