Self-Directed 401k Prohibited Transactions Review and Illustrations
Summary
The self-directed 401k plan is often overlooked because the most common retirement plans for the self-employed have traditionally been the SEP IRA and the SIMPLE IRA. While IRAs are generally less expensive to adopt and administer, they generally don’t allow for high contributions or as broad investment types as defined contribution plans such as the solo 401k plan.
Even though you can invest your solo 401k (referred by other names such as small business 401k, self-employed 401k, owner only 401k, Solo K, etc.) in many types of alternative investments (e.g., real estate, notes, LLC, Gold, etc.), you still must be careful not to engage in prohibited transactions when investing your Solo 401k. A transaction is deemed prohibited if it benefits you, as trustee/participant of the Solo 401k plan, or other disqualified persons such as your beneficiary, spouse, son, daughter, father or mother, to name a few.
Simply stated, any transaction that does not only benefit your solo 401k, but instead you personally or someone you know who is defined as a disqualified individual by the IRS will be deemed prohibited.
Self-Dealing
Prohibited transactions are often referred to as “self-dealing.”
This means your Solo 401k/self-directed 401k is prohibited from engaging in transactions that benefit you, your direct family, or your business. The negative consequences to your Solo 401k include tax penalties and loss of tax deferred status. Simply put, prohibited transactions are investments or forms of self-dealing that would put the government at risk of losing its tax on the solo 401k. To be clear, prohibited transactions only occur when funds within your solo 401k are used improperly. You can always withdraw from your solo 401k, pay the tax (and penalty if you are under 591/2 and no exceptions apply) and spend the money any way you wish, because now the government got their tax and the money you are spending is no longer solo 401k money. They worry when you spend money within your solo 401k on certain items because they think you might just be planning to beat them out of the tax that you would have paid on a solo 401k distribution.
Prohibited Transactions Examples
Real estate
The rules prohibit your Solo 401k / Self-Directed 401k retirement account from holding property in which you or disqualified persons currently occupy or plan to occupy. In other words, the property must be for investment purposes only.
Illustration 1
A lease between Solo 401k plan and daughter of Solo 401k plan trustee
Matt’s Solo 401k owns an apartment building. One of the tenants is his daughter Susan. As a party-in-interest, Susan’s leasing of the apartment is a prohibited transaction because the apartment is a solo 401k asset.
Illustration 2
Sale or exchange or leasing of any property between a plan and a disqualified person
Jay holds a parcel of land in his self-directed solo 401k plan. He now wants to build a retirement home on the property. Jay wires funds from his self-directed solo 401k bank account to purchase the property. This investment would result in a prohibited transaction because Jay falls under the disqualified party category. You are not allowed to build your own home on a parcel of land owned by your solo 401k plan.
Private company
Your Solo 401k / self-directed 401k can’t purchase private shares (for example, company shares that are not traded in a public exchange such as New York Stock Exchange or NASDAQ) in your own business or of a disqualified person (e.g., your son, daughter, father and mother to name few).
Illustration 1
The purchase of shares by Solo 401k in your own corporation
John personally owns 15% interest in a private corporation that he manages. Two years later he decides to use his Solo 401k plan to purchase Nick’s, another shareholder, 20% worth of shares. This is a prohibited transaction because John already owns and manages the corporation.
Illustration 2
Susan uses assets from her self-directed 401k plan to purchase 100,000 shares of a new private
law practice. Because of this investment, Susan is elected to the board of directors and is named
general counsel (i.e., trustee/fiduciary dealing with the income or assets of a plan in her own
interest or for her own account).
Promissory Notes
You can’t loan your Solo 401kor self-directed 401k funds to a disqualified person such as your father, mother, son, or daughter, for example.
Illustration 1
promissory note to daughter
Tina loans $50,000 from her Solo 401k to her daughter charging her 10% interest per year. This is considered a prohibited transaction because Tina’s daughter is considered a disqualified person.
Illustration 2
Lending of money or other extension of credit between a plan and a disqualified person.
