I love it when rollover business startups make the news. A recent article on Entrepreneur touts one of the benefits of a rollover business startup as “partially fund their business ventures using their current 401(k) savings and then funnel some of their new business’ profits back into their retirement account completely free of taxes!” The author is correct, but this is a complicated issue.
Yes, a rollover business startup allows someone to partially (up to 98%) fund their venture using current savings, with the caveat that one is creating a corporation (no other business entity) that sponsors a specifically worded 401(k) plan (which must allow for “qualified employer securities”) for the benefit of all of its employees (whether you want to offer company stock to them or not). The current qualified funds must be transferred into an account that is owned by this specific plan, not just any 401k savings.
How do profits from a proper ROBS get back to the Plan? The corporation is not allowed to make an “S” election (which makes the shareholders responsible for the taxes on the business income), because a Plan is not an eligible shareholder for an “S” election, so we can’t get profits to the plan through owner equity transfers. The Plan is also prohibited from making loans to the corporation so we can’t pass profits to the plan as high-interest loan payments. This essentially leaves dividends, which are after tax to the corporation and taxable to shareholders. Individual shareholders will pay taxes at the dividend / investment rate, and the Plan will not initially pay any taxes on the dividends. While this dividend “funneling” of profits is allowed, none of my 1,500+ clients in the past 10 years ever wanted to do it for several reasons: corporation must declare an income on its tax return, they are investing for growth rather than dividends, they prefer to get company money into the plan through salary deductions and matching contributions, and the issue raised below.
Free of Taxes
While it is true that the dividends received by the plan are tax free to the plan, declaring dividends to the plan involves two taxable events. The first is that dividends are not tax deductible to corporations, they are after tax money that is either retained to increase share value or distributed to shareholders by declaration of the board of directors. Corporations pay 15% tax on the first $50,000 of taxable income (see Form 1120 Instructions) so ANY declared income will be a taxable event. The 2nd taxable event is at time of distribution. Even though most qualified funds distributions are in the form of gains, taxpayers owe ordinary income tax on the total amount of a plan distribution. Full corporate income tax to create the dividends, and then full ordinary income on the dividends themselves and any gains on those dividends.
An Alternative Idea
Having a larger cash flow than your business needs to grow is a great problem to have. What does one do with all of that cash? This is a great problem to have. With your 401(k) plan you can invest up to $53,000 (combination of salary deferral, which maxes out at $18,000, then add profit sharing and matching contributions) per year tax deferred for your retirement. Both the salary deferral and matching are deductible to the corporation. This idea can help max out your plan contribution and reduce your corporate taxes. If you still have cash left over, dividends on existing shares are not part of the contribution limit so feel free to create them in addition to deferrals and employer matches.
If you want to set up a ROBS plan, or need legal assistance with the one you already have, call me. I can fill in the details missed in some internet stories.