There are 25 trillion dollars in retirement plans in the United States. Do you know that these funds can be invested into your business? Yes, it’s true, IRAs and 401(k)s can be used to invest in start-ups, private companies, real estate, and small businesses. Unfortunately, most entrepreneurs and retirement account owners didn’t even know that retirement accounts can invest in private companies but you’ve been able to do it for over 30 years.
Think of who owns these funds: It’s everyday Americans, it’s your cousin, friend, running partner, neighbor…it’s you. In fact, for many Americans, their retirement account is their largest concentration of invest-able funds. Yet, you’ve never asked anyone to invest in your business with their retirement account. Why not? How much do you think they have in their IRA or old employer 401(k)? How attached do you think they are to those investments? These are the questions that have unlocked hundreds of millions of dollars to be invested in private companies and start-ups.
How Many People Are Doing This?
Recent industry surveys revealed that there are one million retirement accounts that are self-directed into private companies, real estate, venture capital, private equity, hedge funds, start-ups, and other so-called “alternative” investments. It is a sliver of the overall retirement account market, but it’s growing in popularity.
So, how does it work? How can these funds be properly invested into your business? If you ask your CPA or lawyer, the typical response is, “It’s possible, but very complicated, so we don’t recommend it.” In other words, they’ve heard of it, but they don’t know how it works, and they don’t want to look bad guessing. If you ask a financial adviser, particularly your own, they’ll talk about how it’s such a bad idea while thinking about how much fees they’ll lose when you stop buying mutual funds, annuities, and stocks that they make commissions or other fees from. Well, not all financial advisers, but unfortunately too many do.
Now, there are some legal and tax issues that need to be complied with, but that’s what good lawyers and accounts are for, right? And yes, there is greater risk in private company or start-up investments so self-directed IRA investors need to conduct adequate due diligence and they shouldn’t invest all of their account into one private company investment. So how does it work?
What is a Self-Directed IRA?
In order to invest into a private company, start-up, or small business, the retirement account holder must have a self-directed IRA? So, what is a self-directed IRA? A self-directed IRA is a retirement account that can be invested into any investment allowed by law. If your account is with a typical IRA or 401(k) company, such as Fidelity, Vanguard, TD Ameritrade, Merrill Lynch, Charles Schwab, then you can only invest in investments allowed under their platform, and these companies deem private company investments as “administratively unfeasible” to hold so they won’t allow your IRA or 401(k) to invest in them (some make exceptions for ultra-high net-worth clients, $50M plus accounts). As a result, the first step when investing in a private company with retirement account funds is to rollover or transfer the funds, without tax consequence, to a self-directed custodian who will allow your IRA, Roth IRA, SEP IRA, HSA, or Solo 401(k) to be invested into a private company. There are over 30 companies who provide self-directed IRAs. For a detailed list of the companies that provide these types of accounts, check out the Retirement Industry Trust Association’s website and membership list. RITA is the national association for the self-directed retirement plan industry, and most major companies who provide these accounts are members of RITA.
Legal Tip: If an investor’s retirement account is with their current employer’s retirement plan (e.g. 401(k)), they won’t be able to change their custodian until they leave that employer or until they reach retirement age (59.5 years old). So, for now, they’re 401(k) is usually limited to buying mutual funds they don’t understand and don’t want.
Sell Corporation Stock or LLC Units to Self-Directed IRAs
Are you seeking capital for your business in exchange for stock or other equity? If so, you should consider offering shares or units in your company to retirement account owners. You don’t need to wait until your company is publicly traded to sell ownership to retirement accounts. Here are a few well-known companies who had individuals with self-directed IRAs invest in them before they were publicly traded: Facebook, Staples, Sealy, PayPal, Domino’s, and Yelp, just to name a few.
You can also raise capital for real estate purchases or equipment whereby a promissory note is offered to the IRA investor who acts as lender, and the funds are usually secured by the real estate or equipment being purchased. There are many investment variations available, but the most common is an equity investment purchasing shares or units where the IRA becomes a shareholder or note investment whereby the IRA becomes a lender. Keep in mind, you need to comply with state and federal securities laws when raising money from any investor.
