In court case Robert Kobell v. Commissioner (T.C. Memo 2011-66; March 17, 2011), the Tax Court ruled that a taxpayer did not qualify to be treated as a professional trader. As such, the income from his investments was not compensation and he was therefore ineligible to receive a deduction for an IRA contribution as he had no other earned income. While this court case mentions an IRA, it is safe to say that it also applies to a solo 401k because contributions to a solo 401k plan are based on earned income from self-employment activity.
The Court explained the tax payer was clearly not a professional trader as he met none of the general guidelines for determining if one is a professional trader.
From the Court:
- “Petitioner held corporate bonds which produced interest, but the bonds were not held for sale to customers. Moreover, he engaged in only three stock transactions, did not have any customers, and did not operate from an established place of business.
- “In short, petitioner was not a dealer, had no compensation, and is not entitled to a deduction for his IRA contribution.”
Note: The Court ruled the tax payer was not entitled to a deduction for an IRA contribution, because this is what the IRS challenged. In reality though, the tax payers was not eligible to even make the contribution, regardless of whether or not he claimed a deduction. Like solo 401k plans, IRA contributions require that an individual have compensation, and here, the tax payer had none.
Summary of Key Points
Taxpayer took a deduction for an IRA contribution. Taxpayer’s return indicated he was actively working as an investor/trader although he made only three stock transactions for the entire year and he included no income from his investing on Schedule C (Profit or Loss From Business) of his return.
IRS denied the IRA deduction, stating that he had no compensation with which to make a deductible IRA contribution.
The Court agreed with IRS and determined that there was no compensation. Taxpayer’s deduction was denied.
Without “compensation” during an applicable tax year, individuals cannot make solo 401k or IRA contributions, whether those contributions are deducted or not. Roth IRA contributions would also be prohibited.