IRS Publication 560 Defines Earned Income for setting up a Solo 401k plan

BACKGROUND: Thanks for sharing the time you did on phone. I know I took a lot of your time and you were busy. I am debating what is the best option for me. I basically want to have the Solo 401k plan money available to invest in real estate when I come across a deal. I would also like the ability to borrow against the solo 401k plan as a loan 50% of my total. I am I not being realistic? I will be employed by a corporation in Florida as there employee but I want a side business in real estate flipping. What is your professional opinion to help me accomplish this. I will be the only person on the account. You gave me good information and made me think. I can start a c corp if I need to as a real estate investor, but may not show income for a little while until I find a property. Can I just borrow half the money as a loan and buy the rest with personal funds. 

Jack in Miami Florida

ANSWER: It doesn’t appear that you will qualify to open a solo 401k plan unless you have earned income from self-employment, whether through an LLC, Partnership, Corporation or Sole Proprietorship. Further, if you are trying to use one house that you will flip for qualifying to open a solo 401k I don’t recommend that you open a solo 401k as in the event of an audit the IRS may rule that only treating one house as a flipper does not constitute a self-employed business. Further, note that in order to continue to participate in a solo 401k plan, the individual must continue to be self-employed. If self-employment ceases, you can no longer participate in a solo 401k, and thus it must be transferred to an IRA or another qualified plan, such as one with the individual’s day-time employer.

Please read following information taken directly form IRS Publication 560 to learn about the self-employment earned income requirement.

Page 4 of 2012 IRS Publication 560:

For a self-employed individual, compensation means the earned income of that individual.

Earned income. Earned income is net earnings from self-employment, discussed later, from a business in which your services materially helped to produce the income.

You can also have earned income from property your personal efforts helped create, such as royalties from your books or inventions. Earned income includes net earnings from selling or otherwise disposing of the property, but it does not include capital gains. It includes income from licensing the use of property other than goodwill.

Earned income includes amounts received for services by self-employed members of recognized religious sects opposed to social security benefits who are exempt from self-employment tax.

If you have more than one business, but only one has a retirement plan, only the earned income from that business is considered for that plan.

Employer. An employer is generally any person for whom an individual performs or did perform any service, of whatever nature, as an employee. A sole proprietor is treated as his or her own employer for retirement plan purposes. However, a partner is not an employer for retirement plan purposes. Instead, the partnership is treated as the employer of each partner.

Page 7 of 2012 IRS Publication 560:

Compensation of self-employed individuals. If you are self-employed, compensation is your net earnings from self-employment as defined in chapter 1.

Compensation does not include tax-free items (or deductions related to them) other than foreign earned income and housing cost amounts