Hi experts.
I recently found out how contributions work for a solo 401k and that rental income is passive. So basically I'll never be able to contribute my solo 401k in this entity. Not the end of the world, but certainly not something I want to find out after setting up the fund. (p.s. Thanks @Brian Eastman for the great breakdown on that).
I was just told that I may not even be allowed to have the solo 401k because the entity it is attached to makes more than 25% of its income from investment. It actually makes 100% from passive because that is what I made the entity for!
I get the feeling I was steered wrong in setting up this plan, but I don't want to jump to any conclusions and I've been unable to find anything from the IRS or elsewhere regarding the requirements of the entity that the 401k attaches to. Is this 25% income threshold real?
@Bryan O. @Dmitriy Fomichenko not sure why I didn't reply to Bryan's questions the first time around - sorry about that.
First, while the IRS pubs are great resources to further one's understanding, it's important to note that they cannot be relied upon as authority. So when we are researching a topic, we want to get at the source code.
Sec. 1402(a) defines net earnings from self employment. Sec. 1402(a)(1) states that rental income is generally excluded (unless rents are related to agriculture) from the definition of net earning from self employment under Sec 1402(a).
Because we can only contribute earnings from self employment (or regular employment) income to retirement plans, and rental income is excluded from this definition, my stance is that rental income cannot be contributed to retirement plans. If someone has a court case that proves otherwise, I'd love to see it.
Keep in mind though, that a real estate professional may have real estate income other than rental income that can be contributed. For instance, the taxpayer may qualify as a real estate pro from their development biz and may be able to demonstrate material participation in their rentals making the income non-passive. But they still can't contribute the rental earnings, just those from their development biz.
Also, non-passive means non-passive. It does not mean "earnings from self employment." A real estate professional's non-passive rental income will not be subject to SE tax.
The real question is: what were the congressmen drinking when they concocted all of this?
Bryan, the Solo 401k plan is designed for those who are self-employed. It doesn't like that this is the case with you since the only income you have is passive.
Review the following link which talks about earned income for those who are self-employed and also review IRS Pub. 560.
http://www.irs.gov/Businesses/Small-Businesses-&-S...
Hi @Dmitriy Fomichenko. Does this mean that the business is not allowed to have a solo 401k? I realize now that it doesn't make sense to set one up for this entity, but it is already set up so now I'm trying to determine if I am now at risk. Ultimately, I want to know if I should be worried about the IRS. My preference would be to have my solo 401k provider either refund the cost or open the 401k within an entity that is better suited for it. If they advised me to open an account that is not even allowed then I think they would happier to fix it.
@Mark Nolan I will check out the Publication today. Thank you for letting me know which publication might be relevant.
After reading through IRS Pub 560, I am no more clear on my question. Pub 560 addresse how to contribute, distribute, etc. None of it sets out the requirements of the entity that the plan attaches to. There was one thing that might help me, and that is the definition used for Business:
"A business is an activity in which a profit motive is present and economic activity is involved. Service as a newspaper carrier under age 18 or as a public official is not a business."
What does the IRS define "economic activity" as?
I called the IRS and they cheerfully informed me that technical questions cannot be answered by phone and that they have shut down the office that used to answer technical questions.
Did you checkout the following yet?
Generally, you are self-employed if any of the following apply to you.
Hi @Mark Nolan. I am considered Self-Employed according to the IRS per the 3rd bullet in the list, but that is not the question I am trying to answer. What I am trying to understand is this one thing:
Is my LLC ineligible to host a 401k plan because it derives most (all) of its income from rental income (passive)?
The IRS says to talk to "an expert", but I am getting different answers from different experts. I am trying to find the rule that confirms or denies the position that an entity that generates more than 25% (or any large percentage) of its income from passive income is not eligible to have a solo 401k plan.
Hi @Dmitriy Fomichenko. Does this mean that the business is not allowed to have a solo 401k? I realize now that it doesn't make sense to set one up for this entity, but it is already set up so now I'm trying to determine if I am now at risk. Ultimately, I want to know if I should be worried about the IRS. My preference would be to have my solo 401k provider either refund the cost or open the 401k within an entity that is better suited for it. If they advised me to open an account that is not even allowed then I think they would happier to fix it.
Bryan, any legal business entity can adopt a qualified plan, however if your business does not produce any earned income and only passive income that means that you will not be able to make any contributions to the plan. Contributions to the plan are not required every year. However, the plan will not be considered qualified if it appears from surrounding facts and circumstances that it was established as a temporary program. A plan will be considered temporary if substantial and recurring contributions are not made.
Hope this helps.
@Bryan O. I've not heard of this 25% passive income rule as it relates to LLCs and qualified retirement plans. Any business that generates earned income can utilize a qualified retirement plan. To make your passive income "earned" you will need to qualify as a real estate professional and demonstrate material participation in the passive activity.
Two 25% rules you may be getting confused with:
1. Employers can contribute up to 25% of your compensation in the form of profit sharing as defined by the plan.
2. When a C-Corp elects to change it's status to an S-Corp and carries with it accumulated earnings and profit (retained earnings), then the S-Corp cannot generate more than 25% of it's gross receipts from passive income as long as those retained earnings remain in the company. S-Corporations don't have retained earnings since everything passes through to partners at year end, so if the S-Corp generates more than 25% of its gross receipts from passive income and still have retained earnings from the C-Corp, then we have a problem.
