The short (but really long) answer is maybe!
If you and your spouse are legally married, the IRS considers you and your spouse to be one tax paying entity and that means the IRS may consider all of your businesses as if you both own all of them.
The wrinkle occurs when spouses have separate businesses and one spouse decides he or she might need a full-time employee.
An employee is defined as someone in your business who receive W-2 wages. A full-time employee is then defined as someone who works for the business 1,000 hours or more per year, doesn’t have ownership in the business, and receives W2 wages.
With the Solo 401k, you can compliantly exclude any part time employee who works fewer than 1,000 hours per year from participating in the retirement plan. This is what keeps your 401k plan “solo”.
However, if you hire an employee who works more than 1,000 hours per year – you have to offer that full-time employee the ability to participate in your 401k plan. This is an issue of fairness for for the IRS.
When you hire a (full-time) employee, they become eligible to participate in your (or your spouse’s) company retirement plan. When multiple employees are involved in a company retirement plan, nondiscrimination testing must be put in place and the entire plan loses its “Solo” status and becomes a lot more complicated and expensive to administer.
And since the IRS considers you and your spouse one tax paying entity, when your spouse loses his/her eligibility for the Solo 401k – you lose your eligibility, too.
Your business growing is a great thing! So how do you nurture that growth while still retaining the ability to harness the most powerful retirement account on the planet?
There a couple solutions to consider:
Hire two part-time employees instead of one full-time employee: As long as your employees work under 1,000 hours (each) per year, you keep your eligibility to have a Solo 401k.
Hire independent contractors: If your business qualifies you to have 1099 Independent Contractors instead of employees, that can be a great route to explore. Check with your CPA and legal counsel to ensure this is compliant for your business and the state as the Department of Labor and IRS have strict qualifications on when the line ends from someone working in your business in the capacity of independent contractor to becoming an employee.
Here's where things get interesting.
Enter the "Controlled Group Spousal Exception".
The IRS states there isn't any ownership attribution between spouses as long as all three rules below apply:
"No direct ownership or participation in the management of such corporation at any time during the taxable year. Additionally, the spouse cannot be a member of the board of directors, a fiduciary, or an employee of such organization at any time during such taxable year.
No more than 50% of business gross income is from passive investments.
Stock is not subject to conditions that restrict a spouse’s right to dispose of the stock and that run in favor of the individual or his children under age 21." (Source)
Let's return to our example of the husband and wife having separate businesses but being a part of a brother-sister controlled group.
The husband setup his Solo 401k and is happily making investments. His wife's (totally separate) business is beginning to grow and she decides it's time to hire a full-time employee.
If we were to simply view the husband and wife as a part of the same brother-sister controlled group, the husband would lose his Solo 401k eligibility as soon as his wife hires a full-time employee.
That would mean he needs to roll out all his assets/funds/investments from his Solo 401k and shut down his Solo 401k plan.
If the husband and wife meet the IRS three criteria above, they qualify for a spousal exception.
That means the wife can hire a full-time employee and lose her Solo 401k eligibility for herself and her business without affecting the husband and his Solo 401k.
The wife can grow her business (without the benefits of a Solo 401k of course) and the husband can continue in his business and keep his Solo 401k.
In order to execute this successfully, the wife must not be listed on the husband's Solo 401k documents.
That means she cannot participate or be a trustee in her husband's plan. It also means the husband must maintain those three IRS criteria: 1) he can't work for, be a board member of, or own any part of her business, 2) her business can't have more than 50% of its revenue from passive investments, 3) children must be older than 21 years old.
Do you and your spouse own separate businesses?
Are you wondering if you're part of a controlled group? The best way to find out is to ask your legal counsel or tax advisor. Once you determine if you are part of a controlled group, then you can determine what type of controlled group it might be (parent-subsidiary or brother-sister) and if the spousal exception applies to your situation.
This can be a very tricky part of the tax code, so engage the help and support of your trusted advisors.