How Controlled Group Rules Affect Eligibility for Self-Directed Solo 401(k) Plans

As explained in previous posts and in this video, people who earn self-employment income as independent contractors and business owners with no W-2 employees working more than 1,000 hours per year are eligible to establish a Self-Directed Solo 401(k) plan. (Spouses, business partners, and 1099 independent contractors working with the business, and business owners paying themselves a W-2 salary are all OK and do not negate eligibility.)

There is one more stipulation that determines eligibility, however, which should be properly vetted prior to adopting a Self-Directed Solo 401(k) plan. If the person is part of a “controlled group” their eligibility could be in jeopardy.

Since Self-Directed Solo 401(k)s allow for higher contribution amounts and are much more cost effective for the business owner than regular 401(k)s, which must be offered to all eligible W-2 employees, many business owners who have eligible W-2 employees attempt to set up a solo 401(k) plan for themselves through a separate business or entity.

Here is an example: An entrepreneur owns Business A, which has several full-time W-2 employees. Instead of setting up a regular 401(k) plan for Business A, he creates Business B just for himself and sets up a Self-Directed Solo 401(k) plan for Business B (without including employees from Business A). Unfortunately for the entrepreneur, the IRS caught on to this strategy and developed the controlled group rules to protect the W-2 employees from not being included.

The Controlled Group Rules

The Revenue Act of 1964 established the controlled group rules. Generally speaking, a controlled group exists between businesses if one of these relationships applies:

• Parent-subsidiary

• Brother-sister

• Family attribution

• A mix of the above

• Affiliated services

Parent-Subsidiary Relationship

This controlled group occurs when one or more owned corporations are linked via stock ownership with a common parent corporation owning at least 80% of another corporation. For example, Jane Doe owns 100% of Corporation X, which owns 90% of Corporation Y. The parent-subsidiary controlled group rules would apply requiring a regular 401(k) plan established by either Corporation X or Y to be made available to all eligible employees of both companies.

Brother-Sister Relationship

This controlled group relationship exists if a group of at least two corporations has the following attributes: