Can I Use A 457 Retirement Plan To Buy A Business?

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If you have worked for a government agency or a municipality then you may have built up a significant 457 retirement plan.  At some point toward the end of your career in the government, you may be thinking about using the funds inside your 457 plan to buy a business.

There are many considerations to address before you withdraw some or all of your retirement account to purchase a business.  First, know that it is possible to use the funds without incurring taxes right away; but you need to be aware of new regulations which must be met in order to stay compliant with the IRS.  You are welcome to contact Fred in order to start the process.

You are encouraged to read more of the articles on this website and learn more about the ERPA program regarding how it can benefit you.  You also need to know what your obligations are to stay compliant so that you do not incur any penalties or have an unexpected tax obligation because you forgot to take certain steps.

Here is an article by Monty Walker (with permission) which goes into much more detail about any retirement plan, including a 457 plan, to be used in the purchase of a business.  Again, call Fred to discuss your specific situation.

The IRS and Retirement Plans used as a Source of Business Capital

By Monty W. Walker CPA, CGMA, CBI

On October 1, 2008, with the issuance of a Director Memorandum to its field agents, the Internal Revenue Service “IRS”, for the very first time, addressed the use of retirement funds being used as a business capitalization source.  In the Director Memorandum the IRS identifies the use of retirement money as a business capitalization source as an arrangement known as Rollover as Business Startups or more shortly referred to with the acronym of “ROBS”. If the acronym is an indicator of the IRS’s opinion, it certainly appears that the IRS is signaling that it is hostile toward the innovative application available under existing retirement plan regulations.

The IRS does allow for recognition that a plan which invests in a Plan Sponsor structurally is a qualified plan.  There is nothing inherently wrong with a plan document that allows a plan to invest in the Plan Sponsor, assuming the document is properly drafted, or the actual purchase of stock in the Plan Sponsor.

The IRS says, “Even though these transactions would otherwise serve legitimate tax and business planning needs, they are questionable.”  The IRS goes further to explain that “these transactions may serve solely to enable an individual’s exchange of tax-deferred assets for currently available funds” because “by using a qualified plan and its investment in employer stock as a medium, an individual is able to gain access to tax-deferred retirement funds while preserving the tax deferral and not incurring a penalty.”

The author of the memorandum, Michael D. Julianelle, Director of Employee Plans, essentially sets forth that since the form of the plan and related transaction is not necessarily “non-compliant per se”, the IRS shall focus on identifying operational or administrative defects to cause these plans to be disqualified or for penalty assessments to be applied.

The IRS has examined a number of plans involving the purchase of employer stock.  The examinations generally started with a tax return review.  The IRS states that significant disqualifying defects have been found in most of the plans reviewed.  Examples of defects provided in the memo are:

1)      Employees in some arrangements were not notified of the existence of the plan, did not enter the plan or receive contributions or allocable shares of employer stock.

2)      Plan assets are either not valued or are valued with threadbare appraisals.

3)      Required annual reports for some plans were not filed.

4)      The business was not successful and failed

5)      Some cases involved funds being used for non-business personal purposes such as the purchase of recreational vehicles.

Note: Regarding item 5, the IRS does further to state that in many, if not most of the transactions, the funds were in fact used to purchase legitimate businesses or franchises, plus appropriate start-up costs.

Despite the IRS’s statement that significant disqualifying defects have been found in most plans which have been reviewed, the memo discusses only minor or arguable operational defects in some plans.

So what is the IRS’s biggest concern?  It is obviously not the legitimacy of the plan structure because the regulations enable the structure to exist.  It is obviously not the transaction of acquiring employer stock because the regulations enable this transaction to occur.  At least it is an assumption that these items are not the problem because the memo itself identifies these components as being compliant.

Can it be that IRS feels this innovative way of accessing tax-deferred retirement funds while preserving the tax-deferral and not incurring a penalty is being utilized in such a way as to provide benefits to Entrepreneurs which extends beyond the spirit of the regulations?

Does the IRS dislike that fact that the regulations allow for retirement plans to invest in employer stock?

Can it be that the IRS just plain dislikes innovative planning?

OR

Can it be that some individuals are 1) Using this structure to capitalize a business and then not operating the plan as a true retirement plan, 2) Not informing employees about the existence of the plan so they do not have to incur a cost for their participation, 3) Running the business for their personal benefit and ignoring the fact that the plan is an investor, 4) Excessively compensating themselves leaving the plan to receive no investment benefit, 5) Etc…?   In other words, some individuals are abusing an otherwise legitimate planning solution.

As with any planning solution involving a tax component, some individuals choose to abuse the process and these individuals do deserve to be sanctioned.  The problem is that the actions of a few often impact the majority.

In addition to the defects previously listed, the IRS is looking for the following during an examination:

1)      Permanence: Does the plan receive any form of ongoing contribution?

2)      Exclusive Benefit: The plan must be operated for the benefit of employees and beneficiaries.  Thus, as long as the funds from the plan used to capitalize the business are not used for personal purposes and the plan is in fact operated to benefit to business’s employees and beneficiaries, then the exclusive benefit requirement should not be a problem.

3)      Benefits, Rights and Features Discrimination: The IRS has not specifically found that these plans typically discriminate against rank and file employees in coverage or contributions.  So the IRS instead is looking at whether the plan is discriminating in favor of “Highly-Compensated Employees”.  The key issue to be reviewed here is the method by which the employer stock was offered and sold to the plan.

4)      Prohibited Transactions: The IRS will be looking at the employer stock transaction and whether the plan paid “Adequate Consideration”. This is where a valuation by an independent qualified business valuator is extremely important to support that the Plan did in fact not overpay for its employer stock investment.  The way Plan Implementation Fees were paid will be reviewed.  The issue with the fees is to see if plan assets were indirectly used to pay the fees.

Overall it really looks like Michael D. Julianelle, the memorandums author, appears to just plain not like the fact that Entrepreneurs can use this legitimate plan design to allow a plan to serve as a business capitalization source.

It is not possible to make a blanket policy to disqualify these types of plans because retirement plans are in fact allowed to invest in employer stock.  So the IRS is left to review plans on a “case by case” basis to try and identify disqualifying or penalty based defects.

The memorandum really highlights a big issue which is generally true for retirement plans, compliance is not about being compliant when a plan is formed because being compliant at the start is the easy part.

Compliance is about how the plan has been managed and administered over a period of time especially in the case of these types of plans.  Time will be the best indicator as to whether the Entrepreneur established the plan to be a real retirement plan or whether the plan was established solely to benefit the Entrepreneur.

Individuals who self-deal and are abusive expose themselves to the long arm of the IRS.

On the other hand, individuals who are compliant will not fall when scrutinized by the IRS.

In the end, Retirement Plans which are properly designed, properly implemented, and properly administered should be able to withstand any scrutiny brought against them.

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