Sue’s solo 401k plan has a balance of $100,000. Her father recently started a new business and needs a short-term loan to cover payroll. Sue offers to loan $60,000 from her solo 401k to her father in a form of a promissory note paying 8 (eight) percent interest in 12 monthly installments. This investment deemed prohibited because Sue’s father falls under the disqualified party umbrella.
Family Member
Illustration 1
While helping a family member is something one should not have to think twice about, helping a family member with your solo 401k plan can result in a prohibited transaction under the Internal Revenue Code (the “Code) and the ERISA rules.
For example, a son asks his mother, who is an advisor at a broker-dealer, to manage his self-directed 401k plan, any compensation paid to the mom would be a prohibited transaction. That is, the son is causing a family member – a person in whom he presumably has an interest that could affect his fiduciary judgment – to receive compensation.
Such transaction is considered a prohibited transaction because the mother is a “member of the family” of the fiduciary (the son). The Code defines a family member as the fiduciary’s “spouse, ancestor (e.g., parent or grandparent), lineal descendant (e.g., child, grandchild), and any spouse of a lineal descendant.”
Such transaction would not run afoul with the prohibited transaction rules, however, if the advisor (the mom) did not receive compensation for the advice.
In sum, advisors (and their firms) should not provide advice to family members about transferring their IRAs or 401k plans or about investing their solo 401k or IRA assets… unless they waive compensation for the advice.
Illustration 2
Q:My brother is considering purchasing a vacation rental property from my father. Can my 401K loan my brother the funds to make the purchase?
A: While it is not prohibited to invest one’s solo 401k funds via a promissory not to the solo 401k owner’s sibling, it is prohibited for the sibling to turn around and loan/invest those funds to the solo 40k owners parents. Such transaction would be deemed a roundabout/straw-man transaction which would result in a solo 401k prohibited transaction.
Roundabout Transactions; Direct vs. Indirect Prohibited Transactions
A roundabout transaction occurs when the Solo 401k participant/trustee structures one or more transactions with the purpose of making a prohibited transaction. A disqualified person may not indirectly do what cannot be done directly.
If a transaction directly violates the prohibited transaction rules, changing the transaction to remove
the disqualified person from direct involvement would still deem the transaction prohibited. Put differently, merely insulating that person from the transaction and enlisting a third party does not make a prohibited transaction allowable.
Illustration 1
You loan money from your Solo 401k /self-directed 401k to your friend (who’s not a disqualified person), and he or she then turns around and loans the same funds to your mother. This is considered a roundabout transaction and viewed by the IRS as not only prohibited but also as an attempt to evade the tax rules because you can’t loan money from your Solo 401k to your mother, even if you first loan it to your friend (who’s not a disqualified person), who then loans it to your mother.
Illustration 2
Thomas used his self-directed solo 401k plan funds to invest in a condominium in Cabo San Lucas. Thomas has now reached retirement age now wants to purchase the condo from his solo 401k plan. Thomas direct purchase from the solo 401k plan is a slam dunk prohibited transaction because Thomas is a disqualified person, and the plan cannot have a sale between itself and a disqualified party. Thomas sells the property to Jason Shepard, and individual unrelated to Thomas. Jason and Thomas, however, have agreed that Thomas will immediately purchase the property from Jason after the transaction between Jason and the 401k plan is completed. This is clearly an indirect prohibited transaction because a disqualified person (Thomas) attempts to circumvent the self-directed 401k prohibited transaction rules by inserting a third party (Jason) into the transaction.
Disallowed Investments
For the most part you can invest your Solo 401k / self-directed 401k in any investment type with the exception of the following:
Collectibles
A collectible includes a work of art, rug, antique, metal, gem, stamp, certain coins, alcoholic beverage, and musical instruments to name a few. The U.S. Treasury has the power to add to this list any other tangible personal property.
Click here to read our blog about the negative tax consequences of investing your Solo 401k in collectibles.
