If your business sponsors a “solo 401(k)” plan, it may be in the crosshairs of the Internal Revenue Service. The Service’s TE/GE (Tax Exempt and Government Entities) division has identified one-participant 401(k) plans as among its current audit initiatives. In its web posting announcing the initiative, TE/GE states: “[t]he focus of this strategy is to review one-participant 401(k) plans to determine if there are operational or qualification failures, income and excise tax adjustments, or plan document violations.”
By way of background, a solo 401(k) plan is a traditional 401(k) plan covering a 100% business owner with no employees, or that person and their spouse. As this handy IRS info page describes, solo 401(k) plans are subject to the same rules and requirements as any other 401(k) plan, however because no common law employees participate, you do not have to worry about minimum coverage and nondiscrimination testing, top heavy rules, or most of the requirements of Title I of ERISA. Solo 401(k) plans can be a great fit for some businesses, but those that stray outside the strict eligibility requirements for these plans have potentially high exposure to correction costs and sanctions in an audit setting.
Below we list some common solo 401(k) compliance pitfalls. If you are a solo 401(k) sponsor, check your plan design and operations to determine if these might be issues for you. Take steps now to correct any compliance failures through use of EPCRS and other voluntary compliance programs, where applicable, so that, if an IRS audit does occur, it is resolved without incident.
- Employees Eligible for Benefits: One of the most frequent errors with solo 401(k) plans is that they lose their solo status when the business sponsoring them acquires employees, and the employees work the necessary number of hours required for eligibility under the plan. (These generally cannot exceed 1,000 hours in a year of service.) This will trigger application of minimum coverage, nondiscrimination, and top heavy rules, as well as ERISA reporting and disclosure requirements (Summary Plan Description, Form 5500-SF, etc.). Failure to meet requirements under any of these sets of rules will be fodder for the IRS in an audit setting. Business owners who need employees should probably avoid solo 401(k) plans unless they can be certain that the employees’ work hours never reach or exceed 1,000 hours in a year.
- Controlled Group/Affiliated Service Group: This issue is related to the first in that, if the business that sponsors the solo 401(k) plan is under common control with a business that has common law employees, the answer to the question “who is the employer” — and who has employees — will be both businesses under common control, not just the business that sponsors the solo 401(k). Generally, solo 401(k) status will be lost as a result. The same potential coverage, testing, and top-heavy issues listed above can apply. Potentially, employees of the other business could be eligible for benefits under the (formerly) solo plan.
- Form 5500 Filing Duties: Solo 401(k) plans are exempt from filing Form 5500-EZ so long as plan assets remain under $250,000. If plan assets exceed this threshold and a Form 5500-EZ is not filed, significant penalties could be assessed by IRS and by Department of Labor. Participation in the Department of Labor Penalty Relief Program for Form 5500-EZ Late Filers should be considered in such instances.
- Exceeding Contribution and Deduction Limits: The contribution and deduction limits that apply to group 401(k) plans apply to a solo 401(k) plan. Employee salary deferrals cannot exceed the applicable dollar limit under Internal Revenue Code (“Code”) § 402(g) ($19,500 in 2021, plus $6,500 for those 50 and older). The 415(c) limit equal to the lesser of 100% of compensation or $58,000 (in 2021) applies (and is increased by the age 50 catch-up limit, for a total of $64,500). The maximum Code § 404(a) deduction of 25% of eligible plan compensation also applies, but in general the 415(c) limit will be reached first. Failure to observe any of these dollar limits could be picked up on audit.
- Plan Document Errors: Businesses that sponsor a solo 401(k) need to update their plan document periodically to comply with the law just like any plan sponsor, meeting the adoption deadlines for preapproved plan remedial amendment cycles (the next one falls on July 31, 2022). Voluntary plan amendments also have to be properly documented and timely adopted. Failure to meet these document requirements may be able to be corrected under EPCRS.
The above information is provided for general informational purposes only and does not create an attorney-client relationship between the author and the reader. Readers should not apply the information to any specific factual situation other than on the advice of an attorney engaged specifically for that or a related purpose. © 2021 Christine P. Roberts, all rights reserved.
Photo Credit: Markus Spiske, Unsplash