@Bryan O. rental real estate is considered passive by "nature of the business" by IRS which can be a benefit as you don't have to pay self employment tax, if your LLC is set up as an s-corp you could always pay yourself a salary for the property management activities, but you have to file a form 941, 940 and pay employment taxes of about 15% and state forms and taxes depending on your state. If you treat your LLC as a "disregarded entity" and file on schedule E you could possibly set up a separate Llc property management company and pay it a property management fee to get your "earned income" and file the property management company on a schedule C, but you would owe self employment taxes on your earned income, your state taxes and possibly other state requirements such as workers comp, and unemployment tax depending on your state. Also you sound as your strictly buy and hold and depreciation is a huge tax benefit that you can't use in a solo 401k
That said if it's a solo 401k with a "sub Roth" the future tax savings could be huge and it may over come the extra compliance cost and employment taxes. There are so many variables you really need a good licensed tax professional in your area, not those franchises someone with some letters behind their name and find someone who owns rental property themselves. Hope this gives you some help, Good Luck!
I just want to say thank you to everyone for the help! You guys really are amazing.
So here is the answer I've found thanks to all the help I've gotten here:
The IRS says that rental income is passive and not part of trade or business activity (unless you are a real estate professional). The IRS also says that contributions are based on self-employment in the trade. So anyone who is a "real investor" (not flipping or wholesaling because those are jobs) will never make income that can qualify to contribute to their plan. According to pub 925 my business would not be an eligible business because net earnings must not be from investments, where my entity it is strictly buy and hold which is not a "trade or business activity" also required by pub 560 to host the 401k.
IRS Publication 560 specifies:
Self-employed individual. You can make contributions on behalf of yourself only if you have net earnings (compensation) from selfemployment in the trade or business for which the plan was set up. Your net earnings must be from your personal services, not from your investments.
IRS Publication 925 specifies:
Passive ActivitiesThere are two kinds of passive activities.
Trade or business activities in which you do not materially participate during the year.
Rental activities, even if you do materially participate in them, unless you are a real estate professional.
Material participation in a trade or business is discussed later, under Activities That Are Not Passive Activities .
[removed for clarity]
Trade or Business ActivitiesA trade or business activity is an activity that:
Involves the conduct of a trade or business (that is, deductions would be allowable under section 162 of the Internal Revenue Code if other limitations, such as the passive activity rules, did not apply),
Is conducted in anticipation of starting a trade or business, or
Involves research or experimental expenditures that are deductible under Internal Revenue Code section 174 (or that would be deductible if you chose to deduct rather than capitalize them).
A trade or business activity does not include a rental activity or the rental of property that is incidental to an activity of holding the property for investment.
@Cameron Skinner Thoughts on your S-Corp/LLC converting passive income to active scenarios:
First, he'd still have to demonstrate material participation. You can't simply move income from one entity to another and change the economic nature of the transaction. It will still be classified as passive income unless he can demonstrate material participation.
Second, you should read Hillman vs Commish. Hillman tried this method and won the case to the extent that it did not improve his financial position, but the tax court disallowed this income conversion method to the extent that it lowered Hillman's tax liability. http://caselaw.findlaw.com/us-4th-circuit/1214577....
Simply redirecting income to a different type of entity has no bearing on the economic substance of the transaction.
can you comment on what Bryan mentioned above regarding IRS Publication 925, here is the quote:
"If you qualified as a real estate professional for 2014, report income or losses from rental real estate activities in which you materially participated as nonpassive income or losses, and complete line 43 of Schedule E (Form 1040)."
The same subject came up today in a conversation with a potential client. The question is: if he is calming to be a real estate professional, does it mean that passive income from rentals can be used to contribute to a 401k plan?
Thank you!
@Bryan O. @Dmitriy Fomichenko not sure why I didn't reply to Bryan's questions the first time around - sorry about that.
First, while the IRS pubs are great resources to further one's understanding, it's important to note that they cannot be relied upon as authority. So when we are researching a topic, we want to get at the source code.
Sec. 1402(a) defines net earnings from self employment. Sec. 1402(a)(1) states that rental income is generally excluded (unless rents are related to agriculture) from the definition of net earning from self employment under Sec 1402(a).
Because we can only contribute earnings from self employment (or regular employment) income to retirement plans, and rental income is excluded from this definition, my stance is that rental income cannot be contributed to retirement plans. If someone has a court case that proves otherwise, I'd love to see it.
Keep in mind though, that a real estate professional may have real estate income other than rental income that can be contributed. For instance, the taxpayer may qualify as a real estate pro from their development biz and may be able to demonstrate material participation in their rentals making the income non-passive. But they still can't contribute the rental earnings, just those from their development biz.
Also, non-passive means non-passive. It does not mean "earnings from self employment." A real estate professional's non-passive rental income will not be subject to SE tax.
The real question is: what were the congressmen drinking when they concocted all of this?
Thank you @Brandon Hall!
Not sure what they were driving but they must have been drinking something to come up with this ...
That was my understanding also that rental income is passive, regardless real estate professional designation, thanks for confirming that.