While solo 41k plans are generally exempt from bankruptcy creditors, such may not be the case when solo 401k funds are involved in a prohibited transaction. While the following court case involved an IRA, the same would apply to a solo 401k plan since it is also a retirement account. In court case (Willis v. Menotte, u.S. Court of Appeals For the Eleventh Circuit, no. 10-11980, 4/21/11) which began in bankruptcy court, Ernest Willis sought to protect nearly $1.5 million worth of IRAs. Willis claimed that IRAs are exempt from creditors in a bankruptcy proceeding.
However, his creditors felt otherwise and claimed that Willis had engaged in prohibited transactions with his self-directed IRA, such as self-dealing in a real estate transaction and borrowing from his IRA to cover negative brokerage account balances. Such prohibited transactions disqualify an IRA, so those accounts were not exempt.
Unfortunately for the IRA owner, the bankruptcy court agreed with the creditors, and so did a District Court in Florida as well as the Eleventh Circuit Court of Appeals. Not only did creditors have access to the IRAs involved with the prohibited transactions, the creditors also could reach other IRAs funded with money from the “tainted” IRAs.
A common question that we field from solo 401k prospects is: “Can I use my solo 401k money to buy real estate from myself?”
The answer, it turns out, is no. A solo 401k that has engaged in prohibited transactions is liable for income tax and is accessible to creditors. Once a solo 401k engages in a prohibited transaction, it is generally considered fully taxable from January 1 of the year of the first prohibited transaction.