Need to Know #1: Prohibited Transactions
There are two key rules to understand when other people invest their retirement account into your business. First, the tax code restricts an IRA or 401(k) from transacting with the account owner personally or with certain family (e.g. parents, spouse, kids, etc.). This restriction is known as the prohibited transaction rule. See IRC 4975 and IRS Pub 590A. Consequently, if you own a business personally you can’t have your own IRA or your parents IRA invest into your company to buy your stock or LLC units. However, more distant family members such as siblings, cousins, aunts and uncles could move their retirement account funds to a self-directed IRA to invest in your company. And certainly, unrelated third-parties would not be restricted by the prohibited transaction rules from investing in your company. What if you are only one of the founders or partners of a business, and you want to invest your IRA or your spouse’s IRA into the company? This is possible if your ownership and control is below 50%, but this question is very complicated and nuanced, so you’ll want to discuss it with your attorney or CPA who is familiar with this area of the tax law.
If a prohibited transaction occurs, the self-directed IRA is entirely distributed. That’s a pretty harsh consequence and one that makes compliance with this rule critical.
Need to Know #2: UBIT Tax
The second rule to understand is a tax known as Unrelated Business Income Tax (“UBIT”, aka, “UBTI”). UBIT is a tax that can apply to an IRA when it receives “business” income. IRAs and 401(k)s don’t pay tax on the income or gains that go back to the account so long as they receive “investment” income. Investment income would include rental income, capital gain income, dividend income from a c-corp, interest income, and royalty income. If you’ve owned mutual funds or stocks with your retirement account, the income from these investments always falls into one of these “investment” income categories. However, when you go outside of these standardized forms of investment, you can be outside of “investment” income and you just might be receiving “business” income that is subject to the dreaded “unrelated business income tax.” This tax rate is at 39.6% at $12,000 of taxable income annually. That’s a hefty rate, so you want to make sure you avoid it or otherwise understand and anticipate it when making investment decisions. The most common situation where a self-directed IRA will become subject to UBIT is when the IRA invests into an operational business selling goods or services who does not pay corporate income tax. For example, let’s say my new business retails goods on-line, and is organized as an LLC and taxed as a partnership. This is a very common form of private business and taxation, but one that will cause UBIT tax for net profits received by self-directed IRA. If, on the other hand, the same new business was a c-corporation and paid corporate tax (that’s what c-corps do), then the profits to the self-directed IRA would be dividend income, a form of investment income, and UBIT would not apply. Consequently, self-directed IRAs should presume that UBIT will apply when they invest into an operational business that is an LLC, but should presume that UBIT will not apply when they invest into an operational business that is a c-corporation.
Legal Tip: IRAs can own c-corporation stock, LLC units, LP interest, but they cannot own s-corporation stock because IRAs and 401(k)s do NOT qualify as s-corporation shareholders.
Now, if you’re an LLC raising capital from other people’s IRAs or 401(k)s, you should have a section in your offering documents that notifies people of potential UBIT tax on their investment. UBIT tax is paid by the retirement account annually on the net profits the account receives so it doesn’t cost the company raising the funds any additional money or tax. It costs the retirement account investor since UBIT is paid by the retirement account. Despite the hefty tax, many IRAs and 401(k)s will still invest when UBIT is present as they may be willing to pay the tax on a well-performing investment or their investment strategy. Alternatively, many self-directed IRAs may be investing with an intent to sell their ownership in the LLC as the mechanism to receive their planned return on investment. When selling their LLC ownership, the gain in the LLC units would be capital gain income and would not be subject to UBIT.
If the investment from the self-directed IRA was via a note or other debt instrument, then the profits to the IRA are simply interest income and that income is always investment income and is not subject to UBIT tax. Many companies raise capital from IRAs for real estate purchases or for equipment purchases. These loans from an IRA or IRA(s) are often secured by the real estate or equipment being purchased and the IRA ends up earning interest income like a private lender.
So, here’s a brief summary of what we’ve learned. First, there’s $25 trillion in retirement plans in the U.S. These retirement accounts can be used to invest into your start-up or private company. You need to comply with the prohibited transaction rules and you can’t invest your own account or certain family member’s account into your business as that would invalidate the IRA. But everyone else’s IRA can invest into your company. And lastly, depending on how the company is structured (LLC or C-Corp), and how the investment is designed (equity or debt/loan), there may be UBIT tax on the profits from the investment. Remember, UBIT tax usually arises for IRAs in operating businesses structured as LLCs where the company doesn’t pay a corporate tax on their net profits. This income is pushed down to the owners and in the case of an IRA this can cause UBIT tax liability.
