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August IRA Insights: Funding Your New Business with Retirement Funds

John recently retired from the fire department and is ready to move on to the next phase of his life. At 54 years young, John knew he wasn't ready for "full-time" retirement and had been thinking about starting his own business for several years. As his

By: Jack Callahan

IRA Insights

By: Jack Callahan, J.D., CFP

John recently retired from the fire department and is ready to move on to the next phase of his life. At 54 years young, John knew he wasn't ready for "full-time" retirement and had been thinking about starting his own business for several years. As his retirement date approached, John spent a lot of time exploring various business opportunities. John was an avid fisherman and ultimately decided to start a business that revolved around his knowledge and passion for fishing - a bait & tackle store called "Fully Involved Fishing, Inc."

John estimated he would need $300,000 to secure a retail location, build out the store, buy inventory and cover operating and overhead costs for the first year. As for employees, John planned to hire off-duty fireman strictly on a part time basis. John was familiar with self-directed IRAs and, with approximately $400,000 in his Rollover IRA, he was hopeful he could use some of his retirement savings to fund his new venture. In discussing the options with his CPA, John learned it would be a prohibited transaction for him to lend money from his IRA to himself or to a business he owned. He was disappointed to learn it would also be prohibited to buy a piece of real estate in his IRA and lease that property to a business he owned. But, the CPA had some good news as well. The CPA explained that the rules are different for IRAs as compared to the rules for Qualified Plans, such as a 401(k). If properly structured, John would be able to utilize his retirement account to fund the startup of his new business by establishing a 401(k) for Fully Involved Fishing, Inc. and roll his IRA funds into this new Qualified Plan.

In discussing his plan, John's CPA and Attorney explained that once the Corporation or LLC was established and the Company's 401(k) Plan was adopted, John could roll his IRA into the new Company's 401(k) Plan. John would then have three options for accessing the funds....

Option 1 - John Takes a Participant Loan from His 401(k)

John's CPA explained that he could take a loan from his 401(k) and repay the loan over a five year period at market interest rates with all the interest going back into his own account. However, the loan amount would be limited to the lesser of 1) $50,000; or 2) 50% of the balance in his 401(k). With $400,000 in his account, John would be limited to borrowing only $50,000. This was far less than he needed to start the business.

Option 2 - John's 401(k) Buys Real Estate ans Leases it to the Business

John's CPA explained that while leasing real estate from his IRA to his business would be prohibited, the rules for 401(k) accounts would allow for leasing real estate from his 401(k) Plan to the business under certain conditions. Those conditions and limitations, however, were strict. John could buy a retail location in his 401(k), but he would only be able to lease 25% of the property to his business and no more than 25% of the 401(k)'s income could come from real estate leased to his business. With $400,000 in his account, John would not be able to satisfy both of these requirements.

Option 3 - John's 401(k) Buys Stock in the New Company

Under this option, John would buy original issue stock in his new company within his 401(k) account. His 401(k) would write a check to the company and in exchange, the company would issue stock to his 401(k). John, as President of the Company, would deposit the funds into the company's checking account and could use the funds as needed to secure a location, buy inventory, and cover operating expenses. Meanwhile, his 401(k) account would benefit by sharing in the company's profit as a shareholder. As he reviewed the alternatives, John realized buying Company stock in his 401(k) was clearly the best option for utilizing his retirement account funds.

After doing some more planning, John decided to purchase $200,000 of stock with his 401(k) and another $100,000 with personal funds. The Corporation retained 200,000 shares of authorized, but un-issued stock that would allow John and his 401(k) to add additional capital to the company in the future, if needed.

Because Fully Involved Fishing, Inc. was set up as a C-Corp, John was able to take a reasonable salary from the Company for his duties in managing the store and running the company. Realizing the tax benefits and flexibility of his 401(k), John decides to defer the first $20,000 of his salary back into his 401(k) account, reducing his taxable W-2 income. "This is incredible!" thought John. He was able to use his retirement account to help fund his new business, take a salary from the business to pay living expenses, and was able to put some of that salary back into his retirement account, lowering his taxes. In the future, as the business becomes profitable, the 401(k) which owns 66% of the stock will get 66% of the profits distributed as dividends.

Anyone interested in exploring the use of retirement accounts to fund a new business should consult with a CPA or Tax Advisor and consider all of the tax, legal and financial implications, including these key points:

• The IRS requires and fully expects the 401(k) Plan will be funded with salary deferrals and profit sharing contributions to ensure the requirements of a Qualified Plan being used for planning and saving for retirement under 401(a) of the Internal Revenue Code and not exclusively for the purpose of funding a new business.
• If you wish to take a salary from the business, the entity must be taxed as a C-Corp.
• If the entity is taxed as an S-Corp, Partnership or other pass-through entity, even if you don't take a salary, the 401(k) may be subject to UBIT/UBTI (Unrelated Business Taxable Income).
• The Entrust Individual(k) Plan is best suited for businesses that do not have any common law employees other than the owners of the business and their spouses.
• If the business hires common law employees (work more than 1000 hours per year) who are eligible to participate in the 401(k) Plan, you will need a Plan Administrator who does discrimination testing and other Administration Services required by the IRS and Department of Labor.

For more inforamtion on Individual (k) Plans contact your local Entrust office.

Jack M. Callahan, J.D., CFP^TM is an Attorney and a Certified Financial Planner specializing in advising real estate investors, small business owners and real estate professionals. He is also President of Entrust of Tampa Bay, LLC., with offices in Largo and Gainesville, Florida.

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