Jeff Nabers’ Self Directed IRA & Solo 401(k) Blog

By far, one of the most luring propositions is

Fund your dream business with your retirement fund

“But, how?” you ask, “isn’t it a prohibited transaction to invest your plan (IRA/401k) into something that involves myself as disqualified person?”

Yes. As a general rule, it is prohibited for your plan to invest in a business that you own or run. An exception to that rule is what is promoted through:

• Benetrend’s Rainmaker
• Guidant Financial’s Audeo
• ERSOP
• and others

The arrangement works with a prohibited transaction exemption [IRC 4975(d)(13)] for what is called “qualifying employer securities”. This is how these arrangements are structured:

1. A C Corporation is formed
2. This new corp then sponsors a qualified plan (such as a 401k or profit sharing plan)
3. The customer’s existing retirement funds are transferred into the new plan
4. The plan then purchases a significant portion of the new corp’s stock as qualifying employer securities

Ordinarily, this would be a PT, but based on the special exemption, it is okay that the plan is buying shares in the participant’s company, the participant is paid a salary from the company which is funded mostly from the plan, and the participant works for the company which is owned mostly by the plan.

For this “qualifying employer securities” arrangement to exist, the plan documents must allow for investment into QES and the corporation’s bylaws must allow for QES and a corporate resolution must be made to approve the QES transaction.

Theoretically this can be a very powerful concept. In my honest opinion, however, this arrangement is often being promoted regardless of suitability.

Sales Pitch A - Access your retirement funds NOW

“Do you want to benefit now from your retirement funds before age 59 ½? Just use this QES arrangement!” Let’s examine this further below in some examples. I hate to spoil it for you, but of all the options to receive your retirement funds earlier than 59 ½, the QES arrangement results in maximum taxation.

Sales Pitch B - Make your business income tax deferred

This is simply a half truth. The business income is taxed at the corporate level. Let’s examine:

QES funds legitimate business, but there’s no profit

Jerry wants his retirement funds NOW, but he’s only 45. He doesn’t want to pay distribution taxes & penalties, so this sales pitch appeals to him. He sets up a Rainmaker plan, but his business never makes a profit. That’s okay, he thinks, because I really just wanted access to my retirement funds. But at what cost was this access granted? Firstly, the only money he makes is what his corporation pays him through a W-2. So he pays taxes on this personal income after all that work to “get around the distribution taxes”. Any money he has spent on trying to get the business off the ground would likely exceed the 10% penalty he would have incurred for just directly distributing from his retirement accounts. Plus, he’s spent $4,000 to $5,000 to setup the arrangement in the first place.

Conclusion: He would probably receive less money (net of taxes) through his QES arrangement than he would through direct plan distributions.

QES funds questionable business, but there’s no profit

Joyce wants her retirement funds NOW, but she’s only 50… so she sets up an ERSOP. She never really tries very hard to make the business successful, so her situation is just like Jerry’s except she hasn’t spent that much money on business expenses outside of paying herself a salary. She still ends up paying taxes on her personal income. She thinks she’s clever because she kept her expenses low, but all in all the IRS & DOL may question whether this business was truly created with the intentions of making or selling products or services for a profit. If they conclude “no”, then the entire arrangement may be deemed a “sham” and past due taxes, interest, and penalties assessed.

Conclusion: Joyce’s income (which comes from retirement fund money) is taxed as ordinary income. She receives no tax beneift. Further, she is operating a sham entity that will upset the IRS in an audit.

QES funds legitimate, profitable business

Jill has a great business idea, uses the Guidant’s Audeo QES arrangement to fund it, and lo and behold, it’s a success! As the first example with business income,

• She is still paying ordinary income taxes on the compensation she personally receives (She did not circumvent the taxes she would have paid to distribute her retirement funds to herself)
• Her plan receives its income after corporate taxes are paid. This means her plan’s income will be taxed once at the corporate level and once again later at distribution. This is just bad planning that results in maximum taxation.

Conclusion: Jill still paid taxes on her personal income (that came from her retirement money and its further returns) and the income of her retirement plan is subjected to corporate taxes. This strategy accomplishes little to nothing in the way of tax minimization.

A better way to access your funds NOW

Did you know that you can distribute your retirement funds to yourself at any age without triggering the 10% penalty? All you have to do is agree to abide by a regular payment schedule until you either turn 59 ½ or take distributions for 5 years… whichever is longer. There’s plenty of strategies to follow that make these schedules flexible for anyone who has a fair amount of retirement funds. More on this in a later post…

Sales Pitch C - Quit your job and follow your dreams

Like most people, you probably have a dream or two about starting a business that you would love running. I think this plays a bit strongly on most people’s emotions. Most people are tired of working for someone else, and they want the flexibility and freedom that can be made possible by starting a small business.

The problem is that 90% of small businesses fail in the first 7 years. 90% of the survivors fail in the second 7 years. This famous Department of Commerce study tells us that if you are starting a small business, you have a 99% chance of failing. How do you like those odds? They are worse than the odds you get from a casino… many times over. To complicate matters, many people cite that the #1 reason for small business failure is not enough capital. Now, my goal isn’t to deter you from starting a business. For me, starting and running businesses has been extremely gratifying. I’ve started over a dozen businesses, some of them were profitable successes, but probably the most (more…)

For many real estate investors, leverage is a key factor to their plans for profits - leverage in the form of mortgage financing. When you introduce mortgage financing into Self Directed IRA ownership of real estate, a special tax called Unrelated Business Income Tax (UBIT) is triggered. The tax often isn’t detrimental as will be covered in another post, but nonetheless it reduces the profit.

For the self employed, a fantastic development has occurred over the past few years - the Solo 401(k). One distinct advantage of the Solo 401(k) over an IRA is that it is not subject to paying UBIT on profits from financed real estate. Eliminating UBIT by using a Solo 401(k) eliminates the need to file a return (Form 990-T) as well as the accompanying tax. Sound pretty good so far?

The difficulty in recent times has been obtaining nonrecourse financing. The leader of NR financing in the Self Directed IRA industry for the past few years has been North American Savings Bank. Last year, they took the familiarity of IRA lending and applied it to Solo 401(k). Unfortunately for many Solo(k) investors, this has only been available to plans who choose to name a custodian as trustee of the plan. Qualified plans (which is what all 401k plans are) are different than IRAs in that they are not required by law to (more…)