Here’s the bottom line, retirement account funds can be a significant source of funding and investment for your business, so it’s worth some time and effort to learn how these funds can most efficiently be utilized. While there are some rules unique to retirement accounts they can easily be understood and planned for.
It’s time to start thinking about year-end tax planning and as every savvy business owner knows, effective 2015 tax planning happens before December 31, 2015. One of the most commonly used strategies for our clients is an s-corporation and a 401(k). A properly structured s-corporation is utilized best for tax purposes when the business owner adopts and contributes to a 401(k) plan as the contributions to 401(k) are tax deductible. Whether the business has only one owner/employee (or spouses only) or whether the business has dozens or even hundreds of employees, a 401(k) is a great tool to help defer taxable income. Simply put, a 401(k) plan can be used as a tool for putting the income of the business owner (and applicable employees) away for retirement with the added benefit of a tax deduction for every dollar that can be contributed. There are numerous benefits and options in a 401(k) plan. For example, you can do Roth 401(k) account, you can self direct a 401(k) account, and you can even loan money to yourself from your 401(k) account. While books have been written about all of these options and benefits, one of the most misunderstood concepts of 401(k) plans is how s-corporation owners can contribute their income to the plan. That is the focus of this article.
Rules for 401(k) Contribution
In order to understand how s-corporations income can be contributed to a 401(k) plan, you need to understand the following three basic rules.
- Only W-2 Salary Income can be Contributed to a 401(k). You cannot make 401(k) contributions from dividend or net profit income that goes on your K-1. See IRS.gov for more details. Since many s-corporation owners seek to minimize their W-2 salary for self-employment tax purposes, you must carefully plan your W-2 and annual salary taking into account your annual planned 401(k) contributions. In other words, if you cut the salary too low you won’t be able to contribute the maximum amounts. On the other hand, even with a low W-2 Salary from the s-corporation you’ll still be able to make excellent annual contributions to the 401(k) (up to $18,000 if you have at least that much in annual W-2 salary).
- Easy Elective Salary Deferral Limit of $18,000 or 100% of Your W-2, whichever is less. If you have at least $18,000 of salary income from the s-corporation, you can contribute $18,000 to your 401(k) account. Every employee under the plan is allowed to make this same contribution amount. As a result, many spouses are added to the s-corporation’s payroll (where permissible) to make an additional $18,000 contribution for the spouse’s account. If you are 50 or older, you can make an additional $6,000 annual contribution. Follow this link for the details from the IRS on the elective salary deferral limits. The elective salary deferral can be traditional dollars or Roth dollars.
- Non-Elective Deferral of 25% of Income Up to a $53,000 total Annual 401(k) Contribution. This is usually maximized best in solo 401(k) plans where you as the business owner decided to offer them most generous company match allowed by law (25% of wages). Rarely is this offered or maximized like this in a group 401(k) scenario where you have other employees because what you offer yourself, you must offer to all employees who qualify for the plan (full-time, worked for you a year, over 21). If you are in the solo 401(k) situation, this additional 25% deferral is an excellent tool because in addition to the $18,000 annual elective salary contribution, an s-corporation owner can contribute 25% of their salary compensation to their 401(k) account up to a maximum of a $53,000 total annual contribution. This non-elective deferral is always made with traditional dollars and cannot be Roth dollars. So, for example, if you have an annual W-2 of $100,000, you’ll be able to contribute a maximum of $25,000 as a non-elective salary deferral to your 401(k) account. If you have employees who participate in the plan besides you (the business owner) and your spouse, then the non-elective deferral calculation gets much more complicated because you’d have to offer it to those employees too. But for now, let’s assume there are no other employees and run through the examples.
Let’s run through two examples. The first is an s-corporation business owner looking to contribute around $30,000 per year. The second is a business owner looking to contribute the maximum of $53,000 a year.
Example 1: Seeking a $30,000 Annual Contribution.
