The Solo 401(k) allows small business owners and self-employed individuals to make alternative asset investments with their retirement funds. The Solo 401(k) also has higher contributions and a $50,000 loan feature. It is the most robust retirement plan if you are self-employed or a business owner with no full-time employees.
But there are IRS regulations surrounding Solo 401(k) plans.
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.
What is a Disqualified Person?
The definition of a “disqualified person,” which can be found in Internal Revenue Code Section 4975(e)(2), extends into a variety of related party scenarios, but generally includes the Solo 401k plan participant, as well as:
- Any ancestors or lineal descendants of the Solo 401k plan participant
- Entities in which the Solo 401k plan participant holds a controlling equity or management interest.
Here is a brief overview of disqualified persons and non-disqualified persons.
In essence, under Code Section 4975, a “Disqualified Person” means:
- Fiduciary (e.g., the Solo 401k plan participant, participant, or person having authority over making 401k investments).
- A person providing services to the plan (e.g., the trustee or custodian).
- An employer, any of whose employees are covered by the plan (this generally is not applicable to IRAs).
- An employee organization, any of whose members are covered by the Plan (this generally is not applicable to IRAs).
- A 50 percent owner of 3 or 4 above.
- A family member of 1, 2, 3, or 4 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 1, 2, 3, 4 or 5. [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 3, 4, 5, or 7.
- A 10 percent or more partner or joint venturer of a person described in 3, 4, 5, or 7.
Note: brothers, sisters, aunts, uncles, cousins, step-brothers, step-sisters, and friends are NOT treated as “Disqualified Persons”.
Application of the Solo 401k prohibited Transaction Rules
In order to determine whether a proposed transaction is a prohibited transaction and violates IRC 4975, it is important to examine all the parties engaged in the proposed transaction rather than on just the Solo 401k plan participant.
Pursuant to Internal Revenue Code Section 4975, a Solo 401k plan 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.
The Best Way to Prevent a Prohibited Transaction
As the Solo 401k plan participant, when making an investment with a Solo 401k plan, it is advisable to not engage in any transaction with a disqualified person. There is an abundance of case law that clearly states that a Solo 401k plan can not engage in a transaction that directly or indirectly benefits a disqualified person.
Below are several examples of common prohibited transactions involving disqualified persons:
The direct or indirect Sale, exchange, or leasing of property between a 401k plan and a “disqualified person”
Tom sells an interest in a piece of property owned by his 401(k) plan to his son.
The direct or indirect lending of money or other extension of credit between a 401k plan and a “disqualified person”
Jen lends her husband $20,000 from her 401k plan.
The direct or indirect furnishing of goods, services, or facilities between a 401k plan and a “disqualified person”
Joel buys a home with his 401(k) funds and personally fixes it up.
The direct or indirect transfer to a “disqualified person” of income or assets of a 401k plan
Tim is in a financial jam and takes $3,000 from his 401(k) plan to pay his mortgage and credit card bill.
The direct or indirect act by a “Disqualified Person” who is a fiduciary whereby he/she deals with income or assets of the 401k plan in his/her own interest or for his/her own account
Tina who is a real estate agent uses her 401(k) plan funds to buy a home and earns a commission from the sale.
Carl and Judy, husband and wife, use their 401(k) plan funds to do a joint venture with an LLC they own personally to buy real estate.
Receipt of any consideration by a “Disqualified Person” who is a fiduciary for his/her own account from any party dealing with the 401k plan in connection with a transaction involving income or assets of the 401k plan
Derrick uses his 401(k) plan funds to loan money to a company in which he manages and controls but owns a small ownership interest in.
Get in Touch
At IRA Financial, we will help you navigate the complexities of disqualified persons under IRC Section 4975(e)(2) to prevent triggering a prohibited transaction. As you may know, triggering a prohibited transaction can lead to steep penalties and the disqualified of your plan. If you have any questions or concerns regarding transactions with a potentially disqualified person, get in touch with a specialist today at 800-472-0646 or fill out our form.