Use of Solo 401k plan assets by disqualified person: Prohibited Transaction

The income or assets of the Solo 401k may not be transferred to, or used by or for the benefit of, a disqualified person (e.g., the trustee, spouse, son, daughter, mother, father).See ERISA 406(a)(1)(D).

This type of transaction is fact-specific, meaning the IRS and DOL will analyze whether under the circumstances a personal benefit is being derived by the disqualified person from the transaction involving Solo 401k plan assets. This is a highly subjective analysis.

Exemptions

Fair market value transactions with service providers. IRC 4975(d)(20), as added by section 611(d) of the PPA 2006, provides for an exemption from the prohibited transactions for a use of Solo 401k plan assets described in IRC 4975(c)(1)(D) if:

(1) the transaction is between a Solo 401k plan and a disqualified person who is not a fiduciary (or affiliate) who has or exercises authority or control over the investment of the Solo 401k plan assets involved in the transaction nor provides investment advice with respect to such assets,

(2) the person is a disqualified person solely by reason of providing service to the Solo 401k plan or solely by reason of a relationship to such service provider described in IRC 4975(e)(2)(F), (G), (H), or (I), and

(3) the plan receives no less than, or pays no more than, adequate consideration for the transaction. This exemption applies for qualifying transactions that occur after August 17, 2006.

Exemptions Continued

Payment of benefits to participant who is a disqualified person. Payment of benefits to a disqualified person, in his capacity as a Solo 401k plan participant or beneficiary, is not a prohibited transaction. IRC 4975(d)(9). Note, however, that because of the way 4975(c) is so broadly written, this statutory exemption was necessary to prevent the payment of benefits from being a prohibited transaction.

Prohibited Solo 401k Transactions Examples

Example 1 of prohibited Solo 401k Transaction:

Loans to firm’s clients. In TAM 9238003, the IRS ruled that loans by a law firm’s profit sharing plan to the firm’s clients were prohibited transactions. The assets were being used for the benefit of the law firm, by allowing clients to receive loans from the plan as an “advance” for personal injury settlements that would later be obtained for the client by the law firm.

Example 2 of prohibited Solo 401k Transaction:

Transfer to employer’s checking account. In TAM 9316001, the IRS ruled that the transfer of plan assets to the employer’s checking account was a prohibited transaction, where the employer used the funds in the checking account for corporate purposes. Although benefits payable from the plan were paid from the checking account, the employer was not acting solely in an agency capacity with respect to the transfers. Plan assets were transferred without regard to whether they were immediately payable as benefits, and the employer had discretion to use the checking account for any purpose. This is why it is vital to open the Solo 401k checking account under the name of the Solo 401k trust using its EIN, instead of under the name of your company and your social security number.

Example 3 of prohibited Solo 401k Transaction:

Loan transaction to several companies enhanced value of their stock, providing indirect benefit to a party-in-interest who owned minority interests in the companies. Rollins v. Commissioner, 34 EBC 2523 (Tax Ct. November 15, 2004) contains great information of the prohibited transaction described in IRC 4975(c)(1)(D). Rollins was the 100% shareholder of a professional corporation that maintained a 401(k) plan. The plan extended several loans to three different companies. Rollins had a minority interest in each company in the following amounts: (1) an 8.93% interest in J&J Charlotte, with almost 30 other owners, the next highest ownership percentage being 6.25%, (2) a 26.8% interest in Eagle Bluff, with more than 80 other partners, the next highest ownership percentage being 8.8197%, and (3) a 33.165% interest in Jocks and Jills, with more than 70 other partners, the next highest ownership percentage being 4.8809%. In each case, the loan was a 12% demand note collateralized with assets of the borrower. Rollins’ ownership was not sufficient to make any of the companies a party-in-interest with respect to the plan. Thus, the loans were not direct prohibited transaction under IRC 4975(d)(1)(B), in that the recipients of the loans were not parties-in-interest. However, the court agreed with the IRS that the loans constituted the prohibited use of plan assets for the benefit of a disqualified person (i.e., Rollins), within the meaning of IRC 4975(c)(1)(D). The court noted that a “use of plan assets” need not involve an actual transfer of plan assets to the disqualified person in order to fall within the purview of IRC 4975(c)(1)(D). The benefit obtained by the disqualified person can be a direct one or an indirect one. Evidence that Rollins may have benefited from the transactions is that these companies were able to secure financing without having to deal with independent lenders, which enhanced the value of Rollins’ equity interests in the companies. The use of a plan assets to enhance the price of a security can also constitute a benefit within the meaning of IRC 4975(c)(1)(D). See H.Conf. Rept. 93-1280, at 303, 1974-3 C.B. at 469. The burden of proof is on Rollins to demonstrate that, by a preponderance of the evidence, the loans did not constitute uses of the plan’s income or assets for his own benefit. Rollins failed to carry that burden.

Example 4 of prohibited Solo 401k Transaction: (note that although IRA is used, this still applies to a Solo 401k)

Indirect lease between IRA and company substantially owned by IRA owner. In Advisory Opinion 2006-01A, the DOL ruled that a lease between a company owned 68% by an IRA owner (the disqualified person) and an LLC in which the IRA was an investor constituted an indirect lease between the IRA and the disqualified person. It also constituted the use of IRA assets for the benefit of the disqualified person, in violation of IRC 4975(c)(1)(D).

About Mark Nolan

Each day I speak with energetic entrepreneurs looking to take the plunge into a new venture and small business owners eager to take control of their retirement savings. I am passionate about helping others find their financial independence. Having worked for over 20 years with some of the top retirement account custodian and insurance companies I have a deep and extensive knowledge of the complexities of self-directed 401ks and IRAs as well as retirement plan regulations. Learn more about Mark Nolan and My Solo 401k Financial >>

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