- S-Corporation Owner W-2 Salary = $50,000
- Elective Salary Deferral = $18,000
- 25% of Salary Non-Elective Deferral = $12,500 (25% of $50,000)
- Total Possible 401(k) Contribution = $30,500
Example 2: Seeking Maximum $52,000 Annual Contribution
- S-Corporation Owner W-2 Salary = $140,000
- Elective Salary Deferral = $18,000
- 25% of Salary Non-Elective Deferral = $35,000 (25% of $140,000)
- Total Possible 401(k) Contribution (maximum) = $53,000
As a result of the calculations above, in order to contribute the maximum of $53,000, you need a W-2 salary from the s-corporation of $140,000. Keep in mind that if you have other employees in your business (other than owner and spouse) that you are required to do comparable matching on the 25% non-elective deferral and as a result such maximization is often difficult to accomplish in 401(k)s with employees other than the owner and their spouse. Consequently, the additional 25% non-elective salary deferral is best used in owner only 401(k) plans. If you do have employees though you can at least do $18,000 per year without having a matching requirement for your employees. That’s still three times what you can contribute to a traditional or a roth IRA. There are also common matching formulas used where you end up matching yourself and your employees contributions at a rate of 4% of salary (safe harbor).
Keep in mind that while 401(k) contributions can be made until the tax return deadline (personal, 4/15/16 and s-corp 3/15/16), including extensions, that the 401(k) must be established before the end of 2015 in order to later make 2015 contributions. As a result, you just need to establish the 401(k) before the end of 2015 and that will allow you to later make 2015 contributions prior to filing your 2015 returns.
Have you rolled over your 401(K) plan or other employer based plan to a rollover IRA? Has someone told you that your rollover IRA in California isn’t protected from creditors. They’re wrong.
Retirement plans are known for being great places to build wealth and they have numerous tax and legal advantages. One of the key benefits of building wealth in a retirement account is that those funds are generally exempt from creditors. However, some states have laws that protect employer based retirement plans (aka, ERISA Plans) more extensively than IRAs. California is one of those states as their laws treat IRAs and ERISA based plans differently (the California Code refers to ERISA based plans, such 401(k)s, as private retirement plans) .
California Code of Civ. Proc., § 704.115, subds. (b),(d), treats funds held in a private retirement plan as fully exempt from collection by creditors. “Private retirement plans” include in their definition “profit-sharing” plans. The most common type of profit sharing plan is commonly known as a 401(k) plan.
IRAs, on the other hand, are only exempt from creditors up to an amount “necessary to provide for the support of the … [IRA owner, their spouse and dependents] … taking into account all resources that are likely to be available…” In other words, the exemption protection for IRAs is “limited”. California Code of Civ. Proc., § 704.115, subdivision (e).
McMullen v. Haycock
Notwithstanding the limited creditor protections for IRAs outlined above, the California Court of Appeals has ruled that rollover IRAs funded from “private retirement plans” receive full creditor protection as if they were a fully protected private retirement plan under California law. McMullen v. Haycock, 54 Cal.Rptr.3d 660 (2007). In McMullen v. Haycock, McMullen had a judgement against Haycock for over $500,000. McMullen attempted to get a writ of execution against Haycock’s IRA at Charles Schwab. In defending against the writ of execution, Haycock claimed that the entire IRA was a rollover IRA funded and traceable to a private retirement plan and thus fully protected from collection as a private retirement plan. Haycock relied on California Code of Civ. Proc., § 703.80, which allows for the tracing of funds for purposes of applying exemptions.
Haycock lost at the trial court level but appealed and the appellate court found in his favor and ruled that his rollover IRA was fully protected from the collection of creditors as the funds in the rollover IRA were traceable to a fully exempt private retirement plan (e.g. former employer’s 401(k) plan).
As a result of McMullen v. Haycock, California IRA owners whose IRAs consist entirely of funds rolled over from a private retirement plan of an employer are fully protected from the collection efforts of creditors. IRAs that consist of individual contributions and are not funded from a prior employer plan rollover will only receive limited creditor protection. It is unclear so far how an IRA would be treated that consists of both private retirement plan rollover funds and new IRA contributions. Presumably, the Courts will trace the funds and separate out the private retirement plan rollover IRA portions from the regular IRA contributions and the regular IRA contributions would then receive the limited protection. Unfortunately, there is no case law or guidance yet as to rollover IRAs with mixed rollover and regular IRA contributions.
