Two principles decide every case below:
- The disqualified person test. Your plan cannot lend to you, your spouse, your ancestors or lineal descendants, or any entity that disqualified persons together own 50 percent or more of, regardless of the loan's terms.
- The exclusive benefit test. Even a loan to someone who passes the first test still has to carry a genuine market interest rate and standard, enforceable terms. The loan has to serve the plan, not do a favor.
Family and related parties
Scenario: Lending to your spouse, a parent, grandparent, or child. Verdict: Prohibited. Your spouse, ancestors, and lineal descendants are disqualified persons under IRC Section 4975(e)(2)(F) and (e)(6). Any loan between your plan and a disqualified person is a prohibited transaction under IRC Section 4975(c)(1)(B), regardless of the interest rate or how the loan is documented.
Scenario: Lending to your child's spouse. Verdict: Prohibited. A spouse of a lineal descendant is included in the family definition under IRC Section 4975(e)(6), making them a disqualified person to the same degree as your child.
Scenario: Lending to a sibling, aunt, uncle, or cousin at a market interest rate with standard terms. Verdict: Allowed. IRC Section 4975(e)(6) limits the family definition to spouse, ancestors, lineal descendants, and their spouses; siblings and other collateral relatives fall outside it. The loan still has to satisfy the plan's exclusive benefit requirement (IRC Sections 408(a) and 401(a)(2)) with genuine market terms.
Scenario: Lending to a business your spouse or child owns or controls 50 percent or more of. Verdict: Prohibited. Under IRC Section 4975(e)(2)(G), an entity is itself a disqualified person once disqualified persons hold 50 percent or more of it, directly or indirectly. A loan to that entity is treated the same as a loan to the disqualified person under IRC Section 4975(c)(1)(B).
Scenario: Lending to a business a sibling or cousin owns, where no disqualified person holds an ownership stake. Verdict: Allowed with caution. The business isn't a disqualified person on these facts, but confirm no disqualified person's ownership interest, combined with anyone else's, reaches 50 percent before funding, and document that calculation. Ownership can be harder to trace in a multi-owner entity than it first appears.
Friends and other unrelated borrowers
Scenario: Lending to a friend at a genuine market interest rate with standard, enforceable terms. Verdict: Allowed. A friend isn't a disqualified person, and market-rate terms with standard documentation satisfy the plan's exclusive benefit requirement.
Scenario: Lending to a friend at a reduced interest rate as a favor. Verdict: Proceed with caution. The friend isn't a disqualified person, so IRC Section 4975(c)(1)(B) doesn't apply directly, but below-market terms raise the question of whether the loan serves the plan or the friendship, a fact-specific determination under the plan's exclusive benefit requirement. Get this reviewed before funding rather than after.
Scenario: Lending to a friend with lenient repayment terms, or forgiving missed payments. Verdict: Proceed with caution. Same reasoning as a reduced-rate loan: informal treatment of a loan's terms after the fact can undermine the argument that it was a genuine, arm's-length transaction, even when the borrower was never a disqualified person to begin with.
Businesses and indirect arrangements
Scenario: Lending to a business you personally own or control 50 percent or more of. Verdict: Prohibited. Fiduciary status alone already makes you a disqualified person to your own plan under IRC Section 4975(e)(2)(A), and a business you own or control 50 percent or more of is a disqualified person in its own right under IRC Section 4975(e)(2)(G).
Scenario: Lending to a business where your combined family ownership, split across several disqualified persons, reaches 50 percent or more. Verdict: Prohibited. IRC Section 4975(e)(2)(G) counts ownership held by disqualified persons in the aggregate, not just any single person's share. Splitting ownership across family members doesn't avoid the threshold if the combined stake still reaches 50 percent.
Scenario: Your plan invests in an LLC alongside unrelated investors, and the LLC later leases property to, or transacts with, a business that you or a family member owns. Verdict: Proceed with caution. The Department of Labor has found that a plan's investment in an entity can itself become a prohibited transaction if it was made under an arrangement or understanding that the entity would transact with a disqualified person, even where the plan's co-investors are independent. Whether that arrangement existed at the time of investment is a fact-specific question; have the structure reviewed by an attorney or CPA before committing plan funds.
Loan size and documentation
Scenario: Making a small loan, a few hundred dollars, to a disqualified person. Verdict: Prohibited. IRC Section 4975(c)(1)(B) contains no minimum dollar threshold. A loan to a disqualified person is a prohibited transaction regardless of amount.
Scenario: Documenting a loan informally, with no signed promissory note. Verdict: Allowed with caution. An undocumented loan isn't itself a disqualified-person or exclusive-benefit problem if the borrower and terms are otherwise fine, but proving the loan was arm's-length becomes much harder without a signed note stating the rate, term, and repayment schedule. Document every loan the same way a bank would, regardless of who the borrower is.
The principle behind every scenario above
Every case above comes back to the same two questions: is the borrower a disqualified person, and would this loan look and act like a genuine transaction to an outside lender. Even a loan that would technically survive IRS scrutiny is a poor outcome if it only holds up because no one looked closely. Passing an audit isn't the same as running your plan well. When a scenario falls into "proceed with caution," a CPA or attorney who has reviewed the specific facts is worth the cost before funds move, not after.