Permissible Investments
A defined contribution plan such as a Solo 401k plan may invest in an almost unlimited range of investments. However, the self-directed 401k plan document provider can limit the types of allowable investments that may be made under the solo 401k plan. For example, a solo 401k plan provider such as Fidelity Investments, Charles Schwab, E-Trade, Vanguard and Oppenheimer only allow for common investments such as stocks, bonds and mutual funds. On the other hand a self-directed 401k plan document provider like My Solo 401k Financial provides a plan document that allows for any investment that does not fall under the disallowed investment category. Examples of permissible self-directed 401k investments include notes, options, limited partnership interests, mortgages, real estate, tax liens, crowd funding, and life insurance to name a few. While the list of permissible solo 401k investments is extensive, the trustee of the self-directed 401k must avoid prohibited transactions when selecting various investments as the responsibility for selecting solo 401k plan investments falls on the solo 401k plan trustee.
Disqualified Persons
A “disqualified person” is defined as a fiduciary, you, a member of your family or any other entity such as a corporation, partnership, trust or estate that is 50% or more controlled by you or your family members.
For a solo 401k plan, you, the solo 401k owner, are a fiduciary. This is because you have discretion and control over the plan’s investments. In other words, you can’t blame it on the bank or solo 401k provider. If you misuse your solo 401k plan, it’s your fault.
The IRS considers the following as disqualified persons with respect to Solo 401k / self-directed 401k transactions:
Family members such as your father, grandmother (considered ancestors)
Your children, grandchildren (considered lineal descendents)
For a full list of disqualified persons visit here
Tax Consequence of Prohibited Transactions
Whether you intentionally or accidentally subject your Self-Directed Solo 401k to a prohibited transaction, the tax consequences are the same—your Solo 401k will generally be subject to federal taxes, possible state taxes and penalties.
In sum, thread carefully when investing your Solo 401k, also commonly referred to as a Self-Directed Solo 401k, Self-Directed 401k, Individual 401k, Individual K, Single K, Single 401k or Self-Employed 401k, because of the many different possible ways of structuring alternative investments such as real-estate, private investments, promissory notes, etc.
Prohibited Transaction Exemptions
Prohibited transaction exemptions can be statutory, which apply to anyone who meets the statute requirements.
The most common prohibited transaction exemption is participant loans from a QRP such as a self-directed 401k pan. For these loan conditions, See IRC Sec. 4975(d)(1).
A prohibited transaction exemption can also be granted on an individual basis which are released as “PTEs” or as advisory opinions. Individual exemptions apply only to the individual or organization that applied for the exemption. Nonetheless, individual exemptions include the DOL’s interpretation of ERISA and applicable class exemptions.
Additional Information on Prohibited Transactions
The prohibited transaction rules are found both in the Internal Revenue Code (IRC) and in ERISA.
Click here to learn about prohibited transactions under ERISA.
To learn about prohibited transactions under Internal Revenue Code visit here.
The following pages also cover the prohibited transactions rules:
If you plan to perform sweat equity work on the property, you should not open a self-directed 401k plan.
If you plan to draw a salary for managing (e.g., collecting rent checks for deposit into the 401k plan, hiring contractors for performing repairs or improvements on the 401k owned property, seeking tenants, etc.) the self-directed 401k owned property, you should not open a self-directed 401k plan.
You plan to use the self-directed 401k owned property for personal or business use even if you pay a fair market rent rate, you should not open a self-directed 401k.
You plan to have your children or parents use the self-directed 401k owned property for personal or business use even if a fair market rate rent is paid, you should not open a self-directed 401k.
You or your children or parents later plan to vacation in the self-directed 401k owned property.
You plan to sale, exchange or deposit real estate that you own personally or through your business, or your parent or children personally own or through their business into the self-directed 401k plan.
Unfortunately, it would still be prohibited for your solo 401K to lend funds to your spouse’s solo 401K. Unfortunately, there is no way around this rule. The IRS still views your wife's solo 401k as a disqualified party because the solo 401k is for her benefit. Also, the rules do not allow for a solo 401k to obtain a loan for investing in tax liens or notes. However, the solo 4o1k plan can obtain a non-recourse loan when investing in real estate.
Self-directed 401k owners may not pledge any portion of their solo 401k assets as security for a loan. See (IRC Sec.408(e)(3) and (4)). If such transaction takes place, only the pledged portion is considered distributed and is subject to tax and a 10 percent early distribution penalty tax if you are under age 59 1/2.
