Updated: Apr 23, 2021
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:
• Family attribution
• A mix of the above
• Affiliated services
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.
This controlled group relationship exists if a group of at least two corporations has the following attributes:
• Five or fewer common owners own at least an 80% controlling interest of each business and,
• Five or fewer common owners have “effective control,” which is over half the stock of each corporation.
To pass the first test, the common owners need to own over 80% of all the businesses in the group. To pass the second test, those same owners must own over half of each corporation. Only “identical ownership” is to be considered.
Family attribution is the notion of treating a person as owning an interest in a business when it is actually owned by a close family member. For example, the ownership of a business by a parent of greater than 50% can be attributed to the children and vice versa.
However, the attribution for spouses is somewhat different. There will be no attribution between spouses if there is no direct ownership or participation by a spouse in the company.
Also, there is no spousal attribution if more than 50% of the business’s gross income is in passive investments. The family attribution rules are there to prevent the use of families circumventing the controlled group rules.
The affiliated services rules are effectively catch-all rules the IRS developed to backstop the parent-subsidiary and brother-sister controlled group rules. Without getting into too much legal detail, the affiliated service rules are aimed at preventing a business owner from establishing a service-based business that is affiliated with the principal business. The IRS has determined that any organization engaged in one or more of the following fields is deemed a service organization: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, and insurance. Basically, the IRS assumes that if a business is providing services to the principal business and there is some type of partner or service relationship, the affiliated service rules could kick in to consider the two entities as part of a controlled group.
Complex and Far Reaching Rules
The controlled group rules were designed to protect employees and make sure business owners are not allowed to set up their own retirement plan through a side business without offering the plan to their eligible employees. This post is an overview of these complex and far reaching rules. If you are a business owner with two or more businesses you either control or are affiliated with and you are considering establishing a Self-Directed Solo 401(k) plan, it is advisable to work with a professional Self-Directed Solo 401(k) firm to help you stay in compliance with these rules prior to adopting the plan. Contact us to discuss your situation to see if these controlled group rules affect your Self-Directed Solo 401(k) plan eligibility.