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

Tim Jochim, Chair, Business Succession & ESOP Group, Kegler, Brown, Hill & Ritter

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 [email protected]

Insights Legal Affairs is brought to you by Kegler, Brown, Hill & Ritter Co., LPA

How to plan ahead for your departure from your business

Christopher F. Meshginpoosh, Director, Audit & Accounting, Kreischer Miller

Many entrepreneurs devote the vast majority of their time to building their businesses — creating new products or services, building a team and developing new client relationships — often at the expense of ensuring that there is a viable way to monetize that value at some point in the future.

Unfortunately, this often leads to surprises down the line in the form of a delayed exit or a loss of value upon exiting the business, says Christopher F. Meshginpoosh, director, Audit & Accounting, at Kreischer Miller, Horsham, Pa.

Smart Business spoke with Meshginpoosh about the exit planning process and how to begin.

How soon should an entrepreneur start planning an exit strategy?

The reality is that it is never too soon to begin planning. Oftentimes, some of the early decisions, such as the form of the entity or the nature of the equity issued to the owners, end up having a significant impact on the timing or value of an exit.

Sitting down and spending some time early on thinking about long-term personal goals and exit options can help minimize problems down the road.

What are some of the exit options that an entrepreneur should consider?

There are a wide range of potential options that an entrepreneur can consider depending on his or her objectives. For example, there are strategies that an entrepreneur can use to transfer ownership to other owners, to nonowner employees, to family members or to outside investors.

What should an owner think about when contemplating a sale to another owner?

If this is a potential outcome for the business, owners should formalize their agreement about the mechanics and value of the transfer. If owners wait until an exit is imminent, it is often very difficult to get the parties to agree on these types of matters.

By entering into a buy-sell agreement that defines how the transfer will occur, owners can avoid many problems and distractions down the road.

What if the owner would like to keep the business in the family?

We see that quite a bit in our client base, and the good news is that there are several options available, including negotiating buy-sell agreements, transferring through gifts to other family members, establishing grantor retained annuity trusts, or establishing family limited partnerships. However, these options are all dependent upon identifying and grooming specific family members who can lead the business upon the departure of the existing owners.

Can you describe some of the strategies that can be used to transfer the business to existing employees?

First, there is one prerequisite: existing ownership members have to make sure that they have a plan to hire and develop managers who are capable of running the business. Assuming those managers are already in place, owners can provide senior management with equity incentives that reward management for increases in the value of the business.

This not only aligns management interests with those of ownership but also provides a way to gradually transfer ownership interest in the business. Once an owner is ready to transfer the remaining interest, it is often possible for management to obtain sufficient debt financing to purchase the owner’s remaining interest in the business. Other options include the formation of an employee stock ownership plan, or ESOP, to gradually or immediately redeem existing ownership interests and transfer those interests to employees.

What are the options if there are no other owners or employees capable of buying the business?

In those situations, either a partial or complete sale to a third party is necessary. Determining the right party is often a function of the owner’s goals, as well as of the willingness of market participants to purchase the business.

For example, if the owner is willing to continue to work in the business for a period of time, options such as a sale to a private equity firm or a roll up might be good alternatives. The sale of a partial interest to a private equity firm might also provide the owner with some upside potential if the business continues to increase in value.

If the owner plans to cease involvement at the time of a transaction, then other options such as the sale of the entire business to a strategic buyer might be the best alternative. Regardless of the strategy, owners really need to prepare for a transaction well before the planned exit.

In light of the time it takes to prepare, how do you recommend that an owner start the exit planning process?

There are many potential alternatives, and each one has its own unique complexities. Consulting with experienced advisers — including accounting, legal and wealth management professionals — is essential to avoiding obstacles and maximizing value upon an exit.

Christopher F. Meshginpoosh is a director in the Audit & Accounting group at Kreischer Miller, Horsham, Pa. Reach him at (215) 441-4600 or [email protected]

Insights Accounting & Consulting is brought to you by Kreischer Miller

How retirement plan sponsors should handle the new fee disclosure requirements

Kimberly Flett, CPA, QKA, QPA, Director, Retirement Plan Design and Administration, SS&G

Employer-sponsored 401(k) plan fees can cut retirement savings by 30 percent over a lifetime, according to Demos, a public policy research group. However, recently enacted disclosure requirements will shine a light on the hidden fees for plan sponsors and participants.

For employers that sponsor retirement plans, there is a fiduciary responsibility.

“You, as a plan sponsor, might be overwhelmed due to lack of expertise and wish to avoid extra time spent thinking about and understanding retirement plan fees,” says Kimberly Flett, CPA, QKA, QPA, director of retirement plan design and administration for SS&G. “However, you are ultimately responsible for adequate disclosures if you are the owner of a company that maintains a qualified plan.”

Smart Business spoke with Flett about how employers can take responsibility as retirement plan sponsors beyond passing along a stack of papers or website addresses to participants.

What are the new fee disclosure requirements for plans?

The Department of Labor was concerned that 401(k) plans with underlying investments of different types and the related providers — investment managers, brokerage houses — that maintain the investment accounts take out revenue from the various funds to pay fees without sharing or disclosing the information to plan participants. The disclosure requirements hold the investment managers accountable and educate participants about the costs in the underlying investments within the retirement plans.

The new fee disclosure requirements have been established for a while, with additional retirement expenses being reported on many retirement plans’ Schedule C as part of Form 5500 reporting to the DOL. They were brought to the forefront more expeditiously because of how the economy plummeted a few years ago. Several interim regulations were passed, with final regulations taking place in 2012.

What does disclosing these fees entail?

There are two parts to the disclosure. Under the first part, the covered service provider that manages your retirement funds was required to begin disclosing to you, as plan sponsor, all the plan costs as of July 1, 2012. These included items such as name and type of investment, performance data, benchmarks, ratios used in calculating expenses and the allocation of all fees — to a third-party administrator, the adviser or licensed dealer, or the company that maintains the fund. The formulas used with those amounts also had to be disclosed.

As of Aug. 30, 2012, the plan sponsors of qualified plans had to start disclosing this information to participants in the plan, explaining what the fees are and how they work. The plan’s statements had to be updated to comply with the regulation.

How much do plan sponsors and their accountants need to understand about the disclosures?

Ultimately, as the plan sponsor, you bear what is called fiduciary responsibility. Therefore, you need to work closely with professionals, advisers and vendors who know how to interpret these disclosures. Take time to read the disclosures and understand how the investment provider is complying. Then make sure your participants are truly being informed and will continue to be so on an ongoing basis.

It’s a good idea, for example, to appoint your HR manager, internal accountant and CFO to an internal 401(k) committee with the responsibility of reviewing the data, educating themselves and then sharing their knowledge with participants. Does this committee have to be experts? No, but they have to make a reasonable effort and know where to go if they don’t have the answers, such as to an attorney familiar with the Employee Retirement Income Security Act of 1974 or a third-party administrator.

Your employees, once they get their third quarter statements, will be coming to you with questions. You need to be able to connect them with the right experts so employees can receive the necessary answers.

If a company’s provider fails to properly disclose its costs, will the company be held accountable?

Failure to comply with the regulation is considered a prohibitive transaction that can be subject to fees and penalty impositions from the DOL. But there are further ramifications beyond the DOL coming after the plan sponsor for improper disclosures.

A participant might leave your company and be unhappy with the funds or platform that you, as the plan sponsor, chose, because he or she lost money. That former employee could seek out the DOL and get an attorney. Then you could have to prove that you took every precaution to ensure the plan ran smoothly and made smart investments. If the plan did not, you might be held accountable.

It’s too soon to say what the short- or long-term ramifications will be, but as a plan sponsor the first thing you need to do is arm yourself with the right expert advisers. Then make inquires to be forearmed; the preparation phase will help curtail a lot of negative fallout that could potentially happen.

How do you think this will affect the retirement planning industry?

Third-party administrators will be needed more than ever for their expert advice. This disclosure law also brings visibility to the industry, which opens doors for discussion that sets up additional chances for education and awareness about retirement plans.

Despite more costs being in the open, employers should still take a comprehensive approach to retirement planning. Looking at service, benchmarking and longevity, as cheap is not always better. A company might have the highest number of new plans each year because of the low costs, but it also could have low retention rates because of service


Kimberly Flett, CPA, QKA, QPA, is the director of retirement plan design and administration for SS&G. Reach her at (330) 668-9696 or [email protected]

Insights Accounting & Consulting is brought to you by SS&G

Financing plan for beleaguered Kodak faces obstacles: report

NEW YORK ― Hedge funds that have been in discussions with Eastman Kodak Co. to help shore up the company’s cash position, have cut the amount they are willing to finance, the Wall Street Journal reported on Sunday.

The 131-year old company has been in talks for new financing with a consortium of hedge funds including Cerberus Capital Management LP and Highbridge Capital Management LLC, the report said.

While discussions originally centered on a package of about $900 million, the hedge funds recently cut the amount they are willing to provide to somewhere between $600 million and $700 million, the WSJ said, citing people familiar with the matter.

The report said that might not be enough to meet the company’s needs.

Kodak has been trying to sell is portfolio of 1,100 digital patents since August with the help of investment bank Lazard Ltd.

While the company is looking at other means of raising cash, unless Kodak closes on the patent sale or gets a large enough amount of bridge financing in coming weeks, it could seek bankruptcy protection during the first few months of next year, the report said.

Kodak had $862 million in cash at the end of September, down from $1.4 billion a year earlier.