Solo 401(k) - No intention of utilizing

Hi - a colleague of mine (RIA Firm) asked me this question.  I read through some QKA materials but I didn't find anything.

Colleague has a client whose income is from real estate holdings, so all passive income, but wants to start a Solo 401(k).  The client knows they cannot contribute to a 401(k) because they have no W-2 income/earned income.  But they want to start a Solo 401(k) to roll large IRA's into the plan so they can begin doing backdoor Roth's on their personal money and dont have to deal with aggregation rules of the large IRA's.

My initial reaction is they cant start a 401(k) as they never have any intention of making personal or employer contributions to the plan (outside of rollovers), as they will not have any earned income to use.

I'm not sure where that thought comes from or what I read that leads me to believe it, but curious on other peoples thoughts.

Assuming there is an employer to sponsor a plan, use a 0% money purchase plan.  

10 hours ago, shERPA said:

Assuming there is an employer to sponsor a plan, use a 0% money purchase plan.  

I was under the impression there was some rule that a plan had to have at least the intention of being funded in order to be qualified? You couldnt just have a plan out there with no intention of ever funding it.  I'm not sure where I read that.

23 minutes ago, MjInvestments said:

I was under the impression there was some rule that a plan had to have at least the intention of being funded in order to be qualified? You couldnt just have a plan out there with no intention of ever funding it.  I'm not sure where I read that.

Contributions to a profit sharing plan have to be "substantial and recurring." A 401(k) plan is a profit sharing plan, but a MPP is not, which is presumably why shERPA recommended it.

Are we sure that there is no exception to the substantial and recurring requirement in the case where the plan sponsor has no pensionable earnings?

The following is the full paragraph in which the "substantial and recurring contributions" requirement is found. That sentence (the second-to-last) applies only to PS plans, but I read the remainder as applying to all forms of "plans" under 401(a).

Although the fact pattern doesn't fit neatly into the permanency or other explicit rules in this paragraph, this would give me some concern, especially with no intent to ever have eligible compensation paid, 0% fixed contributions, and no other employees or employee contributions aside from the owner's rollover. In other words, can something ever be a permanent plan intended to receive contributions and benefit employees if it's explicitly set up to ensure neither of those things ever happens?

1.401-1(b)(2):

The term “plan” implies a permanent as distinguished from a temporary program. Thus, although the employer may reserve the right to change or terminate the plan, and to discontinue contributions thereunder, the abandonment of the plan for any reason other than business necessity within a few years after it has taken effect will be evidence that the plan from its inception was not a bona fide program for the exclusive benefit of employees in general. Especially will this be true if, for example, a pension plan is abandoned soon after pensions have been fully funded for persons in favor of whom discrimination is prohibited under section 401(a). The permanency of the plan will be indicated by all of the surrounding facts and circumstances, including the likelihood of the employer's ability to continue contributions as provided under the plan. In the case of a profit-sharing plan, other than a profit-sharing plan which covers employees and owner- employees (see section 401(d)(2)(B)), it is not necessary that the employer contribute every year or that he contribute the same amount or contribute in accordance with the same ratio every year. However, merely making a single or occasional contribution out of profits for employees does not establish a plan of profit-sharing. To be a profit-sharing plan, there must be recurring and substantial contributions out of profits for the employees. In the event a plan is abandoned, the employer should promptly notify the district director, stating the circumstances which led to the discontinuance of the plan.

I answered the immediate question, but there are other questions about this.  To establish any plan there must be an eligible plan sponsor.  No wages and no earned income imply there may not be.  A real estate investor is not always (or even typically) an employer.  

But this also raises a question about the original goal - a back door Roth IRA. Presumably this is referring to making a traditional IRA contribution and then immediately converting it to a Roth.    But if there is no earned income or wages, is such a person even eligible to make an IRA contribution?

Is(n't) the primary risk of the substantial and recurring issue that contributions would be DQ'd, and/or that immediate vesting is required?  

Also I think if that remains a concern that the sponsor could find some source of earned income.  