No such transaction is not allowed because your are a participant of the solo 401k plan; therefore, you are deemed a disqualified party and disqualified parties cannot guarantee a loan to their own solo 401k plan.
Legal Citation Why Can’t Guarantee a Loan to Your Solo 401k QUESTION:
Per Internal Revenue Code Section 4975(c)(1)(B), you are prohibited from extending credit (directly or indirectly) to your Solo 401k plan. Moreover, it is established that a loan guarantee constitutes an indirect extension of credit (see e.g. Janpol v. Comm’r, 101 T.C. 518, 527 (1993)). Therefore, you are prohibited from guaranteeing a loan to your Solo 401k.
Good question. However, such transaction would run afoul with the prohibited transaction rules. While it is true that siblings are not disqualified parties on the surface, what would make such transaction prohibited is that the siblings would be using their respective solo 401k plans to swap their personal investment properties.
Buying or Distributing Solo 401k Owned Real Estate QUESTION:
Excellent and popular questions. First, no you cannot buy property such as a condo from your own solo 401k plan as that would result in violation of the following prohibited transaction rule.
"Sale, exchange, or leasing of property between a plan (e.g., Solo 401k plan) and a party in interest (the solo 401k trustee)."
However, it would not be prohibited if you take an in-kind solo 401k distribution of the property (the condo) since the rules allow for distributions in the form of an asset instead of cash. You can also spread the tax liability by taking partial in-kind distributions of the property. You will need to get the property appraised each time you process a partial distribution, however.
While the solo 401k investment rules allow for promissory note investments, this transaction would result in a "roundabout" prohibited transaction because the rules do not allow for a transaction that is prohibited to be done indirectly. In other words, while your brother is not a disqualified party from a solo 401k investment perspective, if he were to turn around and loan those borrowed funds or other funds to you, the IRS would view as you essentially processing a promissory note from your own solo 401k which is prohibited. Don't confuse this rule with the solo 401k participant loan rules, though. To learn more about the difference between a "promissory note investment" and a solo 401k participant loan" CLICK HERE.
Correct that a sister-in-law is not a disqualified party from a solo 401k investment perspective. To learn more about the promissory note rules, CLICK HERE.
You cannot be and officer, director, or 10 percent or more shareholder, or highly compensated employee of the startup business as this would run afoul with the prohibited transaction rules. When a solo 401k invests via an equity investment into a business that offers good or services, this will trigger UBIT.
What you described is not possible as it would constitute a prohibited transaction. The best you could do is take a loan from your solo 401(k) (up to 50% of the balance not to exceed $50,000) and then use the proceeds to "pay yourself back". However, you cannot transfer property that you or your business personally owns to the solo 401(k) under any scenario.
A Solo 401k may passively invest in permissible investments but can't own & operate a business, including buying & refurbishing motor vehicles. You could borrow through a solo 401k participant loan up to 50% of the balance of your account (not to exceed $50K) and then use those funds however you wish including buying & refurbishing motor vehicles.
A Solo 401k may passively invest in a business that you and any other related persons have no other relationship with (i.e. you are not owners, employees, directors, lenders, vendors, etc.). This means that a Solo 401k can't operate a business and thus cannot own 100% of a business. It also means that you (or a business that you control) can't transact with a business that is owned by your Solo 401k.
The self-directed 41k rules do not allow for such a transaction because your LLC owns the existing condo. You and your LLC are deemed disqualified parties. Such transaction would violate the following prohibited transaction rule:
"Sale, exchange, or leasing of property between a plan and a disqualified person."
The property is the condo; the plan is the solo 401k plan; the disqualified party is your LLC.
Good question. One, the regulations do not allow for investing retirement funds including solo 401(k) plans and IRAs in physical cars. Second, the rules do not allow the solo 401(k) participant nor his or her self-employed business to use an asset of the solo 401k plan.
