Qualifying for a Solo 401(k) is not as simple as setting it up because you like it better than an IRA. Nor is it as easy as saying that you qualify for a 401(k) because you are going to invest into real estate using your newly established Solo 401(k). And, yes, I have had clients who initially thought they could establish the 401(k) plan for those reasons alone. Add to that the occasional belief that if they had rollover funds in an old 401(k) (previous employer’s plan), that it can just automatically be rolled over into a new 401(k) plan…whether they actually are self-employed or not.
Now that we have addressed the 800 lb. gorilla in the room, keep in mind that regardless of the benefits of a 401(k), you must qualify for the plan. So, how is one qualified for the Solo 401(k) plan or how can they qualify for such a plan? In this case, it is probably good to summarize exactly what the IRS says about qualifying for a Solo 401(k).
“Generally, you are self-employed if any of the following apply to you.
- You carry on a trade or business as a sole proprietor or an independent contractor.
- You are a member of a partnership that carries on a trade or business. You are otherwise in business for yourself (including a part-time business)”
You might say that this is not terribly difficult to understand, and I would agree with you. However, sometimes people confuse this definition because they selfishly want to. But, in establishing your Solo 401(k), keep in mind that the plan has to be attached to your business. Let’s review the IRS’ definitions of the various classifications of how you may establish your self-employed business:
Sole Proprietor – A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.
Independent Contractor – “…The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to Self-Employment Tax.”
Also, keep in mind that one is not an independent contractor if they are “controlled” by the employer, even if the individual is given freedom of action. If an employer-employee relationship exists (regardless of what the relationship is called), you are not an independent contractor.
Partnership – “…A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.”
Trade or Business – “A trade or business 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.”
Part-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 an engineer at the local plant. You fix televisions and radios 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 repair shop.”
John’s Helpful Hint: Here is an example of what we may be discussing.
Ben is a real estate investor and does not meet the IRS’ requirements as a designated real estate professional (e.g., working 750 hours per year as a real estate professional). Combine this with the fact that the IRS does not consider real estate investing to be active self-employment activity, rather a passive activity. Ben, who is establishing a Solo 401(k) plan, considers himself to be self-employed as his intent is for the Solo 401(k) to invest into real estate and he believes this qualifies as self-employment. He is wrong on at least two issues: 1) the Solo 401(k) account is an investment account, not an established business…as such, it is not a business, 2) the very nature of making investments into real estate is, in an of itself, is not self-employment is not active, rather defined as passive by the IRS.
This is simply an example of how people can innocently believe they qualify for a 401(k) plan when, in fact, they do not. It is not only imperative that the Solo 401(k) plan be tied back to a legitimate business, and meet all State and Federal guidelines for the business and the businesses’ entity structure (e.g., C-Corp, S-Corp, Sole Proprietorship).
As always, the information provided is intended to be educational and informative in nature and is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice. You must always consult with your respective professional in all such matters.