The Internal Revenue Code & ERISA does not describe what a Solo 401k Plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of qualified retirement plans for accumulation of retirement savings and to prohibit those in control of Solo 401K qualified retirement plans from taking advantage of the tax benefits for their personal account.
Who is a “Disqualified Person”?
The IRS has restricted certain transactions between the Solo 401k Plan and a “disqualified person”. The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed.
The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the Solo 401k Plan Participant, any ancestors or lineal descendants of the Solo 401k Plan Participant, and entities in which the Solo 401k Plan Participant holds a controlling equity or management interest. In essence, under Code Section 4975, a “Disqualified Person” means:
- A fiduciary (e.g., the Solo 401k Plan Participant, or person having authority over making Solo 401K Plan investments),
- A person providing services to the Solo 401k Plan (e.g., the trustee or custodian),
- An employer, any of whose employees are covered by the plan (this generally is not applicable to Solo 401k Plans but does include the owner of a business that establishes a qualified retirement plan),
- An employee organization any of whose members are covered by the Solo 401k Plan,
- A 50 percent owner of C or D above,
- A family member of A, B, C, or D above (family members include the fiduciary’s spouse, parents, grandparents, children, grandchildren, spouses of the fiduciary’s children and grandchildren (but not parents-in-law),
- An entity (corporation, partnership, trust or estate) owned or controlled more than 50 percent by A, B, C, D, or E. Whether an entity is a disqualified person is determined by considering the indirect stockholdings/interest which would be taken into account under Code Sec. 267(c), except that members of a fiduciary’s family are the family members under Code Sec. 4975(e)(6) (lineal descendants) for purposes of determining disqualified persons.
- A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G,
- A 10 percent or more partner or joint venturer of a person described in C, D, E, or G.
Note: brothers, sisters, aunts, uncles, cousins, step-brothers, step-sisters, and friends are NOT treated as “Disqualified Persons”.
Pursuant to Internal Revenue Code Section 4975, an Solo 401k Plan Participant is prohibited from engaging in certain types of transactions. The types of prohibited transactions can be best understood by dividing them into three categories: Direct Prohibited Transactions, Self-Dealing Prohibited Transactions, and Conflict of Interest Prohibited Transactions.
Direct Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Direct Prohibited Transaction” generally involves one of the following:
4975(c)(1)(A): The direct or indirect Sale, exchange, or leasing of property between a Solo 401k Plan and a “disqualified person”
Example 1: Joe sells an interest in a piece of property owned by his Solo 401k Plan to his son.
Example 2: Beth leases real estate owned by her Solo 401k Plan to her daughter.
Example 3: Mark uses his Solo 401k Plan funds to purchase an LLC interest owned by his mother.
4975(c)(1)(B): The direct or indirect lending of money or other extension of credit between a Solo 401k Plan and a “disqualified person”
Example 1: Ted lends his wife $70,000 from his Solo 401k Plan.
Example 2: Mary personally guarantees a bank loan to her Solo 401k Plan to purchase real estate.
Example 3: Dan uses his Solo 401k Plan funds to lend an entity owned and controlled by his father $18,000.
4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between a Solo 401k Plan and a “disqualified person”
Example 1: Andrew buys a piece of property with his Solo 401k Plan funds and hires his father to work on the property.
Example 2: Rachel buys a condo with her Solo 401k Plan funds and personally fixes it up.
Example 3: Betty owns an apartment building with her Solo 401k Plan and hires her mother to manage the property.
4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of a Solo 401(k) Plan
Example 1: Ken is in a financial jam and takes $32,000 from his Solo 401k Plan to pay a personal debt.
Example 2: John uses his Solo 401k Plan to purchase a rental property and hires his friend to manage the property. The friend then enters into a contract with John and transfers those funds back to John.
Example 3: Melissa invests her Solo 401k Plan funds in a real estate fund and then receives a salary for managing the fund.
Self-Dealing Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Self-Dealing Prohibited Transaction” generally involves one of the following:
4975(c)(1)(E): The direct or indirect act by a “Disqualified Person” who is a fiduciary whereby he/she deals with income or assets of the Solo 401k Plan in his/her own interest or for his/her own account
Example 1: Debra who is a real estate agent uses her Solo 401k Plan funds to buy a piece of property and earns a commission from the sale.
Example 2: Ben wants to buy a piece of property for $120,000 and would like to own the property personally but does not have sufficient funds. As a result, Ben uses $110,000 from in his Solo 401k Plan and $10,000 personally to make the investment.
Example 3: Nancy uses her Solo 401k Plan funds to invest in a real estate fund managed by her son. Heidi’s father receives a bonus for securing Nancy’s investment.
Conflict of Interest Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Conflict of Interest Prohibited Transaction” generally involves one of the following:
4975(c)(i)(F): Receipt of any consideration by a “Disqualified Person” who is a fiduciary for his/her own account from any party dealing with the Plan in connection with a transaction involving income or assets of the Plan.