McMullen v. Haycock was a big win for IRA owners with funds rolled over from a private retirement plan and one that should be kept in mind when planning your financial and asset protection plan.
When a retiree begins taking distributions from a traditional IRA, 401(k), or pension plan, those distributions are taxable to the retiree under federal income tax and any applicable state income tax rules. While federal taxation cannot be avoided, state taxation may be avoided depending on your state of residency. In general, there are some states that have zero income tax and therefore don’t tax retirement plan distributions, some states that have special exemptions for retirement plan distributions, and other states that do in fact tax retirement plan distributions. This article breaks down the basics and discusses some of the states where income taxes can be avoided.
The No State Income Tax States
First, the easiest way to avoid state income tax on retirement plan distributions is to establish residency in a state that has no state income tax. It isn’t just the fun and sun of Florida that helps attract all of those retirees. It’s the tax free state income treatment that you’ll get from all of that money stocked away in your retirement account. The other states with no income tax and therefore no tax on retirement plan distributions are Alaska, Nevada, South Dakota, Texas, Washington, and Wyoming.
States with Retirement Income Exclusions
Second, there are some states that have a state income tax but who exempt retirement plan distributions for retirees from state income taxes. There are 36 states in this category that have some sort of exemption for retirement plan distributions. As each of these states are very different, so too are their exemptions. The type of retirement account, however, does tend to govern the exemptions available. Here’s a quick summary of the common exemptions found in the states.
- For Public Pensions and Retirement Plans. Distributions from federal or state employer plans are exempt from taxation in many states. This is the most common exemption amongst states that have an income tax but who exempt some types of retirement plan distributions from income. Most of the 36 states that have an exemption for retirement plan income provide an exemption for public employee pensions and retirement plans.
- For Private Pensions and Retirement Plans. About 10 states offer a full exclusion for private pensions and retirement plans. Some of them differ between pension and contributory plans (e.g. 401(k)) and some of them make no distinction. Pennsylvania, for example, excludes all income distributions. Hawaii excludes certain distributions from state income tax for private retirement plans and for portions from company plans rolled over to a rollover IRA and then distributed from the rollover IRA.
- For IRAs. There are some states that do no tax any retirement pan distributions, including IRA distributions to retirees. Illinois for example does not tax distributions from retirement plans at all (pensions, IRAs, 401(k) s). Tennessee and New Hampshire are states that do not tax wage income and therefore they do not tax retirement plan distributions of any kind (IRA, 401(k), etc.). There are also numerous states that exclude a certain limit of retirement plan income from taxation. For example, Main exempts the first $10,000 of income from any retirement plan, including IRAs.
In sum, the state tax rules for retirement plan distributions are complicated and vary significantly. Each state can be understood rather quickly though and everyone planning for retirement should understand how state income taxes may eat into their planned retirement plan distributions. I, for example, looked into Arizona and found that there is no exemption for 401(k) or IRA income in the state of Arizona. While we do have a low state income tax rate, Arizona state income tax includes income from private retirement plans (pensions and 401(k) s) and IRAs and has a modest deduction for distributions from public retirement plans. Each state is unique to the type of plan, and the amounts being distributed but don’t just think you need to be in a state with zero income tax to avoid taxes on retirement plan distributions. For example, you could be in Illinois, Tennessee, or New Hampshire and could realize state income tax-free distributions of your IRA or 401(k). The National Conference of State Legislators has an updated 2015 chart that is very useful and can be used to look up your state’s tax treatment of retirement plan distributions for retirees.
If you are establishing an estate plan, it is likely that you will have a Revocable Living Trust (“Trust”) as the primary document that outlines who will receive your assets upon your death and what conditions, if any, will be placed on those assets. As many persons are aware, a Trust has numerous advantages over a will because upon the death of the owner(s) of the Trust, the surviving trustee of the Trust will have control and authority to distribute the estate of the deceased person without having to go to probate court. A will, by contrast, typically must receive Court approval and distribution of the assets occurs only after going through probate court and getting orders from the Court. The probate process of a will is expensive, time consuming, and is part of the public record.
