When it comes to using IRA or retirement funds to start to finance a business, there are a number of IRS and Internal Revenue Code rules that must be reviewed. In general, the IRS allows one to use their retirement funds to invest in a business that they or any disqualified person will not be directly or indirectly involved in. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest. However, the prohibited transaction rules under Internal Revenue Code Section 4975 prohibit an individual to use their IRA funds to invest in a business they will be involved personally. Internal Revenue Code Section 4975(c)(1)(d) outlines that a transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan is treated as a prohibited transaction. Accordingly, an IRA holder is not permitted to transfer IRA funds to a business he or she is personally involved in as that would be treated as a transfer of the income or assets of the IRA to a disqualified person (IRA holder’s personal business).
So how can one use their IRA funds to buy or finance or a business?
There is really once one way to use IRA funds to start a business without tax or penalty. The structure involves the formation of a C Corporation and the adoption of a 401(k) qualified plan. Your existing retirement funds can then be rolled into the newly adopted 401(k) Plan tax-free. The 401(k) Plan will then purchase the stock of the new corporation. The new corporation will then use those funds to purchase a new business or franchise tax-free! The legality of the structure is centered on Internal Revenue Code Section 4975(d)(13). The Internal Revenue Code exempts the purchase of “qualifying employer securities” as a prohibited transaction pursuant to IRS Code Section 4975(d)(13). “Qualifying Employer Securities” is defined as a security issued by an employer of employees by the plan. Under section 407(d)(5) of ERISA, the term “qualifying employer security” includes an employer security, which is stock of a “C” Corporation.
The advantages of using a Business Acquisition solution is that one can use their IRA, 401K, or other retirement funds to buy a business tax and penalty free! For example, if a new business buyer has $150,000 in a 401(k) or IRA account and takes an early distribution, the following taxable events would be triggered: a 20% mandatory hold-back, Federal (and state) income taxes (at higher tax rates) and a 10% early withdrawal penalty. This could easily be a $50,000 tax bite. With the Business Acquisition Solution, a business owner can get the down payment for his new business or help finance an existing business without owing any money to the IRS. Plus, the Business will now have a 401(k) Plan available for its employees to contribute to.