Prohibited Transactions in a Solo 401(k)
The Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC) do not specify what investments a Solo 401k Plan is allowed to have. Instead, they describe who or what is prohibited from investing. These types of transactions are known as prohibited transactions. In general, a prohibited transaction is the improper use of the qualified account by you, a beneficiary, or a disqualified person.
These rules are meant to encourage people to use qualified retirement plans to grow savings; at the same time, the restrictions block participants in Solo 401k retirement plans from exploiting tax benefits for their personal account. These regulations are based on a congressional assumption that certain transactions are inherently suspicious.
What is a “Disqualified Person?”
There are some related definitions, but the “disqualified person” category (Internal Revenue Code Section 4975(e)(2)) generally includes the Solo 401k Plan participant, ancestors or lineal descendants of that participant, and entities in which the client holds a controlling equity or management interest.
Under Code Section 4975, a disqualified person is described as:
- A fiduciary (such as the Solo 401k Plan participant or an individual authorized to make investments for the Solo 401K Plan).
- A person offering services to the Solo 401k Plan (such as a custodian or a trustee).
- Any employer whose employees are included in the plan (usually this doesn’t apply to Solo 401k Plans but does include owner(s) of a business that sets up a qualified retirement plan).
- An employee organization which has any member included in the Solo 401k Plan.
- A 50% owner of 3 or 4 above.
- A family member of 1, 2, 3 or 4 above (including the fiduciary’s spouse, grandparents and parents, grandchildren and children, spouses of the fiduciary’s grandchildren and children, but not including parents-in-law).
- An entity (partnership, corporation, estate or trust) owned or controlled more than 50% by 1, 2, 3, 4 or 5. To determine if an entity is a disqualified person, we will consider the indirect stock-holdings/interest that would be considered 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 the purposes of determining disqualified persons.
- A 10% owner, director, officer, or highly compensated employee of 3, 4, 5 or 7.
- A 10% or more joint venture or partner of a person described in 3, 4, 5 or 7.
Who is not disqualified?
Uncles and aunts, sisters and brothers, cousins and friends, step-sisters and step-brothers are not considered disqualified persons.
Solo 401(k) Prohibited Transactions
IRS Section 4975 prohibits a Solo 401k Plan participant from making certain transactions. The kinds of prohibited transactions generally fall into three categories:
- Self-dealing prohibited transactions
- Conflict of interest prohibited transactions
- Direct prohibited transactions
Self-Dealing Prohibited Transactions
A self-dealing prohibited transaction usually involves one of the acts described below:
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. For example:
- Nick, a real estate agent, uses his Solo 401k Plan funds to purchase an investment property and receives a sales commission.
- Scott wants to purchase a rental property for $100K and would like to own the property personally but does not have enough money in his account. Therefore, he uses $10,000 from his Solo 401k Plan and $90,000 from his personal fund to finance the purchase.
Conflict of Interest Prohibited Transactions
A Conflict of Interest Solo 401k Prohibited Transaction usually 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 that involves income or assets of the plan. For example:
- Irene uses money from her Solo 401k plan to loan to a business that she controls and manages but has a small ownership interest in.
- Nancy uses her Solo 401k plan to loan money to a company she works for so that she can earn a promotion.
- Ross invests his Solo 401k Plan in a fund that he manages and his management fee is depended on the total asset value of the fund.
Direct Prohibited Transactions
A direct Solo 401k prohibited transaction generally involves one of the following:
4975(c)(1)(A): The direct or indirect sale, trade, or renting of property between a Solo 401k plan and a “disqualified person.” For example:
- Bob uses his Solo 401k plan funds to purchase an LLC interest owned by his son.
- John sells an interest in a partnership belonged to his Solo 401(k) plan to his father.
- Mary rents rental property belonged to her Solo 401(k) plan to her parents.
4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between a Solo 401k plan and a “disqualified person.” For example:
- Peter uses funds from his Solo 401k plan to buy a building and pays his son to do repairs on the building.