When establishing a revocable trust you will be outlining your assets and who will receive those assets upon your death. You will also outline certain conditions that may be placed on your assets. For example, you may state that your children will receive an equal share of your estate upon your death and the death of your spouse but your children shall not receive a distribution if they have a drug or alcohol addiction or if they have a creditor who would cease the funds. The trust may also restrict distributions to minor children so that they don’t receive a large inheritance when they are 18.
One of the most significant decisions you will make when you establish your Trust is who will be the Trustee of your Trust upon your death. In most situations, you will be the trustee during your lifetime and if you have a spouse your spouse will be trustee if they survive you. However, you will need to select a successor Trustee of your Trust who will manage your estate following your death (and the death of your spouse, as applicable). This successor Trustee may be a family member, friend, bank or trust company, or an attorney or other professional. When determining who should be your Trustee, you should consider the following issues and factors.
- What Will the Trustee Do? The Trustee will need to undertake the following tasks.
- Typically will make funeral and burial arrangements along with family members (generally the Trust pays for these things).
- Inform family members and heirs of the estate plans of the deceased.
- Will pay off creditors and hire professional as needed to assist with the estate (accountants, attorneys, real estate agents, etc.).
- Determine assets. They will need to know the assets of the deceased in order to ensure that they are distributed to the heirs/beneficiaries of the Trust.
- Organize assets for distribution. This may include listing and selling real property. It will likely include coordinating the distribution of bank accounts and insurance policies. It will also include organizing and distributing personal effects (e.g. jewelry, furniture, art, personal effects). And finally, it may include the winding down, sell, or transfer of businesses.
- Size of the Estate. Most Trusts will list a family member as the Trustee of the estate and for estates of a couple million dollars or less this is generally a good fit. However, for estates over $3M you may want to consider listing a professional (attorney or law firm) as the successor trustee of your estate and for estates over $10M you may want to consider listing a trust company or bank as the trustee of your estate. Large estates can overwhelm a family member who has never handled such matters before and having a professional with experience can go a long way. The Trust will need to pay for these services (generally in the tens of thousands of dollars) so it isn’t typically advisable for smaller estates unless there is no other adequate family member of friend available.
- When to List Non-Family? If you have heirs/beneficiaries who are likely to disagree and cause contention, you may want to list a non-family member or a friend as the Trustee so that a third party can make decisions and so that you can avoid potential contention and litigation over your estate.
- Financial Expertise of the Trustee. If you are selecting a family member, choose one who has shown good financial skills over their life. If you’re selecting a child over another, consider their financial expertise, work background, location, and family dynamics in selecting one child as Trustee over another. Also, choose someone who is well organized and who is task oriented. The Trustee will have many things to accomplish and you want someone who will take care and responsibility for these things.
- Family Dynamics. All families are different and all situations are unique. As a result, you may select a brother or sister as your successor Trustee instead of choosing a child or other family member. This may be because your children are younger or because a sibling is better equipped to handle the administration of your estate.
- Trustee Compensation. If you are listing a family member as Trustee, they typically will serve without compensation but will be reimbursed for any expenses they incur while serving as Trustee. You may compensate them or give them something extra from the estate for taking on the responsibility but generally family members are listed to serve without compensation.
- Can an Heir/Beneficiary be a Trustee? Yes, you may have a beneficiary/heir serve as Trustee and this is very common. In fact, most persons who have adult children will list a child as the successor Trustee and this person will also typically be a beneficiary/heir. While there is some conflict of interest in this arrangement, the Trustee is bound to the terms of the Trust and can’t abuse that discretion for their own personal benefit.
- Should I Appoint Co-Trustees? Some persons will consider listing co-beneficiaries as successor Trustees. Typically, this is done as a way to involve more than one family member in the distribution of the estate so that one person doesn’t feel left out. While there can be some benefits to involving another person as Trustee (e.g. sharing the workload, combining skills of persons listed) it can cause contention and confusion as to who is doing what so be specific about their authority and responsibility if you are listing multiple trustee.
- Who is Most Commonly Listed as Trustee? Most persons with adult children will list one of their children as successor Trustee. Most persons with younger children will list a sibling or close friend as their successor Trustee.
Your Trustee has an important and critical task in managing your estate following your death. Choose wisely as they will need to make critical decisions that will effect your loved ones.