Required to Return Profits to a 401k Plan Shareholder? | Frank Selden Law

Required to Return Profits to a 401k Plan Shareholder?

A new client expressed concern that he had to return profits to the 401k plan based on its percentage of ownership. Returning earnings to shareholders are allowed in the form of dividends, but not required. 

Business Venture

Yes, a rollover business startup (ROBS) allows someone to fund their venture using retirement funds. A ROBS setup requires a corporation that sponsors a specifically worded 401(k) plan authorizing “qualified employer securities.” The corporation sponsors the Plan for the benefit of all employees. As an employee of the corporation you may then transfer qualified assets into this plan. The plan then invests those funds into the corporation at your direction for stock.

Profits

How do profits from a proper ROBS get back to the Plan? The corporation is not allowed to make an “S” election. An "S" corporation is one that makes the shareholders responsible for the taxes on the business income. A 401K 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 prohibited from making loans to the corporation, so we can’t pass earnings to the Plan as high-interest loan payments.

The corporation may pay dividends to shareholders. Dividends 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, very few ROBS owners will authorize dividends. Why not?

  1. The corporation must declare an income on its tax return, creating a taxable event,
  2. Owners are investing for growth rather than dividends,
  3. they prefer to get company money into the plan through salary deductions and matching contributions, or
  4. the idea doesn't make good tax sense.

Are Dividends Tax-Free?

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. First, 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 a 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 distribution. Even though most qualified distributions are in the form of gains, taxpayers owe ordinary income tax on the total amount of a plan distribution. Distributing dividends to a plan means the corporation pays corproate tax rates on those funds and then you pay ordinary income on the dividends.

An Alternative Idea

An abundant cash flow is a great problem to have. What does one do with all of that cash?

In 2019, inside your 401(k) plan you can invest up to $56,000 (a combination of salary deferral, which maxes out at $19,000, 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. You may also retain the earnings, increasing the stock value. Your CPA is the best person to discuss these tax ideas.

From a legal standpoint, your corporation is under no different accounting rules than any other corporation. Your corporation is not required to pay dividends or pay as much federal income tax as possible. Your CPA is the best person to discuss these tax ideas.

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.

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