Solo 401k IRS Audits Are OK
First off, don’t slam your laptop shut in a panic after reading the title of this article. The IRS audits people all of the time and they get through it just fine (including Solo 401k plan owners). However, the IRS has a division known as ‘Tax Exempt and Government Entities’ (TE/GE) that releases a list of priorities for alignment with the IRS Strategic Goals. For 2021, a ‘Tax Exempt’ priority includes examining the compliance of one-participant 401k plans (aka Solo 401k) to determine if there are operational or qualification failures, income and excise tax adjustments, or plan document violations.
In a nutshell, this indicates the IRS may perform more one-participant 401(k) plan audits in 2021 than historically conducted. We will offer tips for audit avoidance and preparation if an audit does happen. But first, here is a summary of what the IRS indicates it will be focusing on.
IRS Compliance Strategies
You do want to take these concerns seriously, but there is no reason to become fearful. There are several resolutions available if you think you may not be in full compliance with one or more of the areas that the IRS might be looking at.
Plan document errors and updates. Most plan documents require periodic updates for a variety of reasons. Therefore, remedies are available if you need plan updates.
Worker classifications. Only you and your spouse can be full-time employees of the business sponsoring a Solo 401k, but you can use contract workers. As a result, the IRS has stated they will be looking for “misclassified employees as independent contractors.”
Failure to make minimum distributions. Distribution of benefits must begin by April 1 following the calendar year an employee turns 70 ½. Most importantly, failure to make these distributions could cause plan disqualification as well as a tax penalty. Note: the CARES Act waived required minimum distributions (RMDs) in the 2020 calendar year. This includes first year RMDs that have a required beginning date in 2020. Therefore, if you turn 72 in 2020, your RMD schedule will reflect as if you turned 72 in 2021.
Correctly calculating the owner-employee earned income. This primarily involves correctly taking a self-employed deduction on Form 1040 and making income adjustments. This can affect allocations to plan participants and contribution limits.
Participant loans. A Solo 401k does allow loans to participants per IRS rules, of course. Therefore, the IRS intends to examine maximum loan balances compared to total assets and compliance to the repayment of loans.
Unrelated business income. The unrelated business income tax (UBIT) provisions ensure that exempt organizations are taxed on income earned from activities that are unrelated to the purpose for which they were granted exempt status.
More Compliance Tips to Be Aware Of
Form 5500. A Solo 401k does not file Form 5500-EZ as long as total plan asset value is less than $250,000. The IRS will be looking for plans that exceed the limit without submitting the form.
There may be other areas of concern that an IRS audit reveals. However, don’t assume the worst if you find a problem or two. The IRS Tax Exempt and Government Entities statement also included this:
“We’ll continue to process voluntary correction applications submitted electronically through Pay.gov under the Employee Plans Compliance Resolution Program (EPCRS) and enter into compliance statements with plan sponsors to resolve failures to comply with the plan qualification requirements, avoiding plan disqualification.”
~IRS Employee Plans: Voluntary Corrections Program
Solo 401k Compliance and Audit Tips
Below are multiple resources that you might want to become familiar with before a potential IRS audit occurs. There are actions you may want to take now and others that could be appropriate before or after an audit. The right steps now can ensure if an IRS audit occurs, it resolves without incident.
Solo 401k account owners are creative people. We can’t foresee every creative strategy that might trigger an IRS audit, but here are common ways to reduce the risk:
Keep good records. A true benefit of a Solo 401k is that you are in complete control. Along with that comes the responsibility to keep accurate records. This includes contributions to your plan, investments, income, loans, distributions, and more. Check out our article “Keeping Good Records” for more details from a CPA.
Keep your plan document up to date. Changes in tax law and your retirement plans happen often. As your non-custodial document provider, Nabers Group plans are IRS-approved. You can depend on us to support keeping your plan current. Here are links to help you.
Nabers Group’s Role
- What does a Document Sponsor do?
- Our Services We work with the IRS and Department Of Labor on a consistent basis to ensure our documents are up-to-date and afford the greatest freedoms to Solo 401k account holders. We also maintain the strictest compliance standards. The annual maintenance fee allows you permission to continue using the documents, as well as gives you access to all plan updates, amendments, and/or restatements.
- The COVID-19 pandemic resulted in multiple recent changes in tax laws. Some of which may require an amendment to your plan if they apply to you.
How to Avoid Mistakes
Intentionally not following the rules. Above all, be careful about investment strategies that have little or no defense with the IRS. We provide some insight with the article The Most Elusive & Dangerous Self-Directed Solo 401k Practice.
Avoid prohibited transactions. There are rules that every Solo 401k account owner should know about. Some examples include Prohibited Assets, Disqualified Persons, and Prohibited Transactions. If you think you’ve committed a prohibited transaction, you should correct it as soon as possible within the taxable period.
IRS Form 5500-EZ reporting requirements. For assets less than $250,000 in correct value, there is no tax return required. Form 5500-EZ is the filing requirement for Solo 401k plans with $250,000 or more in plan assets. It is simply an informational return filed with the IRS.
- How to file Form 5500-Z (some account holders file the form no matter what to start the clock on the statute of limitations for an audit).
- Department of Labor Penalty Relief Program for Form 5500-EZ Late Filers
Hire a qualified attorney for audits & Tax Court. The best attorneys are fully knowledgeable on the topics of real estate investing, small businesses, and self-directed IRA/401k accounts.
How to Prepare and Respond to an IRS Audit
Firstly, this is not all-inclusive plan. The first thing to do is to examine your potential audit. To clarify, determine if your audit includes your personal taxes or your Solo 401k plan and self-employed business. In the event it is your Solo 401k plan, be sure that all of your documents are up to date. Next, if the IRS requests supporting documents, provide the specific documents listed on the IRS examination notice. Lastly, if an interview becomes necessary, prepare and treat it as a trial or a deposition.
Breathe a sigh of relief. You want to take an audit seriously. As the world’s first non-custodial document provider, Nabers Group plans have been IRS approved since 2006. Therefore, we are the longest-standing document provider in the industry.
In conclusion, this information is intended as basic information for self-employed individuals. If you are self-employed and have questions about your taxes, seek help from an accounting professional.