Plan Asset Rules Apply to Solo 401k

Before you proceed to open Solo 401k for investing in a private company such as a Limited Partnership, read this blog to understand the plan asset rules as it may subject the Limited Partnership or General Partnership to to the Solo 401k prohibited transaction rules.

Defined in the Code of Federal Regulations (CFR) 2510.3-101, the Plan asset rules apply to Solo 401k, especially self-directed Solo 401k, a type of Solo 401k that allows for investing in alternative investments such as private placements and real estate, to name a few.

These rules establish what level of equity interest Solo 401k and IRA interest in non-traded entities (e.g., hedge funds, limited partnerships and LLCS, etc.) deem the entity itself to be a plan asset, thereby imposing a fiduciary status on the manager of the entity and making the entity essentially a disqualified party.

The consequence of deeming the manager of the entity a fiduciary and the entity to be a plan asset and a disqualified party, restricts the types of transactions that may occur without being considered in violation of either ERISA or the Prohibited transaction rules.

Basically, if the sum of Solo 401k and IRA assets in an entity equal 25% or greater of the total equity interest in the entity with few exceptions, the entity will be deemed a Plan asset (aka disqualified party), and the manager a fiduciary. Specifically, the Regulation then provides that assets of an entity (on an undivided interest basis) will constitute plan assets if:

• The plan's investment is an "equity interest:"
• The investment is not a "publicly offered security;"
• The issuer is not an investment company registered under the investment Adviser's Act of 1940;
• The issuer is not an "operating company;" and
• Equity participation by "benefit plan investors" is "significant" (equal to 25% or more of the total interest).

There are exceptions if the entity is considered a:

• Venture Capital Operating Company (VCOC);
• Real Estate Operating Company (REOC); or
• Operating Company (operating a trade or business that supplies goods and services as opposed to being an investment company like a hedge fund).

An VCOC is a company whose primary business is investing in the equity interest of other companies, and that plays an active role in their management.

Generally the definition of a VCOC must satisfy the following conditions to avoid the 25% rule:

• Beginning on the date that the fund first makes an investment (other than a short-term investment pending a long-term commitment), 
• at least 50% of fund assets (valued at cost) must be invested in operating companies or derivative investments in which the fund has direct contractual "management rights" (the so-called "50% test"); and
• The fund must, in the ordinary course of its business after its initial long-term investment, actually exercise "management rights" with respect to at least one operating company.  

A REOC is a company whose primary business is associated with investments and development of real property. Specifically, a  company is deemed a REOC if:

• On its "initial valuation date" and on at least one day within each "annual valuation period," at least 50 percent of its assets valued at cost (other than short-term investments pending long-term commitments or distribution to investors) are invested in real estate that is managed or developed and, with respect to which, such entity has the right to substantially participate directly in the management or development activities, and,
• Such entity, in the ordinary course of its business, is engaged directly in real estate management or development activities.

An Operating Company (e.g., a clothing store) is a company whose primary purpose is to provide goods and services, ad distinguished form being an investment company.

If an entity is deemed  to be either an Operating Company, A VCOC or a REOC, then the entity does not become a Plan Asset (or essentially a disqualified party), until the entity is owned 100% by Solo 401k plan and or IRA assets.