In order to qualify for a solo 401k, self-employment activity is required. In other words, the entity type does not drive whether one can open a solo 401k and the business need not assume any particular legal form. Therefore, a self-employed business owner, a partnership, a limited liability company (LLC), or any type of corporation (including a Subchapter S corporation) may adopt a self-directed solo 401k plan.
The following information will help guide in determining if you qualify for a solo 401k plan.
Yes if you meet ALL of the following.
1. At minimum, perform part-time self-employment work. (Note that you can also work for a full-time employer that offers a 401k plan and still participate in a solo 401k plan as long as you also perform par-time self-employment activity.)
2. Do not own 80% or more of any business that employees non- business owners who are W-2 employees on a full-time basis (i.e., work 1,000 hours or more per year).
3. The self-employed business is only owned by owners.
4. Your self-employed business type is one of the following 7.
1. A trade or business:
It is generally an activity carried on for a livelihood or in good faith to make a profit. The facts and circumstances of each case determine whether or not an activity is a trade or business. The regularity of activities and transactions and the production of income are important elements. You do not need to actually make a profit to be in a trade or business as long as you have a profit motive. You do need, however, to make ongoing efforts to further the interests of your business.
2. Sole Proprietor / Independent Contractor:
In the case of a sole proprietor or independent contractor (click here for independent contractor definition), you have earned income from performing personal services and report the income to the IRS on Schedule C, line 31, or Schedule F in the case of farmers and ranchers. Each of these schedules are attachments to IRS Form 1040. An owner of a sole proprietorship (known as a sole proprietor) is the eligible participant under the employer solo 401k plan. The employer of these individuals is the sole proprietorship (i.e., the individual himself). See IRC 401(c)(4) and IRC 401(c)(1).
Partners of a partnership are also self-employed individuals. The solo 401k plans is established by the partnership as a business entity, not by each partner individually. Therefore, the partnership is the sponsor of the solo 401k plan. The earned income of each partner, for purposes of determining contributions, is the partner’s distributive share of the earnings of the partnership (reportable on Schedule K-1). To be a self-employed individual with respect to the partnership, the partner must have earned income as defined in IRC 401(c)(2), which requires the performance of personal services for the partnership.
4. S-Corporation / C-Corporation:
In the case of a S-Corporation or C-Corporation, if you are an owner-only employee and calculate both the employee and employer contributions using only salary income (e.g., W-2 wages). It does not include income passed through to shareholders of S corporations.
5. Limited Liability Company:
A Limited Liability Company (LLC) where only the members are self-employed individuals. LLCs combine the benefits of partnerships and corporations to create a separate business type. Because LLC members generally can choose to be treated as a partnership (or sole proprietorship if only one owner exists) or a corporation for tax purposes, LLCs must presumably follow the respective entity’s tax rules when opening a solo 401k plan.
6. A wife and husband business:
The employment tax requirements for family employees may vary from those that apply to other employees. CLICK HERE to learn more.
7. Par-time business:
You are otherwise in business for yourself (including a par-time business). You do not have to carry on regular full-time business activities to be self-employed. Having a part-time business in addition to your regular job or business also may be self-employment.
- Example: You are employed full time as computer programmer at Microsoft. You fix computers during the weekends. You have your own shop, equipment, and tools. You get your customers from advertising and word-of-mouth. You are self-employed as the owner of a part-time computer repair shop.
Am I Required to File a Business Tax Return?
If you made or received a payment as a small business or self-employed (individual), you are required to file a tax return to the IRS. Your form of business determines which income tax return form you have to file. To learn about the types of business tax returns and filing deadlines, CLICK HERE.
Self-Employed Entity Types
The most common forms of self-employed entity type are the sole proprietorship, partnership, corporation, S corporation, and Limited Liability Company (LLC) . Click on “self-employed entity types” to learn more about each type of entity and what forms to file.
Determining Compensation for Self-Employed Individuals
The starting point for identifying compensation for contribution purposes on behalf of self-employed individuals is to determine the individual’s earned income or net earnings from self-employment. Depending on the individual’s type of self-employment, an individual will use one of the following forms to determine net earnings for a specific year.
- A partnership generates a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., (an attachment to IRS Form 1065, U.S. Return of Partnership Income) for each individual partner showing the partner’s net earnings for the year.
- A sole proprietor must file Schedule C, Profit or Loss From Business, (an attachment to IRS Form 1040, U.S. Individual Income Tax Return) showing the net earnings from the business for the year.
- Farmers file Schedule F, Profit or Loss From Farming, (an attachment to IRS Form 1040) to show net income from farming.
- Limited liability companies typically elect to treat their members as sole proprietors or partners for tax purposes. In this case, members must file the appropriate schedule, as described above.
- Shareholders in S-Corporations: An S corporation is a “pass-through entity,” which means that income is taxed only once at the shareholder level. Unlike C corporations, which pay tax on profits by filing a corporate tax return, S corporations allocate income, gain, loss, deduction, and credit to each shareholder based on the number of shares owned. These items are reported on a separate IRS Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., for each shareholder. So while S corporation employees may receive two kinds of compensation—W-2 wages and pass-through compensation (dividends)—both are taxed only at the individual level, and not at higher corporate tax rates. In addition, because pass-through compensation is not subject to self-employment tax, shareholder/employees’ tax burden is even further reduced. An S corporation’s solo 401k plan cannot base contributions on their pass-through income. Therefore, an S corporation shareholder employee’s contribution may be calculated only using his salary income (e.g., W-2 wages).
Calculating My Annual Solo 401k Contribution
You can calculate your annual solo 401k plan contribution by using our solo 401k contribution calculator. Click here to use our calculator.