Tax-Free Funding for Your Business--From Your 401(k)
BY Erik Sherman
If you think using retirement money to start a company means a big tax payment, think again. There's a way around the problem.
Bohnne Jones worked in the healthcare industry for 33 years until she was laid off in January 2002. Going back to school and picking up expertise in IT gave her a new start, but only a temporary one. A two-year engagement came to an end and then a position as a VP in a software start-up was over in eight months when the company started feeling the first strains of the oncoming global contraction.
Jones wasn't ready to retire and had a life-long interest in design and decorating. The Decorating Den franchise caught her eye, but she was turned down. "They told me I didn't have enough money, but I had $330,000 in my 401(k)," she says. "They said, 'Oh, we can't count your 401(k).' That's when I started to scratch my head. What should I do? Cash in my 401(k)?" The tax implications would have been enormous.
But, getting some help, she learned that she didn't have to cash out. Instead, using a process of creating a corporation and new 401(k) and rolling the old 401(k) over into the new plan, she could use her money as capital to both buy the franchise and to fund it. Although the business has had its ups and downs, and she invested a total of $250,000 in two parts, the franchise is now running strong.
Guidant Financial, a Bellevue, Wash.-based financial services company that specializes in helping entrepreneurs find capital for their businesses, advised her on the process. According to CEO David Nilssen, there are provisions in the Employee Retirement Income Security Act and IRS tax codes that enable people to invest retirement savings in a business if they are active employees in the company. Absentee ownership designed for passive income doesn't meet the requirements. Here are the basic steps:
1. Establish a C corporation before you create or buy your business. An S corporation, limited liability corporation, or other structures don't offer the necessary legal framework.
2. Put a 401(k) plan in place in the corporation. You must explicitly provide for the acquisition and holding of qualified employer securities, which is essentially stock in the business.
3. Roll over your existing 401(k) or IRA and the existing retirement assets into the new plan.
4. Treat the new business as an asset into which your 401(k) can invest. Put whatever portion of the retirement assets as you want. You can make a series of investments over time if you wish.
5. Once the investment is made, the money is in the corporation and the 401K has become a shareholder. You can use the cash for any ordinary or necessary business expense.
"There's risk in any investment," Nilssen says. "The risk is going to be there, regardless of how [entrepreneurs] capitalize these investments and regardless of what industry and category they invest in." But he argues that using 401(k) financing actually has lower risk than a common choice of entrepreneurs, a Small Business Administration loan.
"If I was to buy a business and got a $200,000 SBA loan and the business was to fail, in order to get that loan, I would have had to put [down] 25 percent, and in most cases that is going to come from money I've earned and paid taxes on," he says. "Then I'm going to have to sign a personal guarantee and it's required that I collateralize my home, and I'll have debt service, which is likely to be one of my larger [business] expenses. In the case where the business owners are not successful, they are certainly on the hook for that capital. And banks will find ways to collect."
If things go badly with 401(k) financing, you still have to pay for the loss, but the 401(k) provides before-tax money, reducing the effective cost. Plus, there are no credit implications and your house is not on the hook. "It is still just an investment loss," he says, "but there is no taxable event that occurs if you lose money in that investment."
You do need a large enough 401(k) that would provide a meaningful investment--which means you are risking a significant portion, if not all, of your retirement savings. But if you have it, Nilssen says the odds of success are good, largely because you've likely had the experience running a group or division of a company and you aren't trying to start a business with insufficient capital.
"When we talk about success in small business, Dunn and Bradstreet says that after four years, only 38 percent of small businesses still operate," he says. Over 80 percent of his clients are still in business and many may have sold their companies.