Tens of thousands of small business owners have used their retirement funds to finance their business without paying taxes or penalties.   The IRS refers to this strategy as a rollover as business startup (ROBS) transaction.  The transaction entails using 401k funds to purchase stock issued by the company that operates the business.  Since the funds are not withdrawn from the 401k, the transaction does not trigger taxes and penalties.  

While the IRS has consistently acknowledged that a ROBS transaction is legitimate it has also highlighted compliance violations that it has found with respect to ROBS transactions.  One compliance concern is whether the ROBS transaction violates the Exclusive Benefit Rule which requires that all plan assets are used for the exclusive benefit of employees and their beneficiaries.  It is possible that a violation of this rule could be found if the business owner receives salary or other compensation for the services he or she performs for the business that is unreasonably high.  As such, it is prudent for the business owner to understand the factors that may be employed in evaluating the reasonableness of such compensation.

Evaluating the reasonableness of the business owner’s compensation is not a “black and white” exercise (e.g., the IRS does not maintain a schedule of reasonable salaries).  Instead, the evaluation is based on the specific facts and circumstances in consideration of several factors.   In a 2013 case the Tax Court considered the following factors in evaluating the reasonableness of compensation paid to the sole shareholder of a C-corporation in his role as president:   
1. Employee’s Role in the Company - Relevant considerations include:

• The position held by the employee;
  
  
• Hours worked;
  
  
• Duties performed; and
  
  
• General importance of the employee to the success of the company.
  
  

2. Comparison With Similar Companies’ Salaries

3. Character and Condition of the Company - Relevant considerations include the company’s:

• Size;
  
  
• Complexity;
  
  
• Net income; and
  
  
• General economic condition.
  
  
  
  

4. Potential Conflicts of Interest – The Court is concerned with whether a relationship exists between the employee and the company that may permit the disguise of nondeductible corporate distributions as salary expenditures.

5. Internal Consistency – This factor considers whether there is an internal inconsistency in a company’s treatment of payments to employees that may indicate that the payments go beyond reasonable compensation.

6. The Independent Investor Test: This factor considers whether an independent investor would approve of owner’s compensation package that depleted the business’s assets without appropriately paying the investor.

Takeaways:

• A business owner who finances his business via a ROBS transaction should not receive salary or other employee compensation that is unreasonably high.
  
  
• Evaluating the reasonableness of a salary is not a “black & white” exercise but rather requires considering the relevant facts and circumstances in light of several factors.
  
  
• For any entrepreneur looking to finance his or her business with 401k, IRA or other retirement funds, it is imperative to work with professionals that specialize in rollover as business startup (ROBS) transactions.
  
  

Additional resources:

• ROBS FAQS

This post provides an in-depth review of contributing to a Solo 401k retirement plan including covering the following topics: contribution types, contribution limits, contribution deadlines, multiple plans, Roth contributions, and an online calculator for determining how much you can contribute (Solo 401k Contribution Calculator).

Solo 401k Contribution Types:

In the words of the IRS, a self-employed individual wears two “hats” in a Solo 401k plan: employee and employer.  As such, the self-employed individual may make both “employee” and “employer” contributions to a Solo 401k.  The practical result is that the individual may contribute more to his or her retirement plan than may be contributed under other types of retirement plans for self-employed individuals such as SEP and SIMPLE IRA accounts.  In fact, the ability to make both employer and employee contributions to a Solo 401k is one of the primary reasons that Solo 401k plans have dramatically increased in popularity relative to SEP and SIMPLE IRA accounts.

Solo 401k Contribution Limits:

• Total Contribution Limit:  For 2014, the total contribution limit for Solo 401k accounts (including both employee and employer contributions) is $52,000 or $57,500 for those age 50 or older.  
  

•  Employee Contribution Limit:  In terms of employee contributions for 2014, a self-employed individual may contribute up to $17,500 of “earned income” (or $23,000 if age 50 or older).  
  

        o  For purposes of the employee contribution limit, “earned income” is defined as net earnings from self-                               employment after deducting both one-half of your self-employment tax and contributions for yourself.

       o  Self-employed persons age 50 or older may make an additional contribution of $5,500 of “earned income” for a                total employee contribution limit of $23,000.  This additional contribution is referred to as a “catch-up” contribution           and must be specifically permitted by the retirement plan.  Catch-up contributions provide an additional opportunity             to save for those who are nearing retirement age.

 

• Employer Contribution Limit: The employer contribution limit is (i) 25% of your W-2 income if your business is organized as a corporation; and (ii) 20% of net income if your business is a sole proprietorship or partnership.   
  

• Example:  Mary, age 51, earned $50,000 in W-2 wages from her S Corporation in 2014. She deferred $17,500 in regular elective deferrals plus $5,500 in catch-up contributions to the 401(k) plan.  Her business contributed 25% of her compensation to the plan, $12,500. Total contributions to the plan for 2014 were $35,500. This is the maximum that can be contributed to the plan for Mary for 2014.
  

Rollover  Contributions and Direct Transfer: With the exception of amounts in a Roth IRA, you may "roll over" or transfer to your Solo 401(k) amounts you have in virtually any other retirement plan (including funds in a former employer 401(k), a governmental 457(b) plan, a 403(b) plan, etc.).   There are no limits on the amount that you can rollover or transfer from another retirement account.

Solo 401k Contribution Deadlines: Per IRS Publication 560, contributions may be made for a tax year up to the due date of your return (plus extensions) for that year.


       Employer Type*                           Tax Return                           Filing Deadline                        Extended Deadline

      Corporation                                    Form 1120                            March 15                                   September 15

      LLC Taxed as Corp.                      Form 1120                            March 15                                   September 15

      Partnership                                    Form 1065                            April 15                                     October 15

      LLC Taxed as Part.                       Form 1065                            April 15                                     October 15

      Sole Proprietorship                       Form 1040                            April 15                                     October 15

     *Calendar year tax filer


Contributions to Multiple Retirement Plans:

If you are participating in another retirement plan in addition to your Solo 401k, you may be able to make contributions in excess of $52,000 for 2014.  This is because employer contributions are not aggregated across all plans in which you participate (in contrast, employee contributions are aggregated across all plans).  For example, consider a self-employed individual who also has W-2 position where the person is participating in the employer-sponsored 401k plan (e.g., an IT professional for a Fortune 500 who also has her own web-hosting company).  For 2014, this person may contribute $52,000 ($57,500 if age 50 or older) to her Solo 401k and another $52,000 may be contributed as an employer profit sharing contribution to the employer-sponsored 401k plan. As a result, a total of $104,000 may be contributed in 2014 to both plans combined.

Solo 401k Roth Contributions:

A self-employed individual may make post-tax (Roth) contributions to his or her Solo 401k.  As these amounts must be segregated from those amounts contributed to the Solo 401k on a pre-tax basis, they must be deposited into a Roth sub-account (or designated account).  When a self-employed individual makes Roth contributions, such amounts are contributed as elective deferrals and as such are subject to the limitations that apply to employee contributions: for 2014, $17,500 of “earned income” or $23,000 if age 50 or older provided that the no employee contributions are made on a pre-tax basis since both pre-tax and Roth employee contributions count towards the limit.

 
Solo 401k Contribution Calculator

To calculate how much you can contribute to your Solo 401k plan, use this online Solo 401k contribution calculator.

Sources: IRS.gov & Publication 560

This post encapsulates the history and qualification requirements, as well as the key benefits and features that have given rise to the tremendous interest in Solo 401k plans today.

Solo 401k: Also Known As Solo 401k plans are sometimes referred to as a Solo K, Individual 401k, One-participant K, One-participant 401k, or Uni-K.[1]

Solo 401k: Not a New Type of Retirement Plan

The Solo 401k is not a new type of retirement plan.  It is simply a 401k – with the same legal authority as 401k plans offered by Fortune 500 companies such as Google, Southwest, and Walmart.  Rather than a 401k plan covering thousands of participants a Solo 401k is a one-participant plan (e.g., the self-employed individual).

The legal basis for today’s 401k plans began with the Employee Retirement Income Security Act of 1974 (ERISA) which Congress enacted on Labor Day 1974.[2]  ERISA allowed defined contribution plans to delegate investment responsibility to participants (i.e., employees who participate in the plan)[3], which is the basis for today’s participant-directed 401k plans.

While participant-directed retirement plans have been around since 1974, it wasn’t until 2002 that Solo 401k plans started increasing in popularity following the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).  EGTRRA made a simple yet very impactful change to the contribution limits applicable to Solo 401k plans.  Prior to the enactment of EGTRRA, it made more sense for self-employed individuals to save for retirement through a SEP or SIMPLE IRA because the annual contributions limits were the same as a Solo 401k, but the SEP and SIMPLE IRA were easier to administer.  With the enactment of EGTRRA, elective deferrals are not taken into account for purposes of deduction limits. [4] In other words, the employee contributions to a 401k plan do not count toward the limit.  With the ability to contribute employee deferrals in addition to employer contributions, a self-employed person can contribute more money to a Solo 401k than to a SEP-IRA – for 2013 the  maximum annual-contribution limit including both employer and employee contributions  is $51,000 (or $56,500  if you are age 50 or older).   This ability along with other important benefits described below led to a surge in interest in Solo 401k plans.

Solo 401k Qualifications: Who can open a Solo 401k

·        Self-Employment: Only a self-employed individual is eligible to set up a Solo 401k (e.g., a person who earns income from a trade or business where his or her personal services are a material income-producing factor).[5]  An individual whose only source of employment is working as a W-2 employee for a Fortune 500 corporation is not eligible to open a Solo 401k.  Neither is an individual whose only source of income is as a silent partner in a partnership. 

·        All Business-Entity Types: A Solo 401k can be adopted by any self-employed business, including a sole proprietorship, limited liability company, partnership, C-Corporation, S-Corporation etc.

·        No employees: Other than the spouse(s) of the business owner(s), the business must not employ any other full-time employees (i.e., an employee who works 1,000 hours or more per year).[6]

 

Solo 401k Benefits & Features: Flexibility and Control

 

• Checkbook Control Solo 401k:  A checkbook feature can be added to a Solo 401k - hence why it’s often called Checkbook Control Solo 401k.  If you plan to invest in alternative investments such as real estate, precious metals, trust deeds, tax liens, etc., a checkbook feature is more cost effective and faster than going through a self-directed Solo 401k custodian (e.g, Entrust, Equity Trust, Pensco Trust, etc.) that will require the submission of investment instructions and charge transaction fees.  Instead, you simply write a check from the Solo 401k checking (or brokerage) account, and you safekeep the paperwork in connection with the alternative investment purchases. Note: For those looking to invest in both traditional investments (e.g., stocks, mutual funds, etc.) in addition to alternative investments (e.g., real estate, precious metals), you can open a Solo 401k with checkbook control at certain brokerage firms (e.g., see Fidelity Solo 401k with Checkbook Control).
• Alternative Investment Options (e.g., Real Estate, etc.): A Solo 401k is often referred to as self-directed 401k because the rules allow for investing in alternative investments such as precious metals (Solo 401k Gold), real estate, trust deeds, private company shares, currency, etc.  For a list of more investment types visit Solo 401k Investments.
• Solo 401k Loan (borrow from Solo 401k):  EGTRRA allows owner-only business owners to borrow from his or her Solo 401k. The Solo 401k loan feature applies to each business owner separately, thus allowing each to borrow the maximum limit: 50% of balance not to exceed $50,000.  To learn more about the specific Solo 401k Loan requirements visit Solo 401k Loan.
• Make Roth Contributions:  A Solo 401k plan may permit business owners to designate some or all of their Solo 401k plan elective deferrals as after-tax Roth contributions.  Please note that this is true even in the case where the owner is otherwise not eligible to contribute to a Roth IRA due to the Roth's annual income limitation.  To learn more please visit Solo 401k Roth Option.
• Simplified Administration Requirements: While Solo 401k falls under same legal authority as the traditional 401k plans offered by Google, Southwest and other companies, the administration requirements applicable to a Solo 401k are much easier to manage.  For example, a Solo 401k is exempt from nondiscrimination testing which applies to 401k plans that cover multiple participants. Moreover, any required annual reporting requirement can be satisfied by filing the simpler Form 5500-EZ (note: this form is not required if the value of the plan assets does not exceed $250,000).  Finally, unlike an IRA a Solo 401k does not require the use of a special custodian (and the related expense can be avoided).  Instead, Solo 401k plans can be structured as trustee-directed plans where the business owner may serve as trustee of his or her Solo 401k.
• No Minimum Contribution Amount: Before the passage of EGTRRA companies that participated in a retirement plan were often required to make a certain minimum annual contribution - especially for money purchase and defined benefit plans. This is not the case for Solo 401k plans, however as there is no minimum annual Solo 401k contributions. This is especially beneficial if the business does not have a very profitable year.
• Opportunity to Consolidate Retirement Accounts:  With the exception of Roth IRAs, virtually all retirement accounts can be transferred/rolled over to Solo 401k.  As a result, a Solo 401k plan can serve as a good vehicle to consolidate all your retirement accounts.  Moreover, consolidating other retirement plans to a Solo 401k plan may allow you to greatly reduce fees, manage funds more easily and can gain tax free access to the rolled over funds through a Solo 401k loan.  Visit Consolidating Retirement Accounts to view complete list of retirement accounts that can be transferred to a Solo 401k.

Solo 401k Prohibited Transactions:

While a self-directed Solo 401k allows more investment flexibility, with more freedom comes more responsibility.  As such, make sure you are well versed in the prohibited transaction rules. For instance, make sure you understand what “self-dealing” means (e.g., your Solo 401k cannot participate in a transaction that benefits you, certain family members or your business). For a list of prohibited transaction examples visit: Solo 401k Prohibited Transactions.



CITATIONS:

1. http://www.irs.gov/Retirement-Plans/One-Participant-401(k)-Plans
2. http://www.legisworks.org/GPO/STATUTE-88-Pg829.pdf
3. See ERISA § 404(c)
4. See ERISA § 404(c)
5. See also http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Business-Activities
6. See http://www.law.cornell.edu/uscode/text/26/410
7. See IRC Sec. 4975(d) 

When many entrepreneurs think of tapping their retirement accounts to finance a franchise or other small business, they think of taking a 401k loan or IRA loan.   While it is certainly acceptable to borrow from 401k accounts or borrow from IRA accounts (provided the owner of the IRA is not a disqualified party such as yourself, father, mother, son, daughter, to name a few), there is another 401k small business funding strategy that may be preferable to obtaining a small business loan from your retirement accounts.  This strategy is sometimes called rollover as business startup or retirement owned business (robs).

While both strategies entail using retirement funds to finance a business, a ROBS transaction presents the following benefits over borrowing from your 401k.

·        Unlike a loan from your 401k, there are no limits to the amount of retirement funds that you can invest in your business or franchise.  While retirement fund loans are limited to 50% of the account balance not to exceed $50,000, there is no such limit in the case of a ROBS business financing strategy.

·        Since you will not be taking a loan from your retirement account there is no required loan payments to your retirement accounts.  For a new business, the ability to minimize debt may be the difference between success and failure.

Find out more at the 401k small business financing page at http://www.mysolo401k.net/

We often are asked whether it's possible to use 401k or other retirement funds to start a business.  The great news is that it is possible!  Follow the link below to you learn more about the process...
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Investor has option to invest Solo 401k in alternative investments such as real estate, private placements, notes, trust deeds, tax liens, etc., in addition to equities (stocks and mutual funds). Whereas a 401k for small business financing is used for what the name implies: to finance one's business or franchise, for example.

Moreover, when you open solo 401k, you are restricted by IRS regulations from investing 100% of the plan's funds in your business, which is not the case with 401k small business financing. Further,  solo 401k is for maximum of two participants--both spouses or two business partners, whereas 401k small business financing allows for unlimited number of participants.