Solo 401(k) Plans to be Audited

Take-Away: The IRS recently announced that it will be targeting solo 401(k) plans for audit, suggesting that the IRS believes that such qualified plans are being abused.

Background: A solo 401(k) plan, or also called a one-participant plan, are growing in popularity as an alternative to a SEP or SIMPLE IRA for self-employed individuals. While they are generally operated by sole proprietors, they can also be sponsored by LLCs, corporations, or partnerships. The sponsor must be engaged in an active trade or business. A sole 401(k) plan is used because the owner can defer larger amounts of retirement savings than if contributions were made to a SEP or SIMPLE IRA.  While the costs to set up and administer a solo 401(k) plan are higher than with a SEP or SIMPLE IRA, the additional amount that can be deducted for contributions to the sole 401(k) plan are viewed as a favorable trade-off to the higher administration costs.

Pros and Cons: Solo 401(k) plans are exempt from a number of the burdensome administrative requirements that regular 401(k) plans face, such as nondiscrimination testing. Nor are these plans subject to ERISA, which is both good and bad: it is good in that the owner-sponsor is relieved from ERISA’s fiduciary requirements and administrative responsibilities, but bad from the exposure of the solo 401(k) plan assets to creditor claims or in bankruptcy, where only state exemption statutes provide any form of creditor protection.

Issues that May be Audited: On its annual list of priority areas in the employer retirement plan realm that the IRA plans to audit, solo 401(k) plans now appear. While such plans have fewer requirements to be met than a regular qualified plan, the appearance on the IRS priority list suggests that the IRS feels that there are many abuses going on by the solo 401(k) plan sponsors.

• Employees: A solo 401(k) plan cannot be used by any business with employees, other than the owner and the owner’s spouse. If the plan sponsor hires employees, or whose existing workers are classified as employees, then the plan must be shut down, or converted to conventional 401(k) plan. If the solo plan sponsor owns another business which must be aggregated under the IRS’ controlled group rules, the ‘no employee’ rule applies to both businesses. When the SECURE Act changed the definition of employee as it relates to 401(k) plans, where employers could exclude those who did not work at least 1,000 hours in any 12-month period, or workers under the age of 21, that creates potentially a bigger problem for the sponsor of a solo 401(k) plan going forward. Part-time workers may now be classified as employees, e.g. anyone who worked at least 500 hours in three consecutive years and is 21 years or older by the end of the three year period is now classified as an employee. Fortunately this new definition starts only in 2021, so the impact of that new definition will not really apply until 2024.

Example: Mom and Pop have a small business which sponsors a solo 401(k) plan. Mom and Pop have employed their 18-year old son Junior as a part-time worker, starting in 2019. Junior works the following hours for Mom and Pop when he is not attending college: 2019-750 hours; 2020- 850 hours; 2021-800 hours; 2022-925 hours; and 2023-550 hours. Prior to the SECURE
Act change, Junior would not be considered an employee, since he had not worked at least 1,000 in any calendar year. Now, because of the new rules, Junior would be treated as an employee as of January 1, 2024, because he had three consecutive years when he worked at least 500 hours for Mom and Pop. Accordingly,  Mom and Pop’s business could not continue to sponsor the solo 401(k) plan after 2023.

Example: Steve works from home as an accountant. Steve sponsors a solo 401(k) plan. Steve also operates a separate investment advisory business which has two other employees besides himself. Because Steve owns the controlling interest in both businesses, the investment advisory businesses employees are considered Steve’s employees for his accounting business. Steve will not be able to continue with his solo 401(k) plan.

• Annual Contribution Limits: The sponsor of a solo 401(k) plan is both the employer and the employee. This permits the owner to make both elective deferrals and deductible employer contributions. However, there are three different solo 401(k) contribution limits. (i) the annual elective deferral cannot exceed $19,500 (plus an additional $6,500 ‘catch up’ contribution if the owner is over age 50); (ii) the annual employer contribution is limited to 25% of compensation for a corporation, and for unincorporated business, the 25% limitation equates to 20% of adjusted net earnings, i.e. the net earnings from self-employment decreased by the deduction for the self-employment tax); and (iii) the overall annual limit on combined elective deferrals and employer contributions is $58,000 for 2021 (or $64,500 if the over 50-years ‘catch-up’ contribution is made.)

Example: Shelly, age 44,  works for her employer and participates in its 401(k) plan. Shelly also operates a side-business on the weekends and she sponsors her own solo 401(k) plan. For 2021, the maximum amount of combined elective deferrals is $19,500.

• Miscellaneous Audit Inquiries: Other topics on which the IRS might audit solo 401(k) plans might include: (i) has Form 5500-EZ been filed, if plan assets have exceeded $250,000? ; (ii) is the plan operating in accordance with the qualified plan document? And (iii) is the qualified plan document updated to account for the law changes which seem to occur annually?

Conclusion: Businesses that sponsor solo 401(k) plans have now been given a warning from the IRS that they are targeted for audits in the next few years. Sponsors of such plans need to take steps to ensure that their plans comply with the few requirements that they must satisfy.