SOLO 401K PLAN - THE PROHIBITED TRANSACTION RULES?
The Internal Revenue Code 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 dos 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: Fred sells an interest in a piece of property owned by his Solo 401k Plan to his son
Example 2: Terry leases real estate owned by her Solo 401k Plan to her daughter
Example 3: Larry uses his Solo 401k Plan funds to purchase an LLC interest owned by his father
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: Jim lends his wife $50,000 from his Solo 401k Plan
Example 2: Beth personally guarantees a bank loan to her Solo 401k Plan
Example 3: Jason uses Solo 401k Plan funds to lend an entity owned and controlled by his mother $35,000
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: Brian buys a piece of property with his Solo 401k Plan funds and hires his son to work on the property
Example 2: Karen buys a condo with her Solo 401k Plan funds and personally fixes it up
Example 3: Shari 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 an IRA
Example 1: James is in a financial jam and takes $15,000 from his Solo 401k Plan to pay his rent
Example 2: David 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 David and transfers those funds back to David
Example 3: Lauren 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: Jessica 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: Ivan wants to buy a piece of property for $90,000 and would like to own the property personally but does not have sufficient funds. As a result, Ivan uses $60,000 from in his Solo 401k Plan and $30,000 personally to make the investment.
Example 3: Heidi uses her Solo 401k Plan funds to invest in a real estate fund managed by her father. Heidi's father receives a bonus for securing Heidi'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: Joey 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: Lisa uses her Solo 401k Plan to lend money to a business that she works for in order to secure a promotion
Example 3: Seth 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.
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.