I think it's an interesting idea but would not undertake it with standard "one-man plan" pricing.

The back-door Roth would be done through in plan conversion, I'm sure.

1 hour ago, shERPA said:

But this also raises a question about the original goal - a back door Roth IRA. Presumably this is referring to making a traditional IRA contribution and then immediately converting it to a Roth.    But if there is no earned income or wages, is such a person even eligible to make an IRA contribution?

11 minutes ago, CuseFan said:

The back-door Roth would be done through in plan conversion, I'm sure.

 

So actually, it appears the client has W-2 wages, just from a different business they work at.  So Backdoor Roth would be with earned income, but it is unrelated earned income.  So not relevant to a potential plan here.  

Thanks for all the info so far!  I am going to work with our company's tax consultant to come up with a recommendation.

16 hours ago, shERPA said:

Assuming there is an employer to sponsor a plan, use a 0% money purchase plan.  

How would that help for OP question? The OP wants to convert existing pretax plan money to ROTH, the only way to do that is through a 401(k) Plan that allows both ROTH contributions and ROTH conversions. I'm pretty sure new Money Purchase plans can not have a 401(k) feature and by extension no ROTH conversions either.

Was there an article or TED talk ont his somewhere recently?

We have received several calls regarding these Roth conversions.  I may start a separate thread with my questions.

@Lou S. @BG5150 My question was more about the ability of this person to sponsor a plan without active income or any intention of putting money earned from the business in the plan, as there would be no earned income to put in. 

The roth conversion question would not be done inside this plan, they would be the traditional Roth conversions (Non deductible IRA --> Roth) using income earned from another business

13 minutes ago, MjInvestments said:

@Lou S. @BG5150 The roth conversion question would not be done inside this plan, they would be the traditional Roth conversions (Non deductible IRA --> Roth) using income earned from another business

Exactly.  this is a good strategy, but to make it work the client cannot have any traditional IRA accounts.  Otherwise the conversion is taxed based on the ratio of pre-tax IRAs to total IRAs, likely making most of the conversion additional taxable income.  So roll all pre-tax IRAs into a qualified plan, then make annual non-deductible traditional IRA contributions and immediately convert them to Roth.  I did this myself for a few years when it first opened up. 

So the MP would work if the client has an employer entity that can sponsor the plan.

An MP plan is not any different that any other employer plan in that it still requires compensation from the sponsoring employer. Solely passive real estate income is not compensation. The taxpayer must be actively engaged in the business of real estate and not just receiving passive rental income.

In order to it be considered self-employed earned income you must be engaged in a trade or business. The IRS reiterated in the Final Section 199A QBI regulations that under Higgins v. Commissioner. In order to be considered engaged in a trade or business. The  taxpayer is required to:

1. Enter into and carry on the activity with a good faith intention to make a profit or with the belief that a profit can be made from the
   activity.
2. To have considerable, regular, and continuous activity.

For example, under 401c, in order to be considered a self-employed individual eligible to adopt, maintain and contribute to a 401k. They must have self-employed earned income from a trade or business in the current or any prior year.

FYI, a rollover is a rollover contribution. If you are not eligible to adopt the 401k in the first place to for employee and/or employer contributions. You have no 401k plan to accept a rollover contributions.

Even though it is a moot point, I fail to see how the "substantial and recurring contributions" requirement is practically applicable to a one-participant 401k plan. It is intended to prevent discrimination and harm to participants. The correction is a partial termination requiring immediate vestment. One-participant 401k plan contributions are always 100% vested.

If he has W-2 income from another source, do they have a QP he could roll his IRAs into? Does he provide any management or operational services that he could justify paying himself a small salary for? Whatever services he is providing for compensation, could he provide as a 1099'd consultant?

It's an extreme situation if the sole individual involved with the company has NO W-2 earnings or SE income. But in such a case, the plan would also seem to violate the exclusive benefit requirement that it be for employees, included SEIs.

The individual could always go to work briefly for a big anonymous company (e.g., sign on as a part-time Walmarter) and roll his IRA into its plan.