How to invest in a company using a 401(k) plan rollover Featured

11:36am EDT November 1, 2012
How to invest in a company using a 401(k) plan rollover

Although it’s risky to take money from a fund set aside for retirement, the advantage of using pre-tax cash has led to people taking their 401(k) funds and investing them in their own businesses.

This option is available when someone leaves a job and can rollover a 401(k) plan into a new investment. They don’t have to be the business owner, but that’s often the case.

“That’s the case with 80 percent of my clients who have done this,” says Tim Jochim, chair of the Business Succession & ESOP Group at Kegler, Brown, Hill & Ritter. “They’re in the business with a larger company, they decided they didn’t want to work in the corporate bureaucracy anymore and they can do better than their existing employer. They developed their business plan, left to start their own company and this is how they funded it.”

Smart Business spoke with Jochim about what’s  involved in rolling over a 401(k) plan into a new or existing business.

How can you use your 401(k) plan to start or invest in a business?

When you terminate employment, you’re eligible for a distribution from your 401(k) plan. You do a direct rollover into the 401(k) plan, profit-sharing plan or employee stock ownership plan (ESOP) of your new company.

For example, an executive decides he wants to leave his job to start a new company and there are assets he wants to buy. He does a direct rollover of the $5 million in his 401(k) into the 401(k) of the new company. The trustee of the 401(k) plan is then directed to purchase $5 million of newly issued stock of the new company. Now the company has $5 million in cash, which it uses to buy the target business. In effect, he’s used his 401(k) plan from a prior employer to start his own business.

What are the tax advantages?

Pre-tax dollars are used to buy a business. That’s saving somewhere between 30 percent and 40 percent when you count federal, state and local income taxes. So instead of $5 million to buy this business, he would have had only $3 million because the other $2 million he would have paid in taxes.

Theoretically you could do it with any amount of money, but with the cost of documentation and the risk of compliance to make this pay, you really need a minimum of $1 million to work with in your 401(k) plan.

Why is setting up an ESOP the best option in most cases?

The company can be a C Corporation or an S Corporation. If it’s a C Corporation, the corporation pays taxes on its profits. If it’s an S Corporation, the owner pays the taxes on the profits, because it’s a pass-through entity. However, the individual is not the owner — the 401(k) is the owner and the 401(k) must pay the taxes. But if it’s an ESOP, those profits are exempt from federal and most state income taxes. That’s the advantage of an ESOP.

Can you set up an ESOP as an individual?

If your new company has other employees, they must be given the same opportunity to direct their assets into company stock. Usually that’s only a temporary window to get it started. The Employee Retirement Income Security Act (ERISA) prudence rules limit investment in sponsor company stock, and certain IRS rules require that the benefits, features and rights be nondiscriminatory. If the owner can do this, then you have to provide that opportunity to everyone else who is a participant in the 401(k) plan, subject to the prudence rules. Because of the prudence rules, employee elective deferrals are usually not invested in company stock.

Considering the tax advantages with ESOPs, why would you take another route with investing your 401(k) rollover?

If you have an S Corporation ESOP, there is an ESOP anti-abuse test — in order to pass, the company should have at least 10 employees because the test prohibits concentration of stock ownership in a few people. That is sometimes called the ‘Seinfeld rule.’ This is hearsay, but the story is that TV’s Seinfeld family had discovered this magic thing called S Corporation ESOPs. They had their own entertainment company and only a few family members who were shareholders. They set up an ESOP, sold all of their stock to the ESOP and were the only participants. So they got all of their stock back and didn’t have to pay any federal income taxes. There was an uproar in Congress about this type of transaction and the S Corporation Anti-Abuse Act was passed.

What risks are involved in having a 401(k) fund a business?

Under the ERISA prudence rules, qualified plans are supposed to be diversified. They are not supposed to be primarily invested in employer securities, such as their own company stock. Only an ESOP has statutory exemption from the diversification requirement. You can amend a profit-sharing plan or a 401(k) plan to allow that, but you’re taking a greater risk under pension law because they don’t have the statutory exemptions that ESOPs have. The risk is that, as a fiduciary of the plan, you’re acting imprudently by permitting investment exclusively or primarily in company stock, and therefore you’ve breached your fiduciary duty and are subject to sanctions from the U.S. Department of Labor.

Do you need to hire an attorney to fund a business with a 401(k) rollover?

There are consulting firms that sell this concept, but they don’t draft the documents, they just sell the concept. A client who did this a couple of years ago had a group that was going to charge $30,000 just for the concept and wasn’t actually going to do the work. The problem is finding qualified attorneys. There are only a handful nationally that do this well. It’s high benefit, but it’s also high risk.

Tim Jochim is chair of the Business Succession & ESOP Group at Kegler, Brown, Hill & Ritter. Reach him at (614) 462-5443 or TJochim@keglerbrown.com.

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