Example 1: Jason uses his Solo 401k Plan funds to loan money to a company in which he manages and controls but owns a small ownership interest in.
Example 2: Cathy uses her Solo 401k Plan to lend money to a business that she works for in order to secure a promotion.
Example 3: Eric uses his Solo 401k Plan funds to invest in a fund that he manages and where his management fee is based on the total value of the fund’s assets.
Under Internal Revenue Code Section 4975(d), Congress created certain statutory exemptions from the prohibited transaction rules outlined under Internal Revenue Code Section 4975(c). For these certain transaction, Congress believed there is a legitimate reason to permit them. For these transactions, Congress has issued a blanket statutory exemptions permitting these transactions assuming that certain requirements specified are satisfied.
Below is a list of some of the statutory exemptions found in Internal Revenue Code Section 4975(d) that apply to Solo 401ks:
- Any contract with a disqualified person for office space, legal, accounting or other services necessary for the operation of the Solo 401k Plan as long as reasonable compensation is paid. Note – this exemption does not apply to a Solo 401k Plan fiduciary (the Solo 401k Plan trustee) as per Treasury Regulation Section 54.4975-6(a)(5).
- The provision of ancillary services to a Solo 401k Plan by a bank trustee.
- receipt by a disqualified person of any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries.
S Corporation Stock
Because of the shareholder restrictions imposed on “S” Corporations, an Solo 401k Plan cannot own stock in an S Corporation. Note – a Solo 401k Plan can own stock in a “C” Corporation.
Plan Asset Rules
The Department of Labor’s (DOL) Plan Asset Rules essentially define when the assets of an entity are considered ‘Plan” assets. Under the rules, 401(k) qualified plans, including Solo 401(k) Plans are frequently viewed as pension plans subjecting them to the Plan Asset Rules. Under the Plan Asset Rules, if the aggregate Solo 401(k) Plan ownership of an entity is 25% or more of all the assets of the entity, then the equity interests and assets of the “investment entity” are viewed as assets of the investing Solo 401k Plan for purposes of the prohibited transactions rules, unless an exception applies. Also, if a Solo 401k Plan or group of related qualified plans owns 100% of an “operating company”, the operating company exception will not apply and the company’s assets will still be treated as plan assets.
In summary, the Plan Asset Rules can be triggered if:
- 100% of an “operating company” is owned by one or more IRAs/401k plans and disqualified persons, in which case all the assets of the “operating company” are deemed Plan assets (assets of the IRA/401(k)), or
- If 25% or more of an “investment company” is owned by IRAs/401k plans and disqualified persons, in which case all the assets of the “investment company” are deemed Plan Assets (assets of the IRA/401k). In determining whether the 25% threshold is met, all IRAs/401k owners are considered, even if they are owned by unrelated individuals.
Exceptions to the DOL Plan Asset Regulations
The Plan Asset look-through rules do not apply if the entity is an operating company or the partnership interests or membership interests are publicly offered or registered under the Investment Company Act of 1940 (e.g., REITs). They also do not apply if the entity is an “operating company,” which refers to a partnership or LLC that is primarily engaged in the real estate development , venture capital or companies making or providing goods and services, such as a gas station, unless the “operating company” is owned 100% by a 401k qualified Plan or IRA and/or disqualified persons. In other words, if an IRA or Solo 401k Plan owns less than 100% of an LLC that is engaged in an active trade or business, such as a restaurant or manufacturing plant, the Plan Asset Rules would not apply. However, the IRA or 401k Plan investment may still be treated as a prohibited transaction under Internal Revenue Code Section 4975. In addition, the Unrelated Business Taxable Income may apply to subject to the IRA or 401k Plan to tax on the income or gains generated from the operating business.
Note: The fact that a transaction does not trigger the Plan Asset Rules does not mean that the transaction may not be deemed a prohibited transaction under Internal Revenue Code Section 4975. In other words, a transaction that does not fall under the Plan Asset Rules can still be treated as a prohibited transaction pursuant to Internal Revenue Code Section 4975.
Determining Whether a Specific Transaction is a Prohibited Transaction
Through an arrangement between the IRS and the Department of Labor (DOL), it is the DOL’s responsibility to determine whether a specific transaction is a prohibited transaction and to issue prohibited transaction exemptions. When the IRS discovers what appears to be a prohibited transaction in an individual’s IRA, it turns the matter over to the DOL to make the determination. The DOL reviews the situation and responds to the IRS, which in turn responds to the taxpayer. If the IRA granter wants to apply for a prohibited transaction exemption, he or she must apply to the DOL. The DOL has the authority to issue prohibited transaction exemptions. Some, known as “prohibited transaction class exemptions” (PTCEs), are available for anyone’s reliance, while others, called “individual prohibited transaction exemptions” (PTEs), are issued only to the applicant.
For additional information on the advantages of using a Solo 401k Plan with “Checkbook Control” to make investments, please contact one of our Solo 401k Plan Experts at 800-472-0646.