Let’s face it. Solo 401k plans have been increasing in popularity in recent years. Retirement investors nowadays aren’t just looking for traditional investment strategies. Alternative investments are playing a critical role in today’s investment world. This is why solo 401k prohibited transactions are becoming more important to understand.
Rather than stocks and bonds, today’s investors often prefer real estate, tax liens, precious metals and private equities. That’s because the probability of receiving higher returns in such investments is more than traditional investment plans.
However, when setting up a solo 401k you must abide by all the IRS rules and regulations when carrying out transactions. Any participation in illegal transactions can lead to disqualification with huge risks of penalties.
Table of contents
Solo 401k Prohibited Transactions: Origination
Before ERISA came in 1974, Congress recognized a few concerns regarding some transactions. The Congress believed people responsible for the running of retirement plans were not honest in their approach. To resolve this issue, both the Internal Revenue Code (IRC) and ERISA have presented guidelines to ban such transactions.
They also impose punishments on those Solo 401k investors who partake in such investment plans.These rules and regulations ensure the benefits of all the Solo 401k investors. The plans should not by any means benefit the plan owner. The rules also prohibit any transactions between the banned individuals and the Solo 401k investor.
To know more about the disqualification of certain individuals, you can refer to IRC Sec. 4975(e) (2). The disqualified individuals can include both the Solo 401k trustee and the provider as well. The criteria can also apply to individuals who charge for investment advice. If in case the Solo 401k owner is accused, then their family members also meet the same consequences. The members can include the owner’s spouse, any ancestor, any descendant and even the descendant’s spouse.
The rules do not only restrict to the plan trustees. In a particular case, other participants are subject to investigation as well
Prohibited Investments
The IRC has listed a few types of investments which are not favorable for investors. Investors should avoid investment schemes involving artwork, precious metals, alcoholic drinks and other listed things as well. These investments could be restricted because of the Congress’s concerns regarding the benefits that the disqualified individuals have availed. Another reason could’ve e been that these investments did not contribute to the betterment of the economy as well.
Illegal Transactions
There are a few prohibited transactions between Solo 401k owners and investors under the law. Here are a few taken from Sec. 408(e) and Sec. 4975(c) to help you understand better:
- Selling/leasing property: The law prohibits property sales and lease between a Solo 401k investor and a disqualified person. For instance, after your retirement, you cannot use the plan for the sale or purchase of a particular property.
- Receiving fees for Solo 401k plan management: no more compensation to those investors who manage their own Solo 401k investment plans. For instance, the Solo 401k owns a rental property; the trustee cannot make use of their Solo 401k for their pays. This includes paying for rent collection and property taxes or searching for tenants.
- Taking Loans using Solo 401k: the use of your Solo 401k ownership for taking loans is against the law. For example, to settle the property value, not even a little transaction is possible by using the Solo 401l plan.
- Using Solo 401k assets to buy property: buying of rental property through your Solo 401k assets is an illegal activity.
Solo 401k prohibited transactions can be challenging to understand. Getting into the Solo 401k and IRA banned transactions is not a wise thing to do. It is important for you to choose the most suitable solo 401k provider to help you avoid prohibited transactions. While making investments through 401K, it is advisable to be careful because you may be making prohibited transactions. Prohibited transactions are investments made into a business led by oneself, their family, or a partnership.
In simple terms, IRS considers a transaction benefiting you, your beneficiary or disqualified people (blood relatives) a prohibited transaction. The Internal Revenue Service (IRS) has enforced these laws and with that; major penalties and consequences for tax evasion. Another common term for prohibited transactions is ‘Self-Dealing’. Investments made into ventures, through solo 401K, which benefit the investor in any way are prohibited. Despite that, the investor can still fund the investments privately.
Disqualified Persons
A disqualified person is someone who has substantial control over a certain organization. Alternatively, they may be the owner, family of the owner, or any other entity such as a corporation or partnership. Such partnership or corporation must have over 50 % control of all assets owned by either you or your family.
More importantly, a fiduciary has much or all the control over the 401K plan investments. The IRS considers the following as disqualified persons and prohibits them from carrying out a variety of transactions:
- Members of your family such as father, mother, Grandmother (considered ancestors)
- Children, grandchildren (considered lineal descendants)
- The employer
- The union
- Service providers
Types of Solo 401k Prohibited Transactions
Real Estate
Rules stated by the IRS Prohibit an investor from holding land with the intention of occupying it. Moreover, an investor cannot invest in the property they own. For example, a father, and a member of 401k cannot lease an apartment in a building that he owns, to his daughter. Let’s also take the example of a man who bought a small piece of land through his solo 401k account. Now this man wants to build an animal shelter on that land, but this is self-dealing in its truest sense. That is because the man cannot build anything on land bought through his 401k account. Real estate can be tricky.
