Retirement Plans as a Source of Business Capital
By Monty W. Walker CPA, CBI, BCB
February 26, 2009
The need to use retirement funds for the purpose of making non-publicly traded investments such as buying a building, purchasing a parcel of land or acquiring a business is growing. It is extremely common to find people whose liquidity is located primarily in qualified vehicles such as IRAs, Pensions and 401(k) rollover accounts. As people are being downsized from Corporate America, they find themselves at a crossroad of either taking the entrepreneurial road or finding another job. Many people are deciding to take control of their own destiny by starting or buying a business. Thus comes the problem.
Large bases of these people have been building retirement accounts so most of their money is located in qualified vehicles. If improperly accessed, they stand to be hit with a 10% penalty and often pay 30% or more in federal income tax. Depending on tax bracket and the state of residence, total federal and state taxes can encroach on 50%. The idea of losing from 30% to 50% on a distribution from a qualified account does not set well with most people. So, the question to be answered is, How can a person access his/her retirement funds to purchase a business or to make other non-publicly traded investments while preserving the income tax deferral and without incurring a penalty?
The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) was signed into law on June 7, 2001, by President George W. Bush. This Act is what opened the planning opportunities available for Entrepreneurs to utilize accumulated retirement money as a business capitalization source.
EGTRRA relaxed the portability rules for retirement plans. What EGTRRA did is allow monies created in various types of different retirement plans to be rolled into each other. For example, prior to passage of EGTRRA, a 401(k) Plan could only hold funds created in a 401(k) Plan. But, with the passage of EGTRRA, funds created in other plans such as IRA’s, Defined Benefit Plans, Traditional Pension Plans, 403(b)’s etc… could be rolled into a 401(k) Plan.
This ability to cross transfer funds between different plan types is what all of sudden expanded the planning opportunity for Entrepreneurs to use retirement funds as a business capitalization source.
When a business establishes a retirement plan, such as a 401(k) Plan, the business is called a “Plan Sponsor”. Once the Plan is active, investment options are placed in the Plan and made available to the plan participants. The plan participants then select which investment options they want for the investment of their retirement funds.
Retirement Plans have had the ability to include the Plan Sponsor as an investment option since the passage of the Employee Retirement Income Security Act of 1974 “ERISA”. But, ERISA contains certain prohibitions regarding the ability of a retirement plan to invest in a Plan Sponsor and it has certain limitations regarding the amount of funds that can be invested in a Plan Sponsor for those Plans which are allowed to invest in a Plan Sponsor.
ERISA states that there is no prohibition on the acquisition or sale by a Plan of the qualifying employer securities of a Plan Sponsor and no limitation on the amount of funds that can be invested in a Plan Sponsor if the Plan is an Eligible Individual Account Plan. An Eligible Individual Account Plan is defined in ERISA to mean an individual account plan which is a profit-sharing, stock bonus, thrift or savings plan. 401(k) Plans fall under this definition.
In 1978, Congress amended the Internal Revenue Code “IRC” by adding section 401(k), whereby employees are not taxed on income they choose to receive as deferred compensation rather than direct compensation. The law went into effect on January 1, 1980, and by 1983 almost half of large firms were either offering a 401(k) plan or considering doing so. By 1984 there were 17,303 companies offering 401(k) plans.
Since a 401(k) Plan is the type of retirement plan that qualifies under ERISA’s prohibition and limitation exemptions, this is the type of plan structure that provides the greatest degree of benefit and flexibility to Entrepreneurs who desire to use their retirement funds as a business capitalization source. Until the passage of EGTRRA in 2001, the only funds that could reside in a 401(k) Plan were pure 401(k) monies meaning that funds from other plan types could not be rolled into a 401(k) Plan. Because of the short amount of time that 401(k) Plans had been in existence, most retirement funds were located in other types of retirement plans such as IRAs and Traditional Pension Plans. So, until the passage of EGTRRA, most aspiring Entrepreneurs were not able to take advantage of the benefits available under a 401(k) Plan because they had developed most of their retirement money in plan types other than a 401(k) Plan.
After over 27 years of a Plan being able to invest in a Plan Sponsor under ERISA and after over 21 years of a 401(k) Plan being available under the IRC, in 2001, with the passage EGTRRA, the planning opportunity for an Entrepreneur to truly benefit from having a 401(k) serve as a business capitalization vehicle became a reality. Entrepreneurs can now roll their retirement funds from their various plans into one bucket and then pour that bucket into a 401(k) Plan. The 401(k) Plan can then be used to develop retirement resources, in part, by investing in the Entrepreneurs business.
First and foremost a retirement plan is exactly that —— A Retirement Plan. Even if a retirement plan can be designed to enable the plan to acquire employer stock, essentially allowing the plan to serve as a source of business capital, it is and always will be a retirement plan. Failing to recognize this fact can and will likely lead to compliance problems.
Many Entrepreneurs who have chosen to use a retirement plan as a source of business capital simply run the business for their individual benefit and disregard the existence of the retirement plan. They themselves do not do salary deferral contributions to the plan, they do not dividend any profits to the plan, they excessively compensate themselves, they do not inform employees about the existence of the plan, etc…
Some of the elements to consider when evaluating the use of a retirement plan as a source of business capital are as follows:
1) Participation – All Employees should be allowed to participate in the Plan without any wait period. This is a part of the Safe Harbor provisions.
2)Contribution Matching – The Plan should provide a contribution match based on Safe Harbor.
3)Vesting – Employees should immediately vest in the company match or company profit sharing contributions. This too is a part of the Safe Harbor provisions.
4)Routine Contributions – Payroll Deferral Contributions should be made to the Plan on a routine basis.
5)Benefits Equality – The Plan must benefit all employees and not just the Entrepreneur.
6)Plan Administration – The Plan must be compliantly managed and administered. For example, employees must be notified about the plan when hired and at least annually thereafter, contributions and investment activity must be properly tracked, plan must be updated with current legislative changes, annual reports with required disclosers must be filed, prudent investment selections should be provided, etc…
7)Independent Trustee/Fiduciary Platform – It is impossible to be independent in the decisions associated with the Plan and Plan Administration especially when it comes to the prudence of investing in employer stock if the Entrepreneur is the Trustee.
8)Business Valuation – A business valuation must be procured to identify the fair market value of the employer stock. This amount will then used to ensure that the Plan does not overpay for its investment. This amount to be paid by the Plan is known as Adequate Consideration.
9)Reasonable Compensation – The Entrepreneur must only be paid Reasonable Compensation.
10)Business Operations – The business must be operated for the benefit of all owners which includes a Retirement Plan when a Retirement Plan is introduced to the ownership mix. The responsibility bar is raised to a much higher level when a Retirement Plan becomes an owner.
Compliance initially and ongoing is extremely important when dealing with any form of retirement plan. But, when a retirement plan is used as a source of business capital this matter of compliance becomes even more crucial.
It makes no sense to use a retirement plan to serve as a source of business capital only to operate the plan non-compliantly and be exposed to penalties and the chance of having the plan disqualified.
This is an area where —- NO SHORTCUTS SHOULD BE TAKEN.
Remember —- COMPLIANCE! COMPLIANCE! COMPLIANCE!
About the Author:
Monty W. Walker is the senior principal of Walker Advisory Associates and Hutcheson Walker Advisors. These firms provide strategic business and transaction advisory services to the closely-held business market with the focus of Hutcheson Walker Advisors being innovative retirement strategies. Monty Walker works with Entrepreneurial clients throughout the country advising them in the areas of Business Transactions, Business Structuring & Design, Business Tax Planning and Business Exit Planning.