The regulations do not allow for investing solo 401(k) or IRA funds in works of art. The IRS considers this type of investment as a disallowed investment (collectible). If a solo 401k invests in works of art, it will result in a taxable distribution. Here are some examples of collectibles:
Artwork,
Rugs,
Antiques,
Metals – with exceptions for certain kinds of bullion,
Gems,
Stamps,
Coins – (but there are exceptions for certain coins),
No. The sale of an asset owned by your 401(k) to an entity that you own or control would constitute a prohibited transaction. Theoretically, you could take the land as an in-kind distribution in which case you would have to pay taxes and penalties on the value of the land at the time the distribution and transfer the title from the solo 401(k) into your name personally. In that case, you would certainly want a robust valuation to be able to demonstrate the fair market value of the property.
While a Solo 401(k) can be a sole member of an LLC, the Solo 401(k) plan cannot loan money to a solo 401k owned LLC as the IRS the rules do not allow for it. However, the solo 401k owned LLC can obtain a non-recourse loan from a third party for investing in real estate, with the borrowed funds used for purchasing the new property. For a list of lenders, Click Here.
Good question. First, the rules do not allow for a solo 401k to own equipment. Second, the solo 401k participant/owner or her business is not allowed to lease or use property (e.g., real estate) owned by her solo 401k plan. Such transaction would run afoul with the following prohibited transaction rule:
Act by a plan fiduciary whereby plan income or plan assets are used for her own interest.
A nephew is not a disqualified party with respect to making solo 401k investments. The solo 401k owner can make a promissory note investment through her solo 401k to her nephew as long as the note was done at market terms, meaning a reasonable interest rate. For a full list of disqualified persons visit here.
No, this would be a prohibited transaction. An option is to take a 401k participant loan of up to 50% of the balance not to exceed $50k - please see HERE and let us know if you wish to do so so that we can prepare the required loan documents.
Your proposed transaction would violate the the following prohibited transaction found in IRC 4975.
Sale, exchange, or leasing of property between a plan and a disqualified person
Yes, such transaction is prohibited because her father and his solo 401k fall under the disqualified party umbrella. This transaction would run afoul with the following prohibited transaction rule:
Sale, exchange, or leasing of property between a plan and a party in interest.
You asked about your Solo 401k funds investing in a surgery center where you perform surgery as a doctor. While you are neither an employee or a contractor, we discussed how this could be challenged a prohibited transaction since this is where you perform your surgeries. Moreover, even if this is not considered a prohibited transaction, any income attributable to your Solo 401k's equity investment in a business that is not taxed as a C-corporation is subject to Unrelated Business Income Tax (see more HERE)
Transfer Personal Private Investment to the Solo 401k QUESTION:
No. Unfortunately, such a transaction is prohibited and it would be deemed a sale, exchange, or leasing of property between a plan and a disqualified person. Specifically, you cannot exchange an asset that you personally own to the solo 401k plan or vice versa.
While your brother is technically not a disqualified person, the fact that you are also a service provider to his business incurs the risk that investing in his business could be challenged as a prohibited transaction.
Can’t Personally Guarantee a Real Estate Loan to the Self-Directed 401k Plan QUESTION:
Under Tax Court precedent, the guarantee of a loan is considered to be an extension of credit to the debtor.
Therefore, if the solo 401k participant/trustee were to guarantee a loan made to his Solo 401k he would be deemed to be making an extension of credit to his Solo 401k.
IRC 4975(c) provides that an extension of credit between a disqualified person and a plan is a prohibited transaction.
Therefore, under IRC 4975(c) the self-directed 401k participant/trustee is prohibited from providing a personal guarantee of a loan made to his Solo 401k.
Using Solo 401k Real Estate to Operate Livestock or Farming Business QUESTION:
You are contemplating using part of the land to raise and sell livestock including using Solo 401k funds to purchase farm equipment to farm the land for grazing and hay production.
A Solo 401k can only be used for passive investing. The activity that you are contemplating including both using the land the raise and sell livestock as well as farming the land is prohibited as it would constitute operating a business on land owned by your Solo 401k.
I note that it would be acceptable for your Solo 401k to lease the land to an unrelated person or company who then raises livestock and/or farms the land provide that you are not otherwise involved (e.g. such person could not lease the land and then hire you to raise livestock or farm the land).
Rent House Owned by Solo 401k to Ex-Husband QUESTION:
