When it comes to being a Solo 401k or self-directed IRA entrepreneur in the small business world, we understand that you probably have a lot going on. This often involves having an active interest in two or more operating businesses. Those two separate businesses can closely relate to your Solo 401k or self-directed IRA. However, the two small businesses must comply with very different Internal Revenue Service (IRS) rules and regulations. Here, we clarify the distinct lines between the two business types and how each can compliantly help the other.
We will use the Solo 401k for most examples and explanations to keep things as simple as possible. Where there is a major difference between a Solo 401k and a self-directed IRA, we will try to clarify the difference. You want to understand the most significant difference between funding your Solo 401k and financing your “for-profit” small business.
The Small Business Funding Your Solo 401k
This IS your self-employed business. This is the small business that you are operating to earn a living today. It could be your full-time business, or it could be a part-time business, or it could be mostly a hobby that you are making a profit from. A key distinguishing fact about this business is that the income is potentially taxable. This is the small business that you use to fund your Solo 401k so that you minimize the taxes owed by this business.
You can structure this small business as a sole proprietor, partnership, LLC, S-Corp, or C-Corp. Whichever business structure you select, it does have to file annual income tax forms based on that business structure. You minimize the taxes this small business owes and contribute as much of the earnings as possible to your Solo 401k. The tax-advantaged earnings that can be contributed to your Solo 401k total $61,000 in 2022 or $67,500 if over age 50. To fully understand your tax-advantaged contributions, you’ll want to learn the differences between a traditional Solo 401k and a Roth Solo 401k. Besides the very high annual contribution limits, you can also fund a Solo 401k by rolling over funds from other retirement accounts.
Self-directed IRA Note: A major difference with a self-directed IRA is that you do not need to operate a self-employed business to get most (but not all) of the benefits that are available to Solo 401k account holders. One of the biggest benefits is being able to invest in alternative assets. You can also roll over funds from other retirement accounts. However, the annual IRA contribution allowed from other income (a day job from another employer) is much smaller — for 2022, the total contributions you can make to a traditional and/or Roth IRA can’t be more than $6,000 ($7,000 if you’re age 50 or older).
So, the basic question we are answering in this article is, “Can I invest My Self Directed IRA or Solo 401k Funds into a Small Business?”
The answer to that question when it applies to the self-employed business that files a tax return and contributes to your Solo 401k is “Yes.” However, the rules are very different from those that apply to a business owned by your Solo 401k.
The Small Business of Prohibited Transactions
Let’s first look at why it is almost impossible to fund your self-employed business using Solo 401k funds directly. People think about rolling over 401k funds (or other retirement funds) from a previous employer into a Solo 401k account and then investing the funds to begin a self-employed business that will ultimately make annual contributions to the Solo 401k. Because of IRS Prohibited Transactions, you CAN NOT do this.
The Prohibited Transaction guidelines can be found in Section 4975 of the Internal Revenue Code. Prohibited Transactions generally have the same rules for Solo 401k and Self-Directed IRA plans.
There are only a few prohibited transactions, which are mostly easy to understand and follow. When it comes to funding your own self-employed business, the prohibited transaction that primarily comes into play is about WHO the Solo 401k CANNOT engage in transactions with. People that cannot engage in transactions with a Solo 401k are called “Disqualified Persons.”
Disqualified people cannot engage in transactions with the Solo 401k because it is quite easy for conflicts of interest to develop. You are a disqualified person as the owner of the Solo 401k. Your self-employed business has a conflict of interest with the Solo 401k.
One of these conflicts of interest is further known as “self-dealing.” This would be a transaction that is structured to benefit the person with a conflict of interest more than it benefits the Solo 401k. The only reason a Solo 401k is granted tax-advantage status is to encourage you to save for your retirement. Your self-employed business exists to provide you with a living today — before you retire. The conflict of interest is that you are trying to fund two different major stages of your life with the same source of money. Not allowing you to fund your self-employed business with your retirement funds is intended to protect your retirement account.
The IRS outlines the consequences of a prohibited transaction in the following way:
“A disqualified person must pay an initial tax on a prohibited transaction of 15% of the amount involved for each year (or part of a year) in the taxable period. If the disqualified person does not correct the transaction within the taxable period, there is an additional tax of 100% of the amount involved.”
Essentially, if you don’t correct the prohibited transaction within a year (taxable period), the IRS will consider it an early distribution. Penalties and taxes will apply up to the extent of fully distributing the entire account.
Follow this link for a simple explanation of all the prohibited transactions.
The Wrong and Right Way to Invest in Your Small Business With Solo 401k Funds
Let’s now look at a risky way of funding the startup or expansion of the self-employed business that you operate to fund your Solo 401k. There is a scheme that some Solo 401k promoters think is IRS-compliant when it comes to financing your self-employed business using Solo 401k funds. That scheme is known as Rollover as Business Start-up (ROBS). At Nabers Group, WE DO NOT believe this is a risk reasonable way of financing a self-employed business. Neither does the IRS. The IRS began issuing warning letters about this in 2008. Since then, the IRS has issued more stringent guidelines on why this closely resembles the “self-dealing” scenario described in the Prohibited Transaction section of this article.
In a nutshell, here is how ROBS works. With ROBS, a C Corporation is formed which adopts a 401(k) Qualified Plan. Your existing retirement funds are tax-free in the new 401(k) Plan. The new 401(k) Plan will then purchase the new corporation’s stock. Finally, the new corporation will use those funds to purchase the self-employed business.
That sounds like self-dealing and is very risky because the IRS is watching it closely. In fact, the IRS created a compliance team just to deal with the issues around ROBS.
Fortunately, there is a low-risk and accepted way to use your Solo 401k funds to finance a self-employed business. The right way is with a Solo 401k participant loan.
You could go to a bank and apply for a small business loan. If you do, you can expect to be hit with a wall of paperwork requirements. Paperwork that they expect you to have but you don’t. If you do manage to qualify for a small business loan, the high-interest rate will probably make you go back to forecast revenues, profits, and future growth. Small business loans are an acceptable way to finance a self-employed business, but a low-interest Solo 401k participant loan is often the better answer.
A participant loan works by setting up a Solo 401k plan and rolling over funds from another retirement account. Perhaps $250,000 from a previous employer’s 401k and/or traditional IRA plan. If you have a spouse, they can also roll over funds to the Solo 401k. Maybe the total comes to $350,000. It’s that simple. You can then take out
a participant loan as a source of financing for your own small business.
Self-directed IRA Note: Participant loans are not permitted from IRAs or IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRA plans. Loans are only possible from qualified plans that satisfy the requirements of 401(a), from annuity plans that satisfy the requirements of 403(a) or 403(b), and from governmental plans. (IRC Section 72(p)(4); Reg. Section 1.72(p)-1, Q&A-2)
The participant loan is an IRS-compliant strategy to get a tax-free loan from your retirement funds. The process is simple and immediate. No banker is underwriting you or your business. You can take a tax-free loan from your retirement account and pay yourself back. The funds from the loan can be used for anything, including small business financing for your business.
With Solo 401k small business financing, you can take up to 50% of your retirement funds on a tax-free loan. The maximum loan amount you can take is $50,000. If your spouse works in your business with you, your spouse can take a loan, too. This means you can take a tax-free loan from your retirement money of up to $100,000. Getting up to $100,000 in financing for your self-employment business is easy.
The loan needs to be paid back to the Solo 401k plan within five years. There is interest on the loan, but the Solo 401k is paid that interest (a much lower interest rate than a bank loan). This means that you pay your own Solo 401k back instead of sending the interest payments to a banker.
And now, you have a Solo 401k that can make alternative investments, including buying all or part of another business.
A Business Owned By Your Solo 401k
Switch gears here. This is NOT your self-employed business. This is an alternative asset owned by your Solo 401k that does not pay taxes on earnings paid to your Solo 401k. It can be almost anything. Many people start an LLC rental house business that is directly owned by the Solo 401k, but it could just as easily be a coffee shop or any other business that you do not directly own. Got that? You do not directly own this business. You are still a disqualified person. You cannot work at this business. There cannot be any prohibited transactions. Not even as small as changing a light bulb at a rental house owned by the Solo 401k.
There are many ways that these can be structured. The overarching term used for a Solo 401k directly investing in a business is “private placement.” There are a few simple rules here, but they go back to the prohibited transactions we already discussed. The business can’t be partially owned or operated by a disqualified person, and there are a few more technical rules that we can help you understand. Still, your Solo 401k can directly invest in thousands and millions of businesses.
Your Solo 401k can partner with other money that may or may not be in a 401k. You can structure your Solo 401k to own an LLC that invests in several different businesses. You might want to go the angel investor route to invest in a startup. You can do that. Or you might want to invest in more mature businesses. Some Solo 401k investors do this through a private equity group. Private equity and venture capital investments are quite similar. Private equity typically invests in mature type and revenue-generating companies needing some revitalization. Whereas venture capital typically invests in very early-stage companies with little to no revenues.
With a Solo 401k, your investment options are almost unlimited. It’s critically important that you understand prohibited transactions and disqualified persons. Still, as long as you stay on the right side of those rules, you can make private equity investments simply by writing a check or wiring funds directly from the Solo 401k bank account. In other words, you can generally make an investment into any private equity investment with which neither you nor another disqualified person has personal ownership or relationship.
Get all the benefits of a Solo 401k by starting a business!
We believe you should control your financial destiny. With money so interwoven through every area of our lives, financial freedom can improve our life experience, health, and happiness. We feel our mission is to help you protect and grow your money, grow your income, and control your destiny.
Set Up Your Self Directed Retirement Plan and Start Investing In Alternatives
The thought of a looming recession has many people concerned about the possibility of unemployment and layoffs that come with it. Starting a business is the best hedge against a recession. But that’s not the only reason to think about a Solo 401k.
Ongoing fluctuations in the stock and bond markets and a breakdown of investor confidence in corporate America are driving the demand for alternative investments with greater choice for retirement accounts. Investors now realize they can invest in real estate and other non-traditional assets using their retirement accounts.
Setting up a Solo 401k retirement plan is easy and allows for tax-deductible contributions much larger than an IRA or employer 401k. Importantly, it puts you in control with access to a world of alternative investment options.