- Trudy owns a rental house with her Solo 401k plan and hires her son to manage the rental.
- Maria buys a rental with her Solo 401k plan funds and personally fixes it up.
4975(c)(1)(B): The direct or indirect loaning of money or other extension of credit between a Solo 401k plan and a “disqualified person.” For example:
- Judy personally guarantees a mortgage loan to her Solo 401k plan to buy residential investment property.
- Mark lends his wife $10,000 from his Solo 401k plan.
- Rob uses money from his Solo 401k plan to loan to an LLC that is controlled and owned by his son.
4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of a Solo 401(k) plan. For example:
- Mark invests his Solo 401k plan in a real estate fund and after that earns compensation for providing management services to the fund.
- John, in financial distress, uses $15,000 from his Solo 401k plan to pay a personal debt.
“S” Corporation Stock
Because of the shareholder restrictions imposed on “S” Corporations, a Solo 401k plan cannot own stock in an S Corporation. However, a Solo 401(k) plan can own stock in a “C” Corporation.
Under IRC Section 4975(d), Congress allowed statutory exemptions from the prohibited transaction rules, believing there was a legitimate reason to allow them assuming that specific requirements are satisfied.
A few of the statutory exemptions in Section 4975(d) that are applicable to Solo 401k plans include:
- Any contract with a disqualified person for office space, legal, accounting or other services necessary to operate the Solo 401k plan provided that reasonable compensation is made. Note – this exemption is not applicable to a Solo 401k plan fiduciary (the trustee of a Solo 401k plan) as stated in Treasury Regulation Section 54.4975-6(a)(5).
- Receipt by a disqualified person of any benefit entitled to him as a plan participant or beneficiary, provided that the benefit is calculated and paid in a manner that is dictated by the terms of the plan as applied to all other participants and beneficiaries.
- The provision of ancillary services by a bank trustee to a Solo 401k plan.
Plan Asset Rules
The Department of Labor’s Plan Asset Rules specify when the assets of an entity are deemed “plan” assets. Considered pension plans under the Plan Asset Rules, Solo 401(k) plans are subject to these rules.
- If the aggregate Solo 401(k) plan ownership of an entity is at least 25% of all the assets of the entity, the equity interests and assets of the “investment entity” are treated as assets of the investing Solo 401k plan for purposes of the prohibited transactions rules unless there is an applicable exception.
- Additionally, when a Solo 401k Plan or group of related qualified plans owns 100% of an “operating company,” the operating company exception is no longer applicable and the company’s assets are going to be considered plan assets.
As a rule, the Plan Asset Rules will apply in the following cases:
- If one or more disqualified persons and IRAs/401k plans own 100% of an “operating company,” in which case all the assets of the “operating company” are considered plan assets (assets of the IRA/401(k)), or
- If disqualified persons and IRAs/401k plans own at least 25% of an “investment company,” in which case all the assets of the “investment company” are treated as plan Assets (assets of the IRA/401k). To determine if the 25% threshold is reached, all IRAs/401k owners will be taken into account, even when they belong to unrelated individuals.
How to Tell If a Transaction Is Prohibited
Through an arrangement between the Department of Labor and the IRS, it is the DOL who decides if a certain transaction is prohibited and whether to allow necessary exemptions.
- In case the IRS finds what looks like a Solo 401k prohibited transaction, it transfers the case to the DOL. The DOL will review and get back to the IRS who will, in turn, respond to the taxpayer.
- An IRA grantor who wants to be granted a prohibited transaction exemption has to apply to the DOL. Some exemptions, called “prohibited transaction class exemptions” (PTCEs), can be issued to anyone’s reliance, while others, known as “individual prohibited transaction exemptions” (PTEs), are only available to the applicant.
It is imperative that each plan participant has a good understanding of Solo 401k prohibited transactions. For more information on the benefits of investing in a Solo 401(k) plan, please talk to one of our Solo 401k plan experts at (949)228-9394.
Internal Revenue Bulletin – Section 4975
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