Lending and Borrowing
Funds present in someone’s 401K account are not transferable to a disqualified person such as mother, father, daughter, and son. Moreover, funds cannot go into a 401K account from a disqualified person. For example, a daughter with a 401K account has a balance of $50,000 and loans her father $20,000. The father must return the payment in 12 monthly installments with 10% interest. An investment of this type will be a prohibited transaction because her father is a prohibited person. Roundabout Transactions
The IRS has ensured there remain no loopholes that can be leveraged by trustees. Roundabout transactions were one such loophole later rectified by the IRS. When an investor makes more than one transaction with the intention of making a prohibited transaction it’s known as a roundabout transaction. For example, you loan money to your friend through your 401k account (which is allowed).
However, later on, your friend loans the same amount to your mother, this certain scenario would be a prohibited transaction. Furthermore, this is one of the many ways to avoid tax laws according to IRS.
Private company
Present in the stock market are shares of many companies, mainly of private limited and public limited companies. The 401K account is only capable of buying public Ltd shares and purchasing of private shares will qualify as a prohibited transaction. Buying shares of your own company, a disqualified person’s company, or companies that don’t trade in a public exchange will qualify as such.
For example, the founder of a company has over a 30% share and ownership of their company. They decide to buy another shareholder’s share through their 401K plan. That’s a prohibited transaction because this owner cannot purchase shares of his own company through 401K.
Goods and Services
Even the transactions that involve the exchange of goods and services are prohibited transaction if bought or sold at the expense of the 401k account. However, this statement is only limited to goods and services sold or purchased from a disqualified person.
Collectibles
Unlike other items, collectibles are an exception in this case. In prior types, it wasn’t the item that held a problem rather the trader. A collectible can include antiques, rugs, musical instruments, Alcoholic beverages, stamps, coins, metal, etc.
Furthermore, the U.S treasury may add to this list any other tangible personal item they deem worthy. Some transactions including disqualified people enjoy exemption from the prohibited transactions. For example, you are a beneficiary or participant in a plan and receive loans or investments. Here, you are still a disqualified person.
However, the benefits you’re receiving are not prohibited transactions. That’s because benefits you received are on the same terms as those of other beneficiaries or partners. Another more common prohibition transactions include; the failure to deposit employee referrals and loan repayment to the plan.
The Department of Labor (DOL) has immensely publicized the consequences of late employee deferrals. If an employer is late in the payment of either a loan or a deferral, the DOL will consider it as a loan to a disqualified party. Hence, charging the employer on behalf of the IRS section 4975.
Consequences of Tax Evasion
Federal and state laws are blind to intention, ignorance or lack of knowledge. Hence, if a 401k account holder commits a prohibited transaction, they have to prepare to face the consequences that will follow.
According to the IRC section 4975, monitory penalties are possible if the disqualified individual violates the act. Therefore, the disqualified person is now subject to section 4975 of the IRS. Moreover, he/she will be forced to pay the excise tax based on the amount involved in the transaction and correct it.
Initially, for the taxable period, the fiduciaries will be charged with a 15% increase on the initial tax involved in every year, for the taxable period. If the initial tax remains unpaid during the first taxable period, an additional 100% will add to the original amount. Any disqualified person can pay the amount if he/she was a part of the transaction.
In the case where there are multiple fiduciaries involved, they will all be charged jointly and severely for the entire tax. Furthermore, the plan can cease by the IRS and in turn sell all related assets on market price.
Ways to Avoid Solo 401k Prohibited Transactions
You now know the consequences of committing prohibited transactions. Moreover, you can see the thin line between normal transactions and prohibited transactions. As a result, you have to be extremely careful when you have a Solo 401k.
Contact your service provider regularly to ensure no acts of unintentional tax evasion takes place or has taken place already. Review your current plan and see whether it needs an upgrade. You must know about prohibited transactions and their implications.
Moreover, their implications on management integrity, cause, and effect of a breach in fiduciary duties and inclusion of ERISA supplemental schedules. Be careful before entering a new transaction and be constant with your filing. Keep yourself up to date about the current fiduciary policies. This will aid in the prevention of prohibited transactions.
How to Avoid Solo 401k Prohibited Transactions
- Prohibited Investments. Be specifically careful with real estate transactions. This is because most prohibited transaction involve real estate. But remember to also be careful with collectibles, private company stock, etc.
- Disqualified Persons. Be careful if you are considering using 401k funds to get involved in a transaction with a family member. You may think it is a harmless transaction, but the IRS may not see it that way.
- Illegal Transactions. There are several prohibited transactions between Solo 401k owners and investors that are clearly specified under the law.
- Seek Legal or Tax Assistance. If you think you may have violated the rules on prohibited transactions you may want to seek out the help of a CPA and/or qualified attorney.
- Quantify the Tax Consequences. If you think you have a prohibited transaction, you can have your accountant quantify the tax impact of the transaction and also consider penalties and any resulting abatement request.
In conclusion, prohibited transactions can happen unintentionally and often lead to huge fines leading the company to go bankrupt. Caution and guidance from professionals or service providers are advisable before entering new contracts. Tax evasion is a crime that a lot of the people don’t know they’re committing until it’s too late. However, if you have the right knowledge and research, you can avoid such mishaps beforehand.
