Using Pension Assets to Finance Your Business

Overview 

My mother always said that I saw the World through rose-primmed glasses. I always responded “Mom, I have been wearing glasses since I was ten and I don’t think that glasses are sold with rose-primmed lens.” 

Even with my rose-primmed outlook on things, you have to be pragmatic and a realistic about the American economy and Corporate America. If you think that you are going to be able to remain with the same employer for your entire career (even if you want to), think again. The corporate solution to quarterly earnings decreases is to cut a few thousand jobs. If you are getting a little “long in the tooth”, your days in Corporate America may be numbered and chances for a new job limited.

The only solution is to do it yourself – start your own business. At least, you can see the train coming! In the current lending environment, the chances of securing a business loan from your neighborhood bank are slim to none? Family and friends? Nope!

This article is an executive summary about a technique that allows you to tap your funds in a qualified retirement plan (specifically 401(k) or profit sharing) to start a new business. The technique may be more powerful than just providing start up funds for that new consulting business. This summary will highlight the key points.

Strategy Overview 

The strategy is relatively straight-forward. The first step involves the tax-free rollover from an existing IRA or 401(k) or profit sharing plan into a new 401(k) Plan established in a new corporation that the client establishes. The new corporation must be a regular or C corporation and not an S corporation or LLC. The Plan document for the new 401(k) has an amendment for the Plan authorizing the Plan participant (you) to purchase employer securities, i,e, shares in the new corporation. Following the sale of corporate shares to the 401(k) Plan, 401(k) proceeds are in the corporation to use for any valid corporate purpose. This sequence of steps does not result in any taxation to the Plan participant or corporation.

Tax Review 

IRC Sec 4975 outlines prohibited transactions for qualified retirement plans as well as tax exempt organizations. IRC Sec 4975(d)(13) provides a list of exemptions. ERISA Sec 408(e) provides an exemption stating that ERISA Sec 406 will not apply to the purchase of qualifying employer securities. The transaction must be for adequate consideration. The Plan must be an individual account plan described in ERISA 407(d)(3). 401(k) plans and profits sharing plans meet this requirement.

The strategy requires the purchase of stock in the new corporation from the corporation itself in order to avoid the application IRC Sec 4975(f)(6). IRC Sec 4975(d) blocks the exemptions of IRC Sec 4975(d) for owner-employees for transactions involving self-dealing. The direct acquisition of stock avoids a prohibited transaction.   

Normally investments in qualifying employer stock would be limited to ten percent or less of plan assets under ERISA Sec 407(b)(1). ERISA Sec 407(d)(3) has an exemption from these diversification requirements for individual account plans such as 401(k) and profit sharing plans. As a result, the Plan holding more than ten percent of the shares of qualifying employer securities does not violate ERISA Sec 404(a)(2). How 100 percent? No problem!

The IRS issued a memorandum clarifying its concerns in 2008. This memorandum largely focused on two aspects of the transaction. First, if the new corporation has employees, adequate notice of the program must be detailed for the company’s employees. Secondly, the purchase must be an arms-length transaction supported by an independent valuation.

Planning Considerations 

Example 1 – Starting Your Own Home-Based  Consulting Business 

Facts 

Bob Jones, age 55, was a vice president for a Fortune 500 company. He was recently “downsized” from his Employer due to a corporation reorganization and given six months of severance pay. Bob would like to continue working in a consulting capacity as he considers it highly unlikely he will find another corporate position equivalent to the one he previously held. His retirement date is the earlier of age 95 or his departure from Planet Earth. Bob had $500,000 in his company 401(k) Plan that he has since rolled over to his personal IRA.

Solution 

Bob creates a new corporation that is organized as a C or regular corporation. He creates a new 401(k) plan within the new corporation. The Plan allows for the purchase of employer securities. Bob executes a tax-free rollover of his IRA into the new 401(k) plan. The trustee of the Plan purchases 100 percent of the unissued treasury stock in the New Corporation. The price is supported by an independent valuation at $250,000. The funds are wired into the corporate operating account. Bob is able to use these funds for any valid and legal purpose including payment of a salary or shareholder loan.

 

Example 2 

Facts

Stan Smith, age 75, is a retired business owner who sold his business for $5 million ten years ago.  Stan has $3 million in his IRA. Stan has a net worth of approximately $10 million. Stan and his wife have adequate assets to provide a comfortable retirement income without the IRA and would prefer to minimize the heavy taxation – income and estate taxes – on qualified plan and IRA assets.

Solution 

Stan creates a new C corporation, Newco,  to serve as the general partner of his family limited partnership. The Corporate GP will provide investment management services for the FLP. The FLP holds commercial real estate and marketable securities. The C Corp establishes a new 401(k) plan. Stan does a rollover of his IRA to his account in the new C Corp. The trustee of the new 401(k) plan purchases stock in Newco for $3.5 million.

Newco decides to sponsor a split dollar life insurance program insuring the lives of Stan and his wife. The policy provides for annual premiums of $500,000 per year, or a single premium of $3.5 million. The death benefit is $15 million. The owner of the policy is an irrevocable life insurance trust (ILIT). The transaction is structured as a inter-generational split dollar program. (See my prior Blog Post on inter-generational split dollar). The corporation transfers its split dollar receivable in the beginning of Year 3 for $350,000 to the trustee of the ILIT. The $15 million death benefit will be paid the ILIT income and estate tax-free.

This planning result occurs at a minimal tax cost compared to the income and estate taxation on qualified plan and IRA assets.

Summary 

This strategy is important for a number of reasons. It has become increasingly difficult in the current economic environment to borrow money to start or purchase a small business. This technique makes it possible to use tax deferred assets to finance a business without incurring taxation on those dollars. Plan loans are of limited value due to the limit – $50,000.  Deferred compensation assets (qualified or non-qualified) are heavily taxed being subject to income and estate taxation.

The pension strategy also has a more sinister benefit as pointed out in Example 2. Many high net worth individuals with significant pension assets would prefer to reallocate those dollars in a more tax efficient manner rather than being exposed to both income and estate taxes. Family LLC and LPs are a mainstay in advanced estate planning. IRAs can’t invest in life insurance. It is a straight-forward approach to create a corporate general partner or managing member in order to facilitate the strategy. From a tax perspective, the strategy is on very solid ground.

 

 

 

 

 

About gerrynowotny

I am a tax and estate planning attorney with a JD and LL.M in estate planning from the Univesity of Miami School of Law. I have worked in the life insurance industry for twenty three years and the last eleven in private placement life insurance.
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5 Responses to Using Pension Assets to Finance Your Business

  1. Does that mean an IRA/401(k) owner can avoid early withdrawal penalties by purchasing a company with the funds and then paying them out as wages to the owner and/or his family and friends?

  2. Dennis says:

    Taking the retirement funds out of the 401(K) as funding the business is one way to use, protect, hold on to the funds. You fund the business with the funds. But to do it, it takes skill. Do it in a way that the company sells you stock and you pay with your retirement funds. Those shares gain value and if you like have the business buy them back. Then you are left with a higher value in your retirement fund. Which your business as set up. Need assistance check out http://www.businessfinancestore.com/newfunding/index.php?id=2425

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