The IRS has restricted certain transactions between the Solo 401(k) 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 401(k) plan participant, any ancestors or lineal descendants of the Solo 401(k) plan participant, and entities in which the Solo 401(k) plan participant holds a controlling equity or management interest. In essence, under Code Section 4975, a “Disqualified Person” means:
- IRC 4975(e)(2)(A): fiduciary (e.g., the Solo 401(k) plan participant, participant, or person having authority over making 401k investments).
- IRC 4975(e)(2)(B): A person providing services to the plan (e.g., the trustee or custodian).
- IRC 4975(e)(2)(C): An employer, any of whose employees are covered by the plan (this generally is not applicable to IRAs).
- IRC 4975(e)(2)(D): An employee organization, any of whose members are covered by the Plan (this generally is not applicable to IRAs).
- IRC 4975(e)(2)(E): A 50 percent owner of C or D above.
- IRC 4975(e)(2)(F): 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).
- IRC 4975(e)(2)(G): 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].
- IRC 4975(e)(2)(H): A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G.
- IRC 4975(e)(2)(I): 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”.
Application of the 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 401(k) plan participant.
Pursuant to Internal Revenue Code Section 4975, a Solo 401(k) 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 401(k) plan participant, when making an investment with a Solo 401(k) 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 401(k) 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:
4975(c)(1)(A): 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.
4975(c)(1)(B): 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.
4975(c)(1)(C): 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.
4975(c)(1)(D): 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.
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 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.
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 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.
Work with Tax Professionals Who Know the IRS Prohibited Transaction Rules
The IRA Financial Group was founded by a group of top law firm tax and ERISA lawyers who have worked at some of the largest law firms in the United States, such as White & Case LLP, Dewey & LeBoeuf LLP, and Thelen LLP. Over the years, we have advised thousands of clients on the Self-Directed IRA prohibited transaction and “disqualified person” rules. With our work experience at some of the largest law firms in the country, our retirement tax professionals’ tax and IRA knowledge in this area is unmatched.