This article originally appeared on Forbes.com –
The subject of business taxes was a popular theme during President-elect Trump’s election campaign and will surely become a hot topic during his first year as president. President-elect Trump has stated that he favors a 15% corporate rate as part of his tax plan as well as eliminate the corporate alternative minimum tax. This rate would be available to all businesses, both small and large, that want to retain the profits within the business.
When it comes to using retirement funds to invest in a business involving the retirement account holder or any of his or her lineal descendants (“disqualified persons”) there is generally only one legal way to do it and it involves the purchase of “C” corporation stock (qualifying employer securities) by a 401(k) qualified retirement plan. The structure is known as a “rollover business start-up” or “ROBS”.
The Internal revenue Code explicitly permits the purchase of corporate stock by a 401(k) qualified plan. Nevertheless, the ROBS structure remains somewhat controversial. Although the Internal Revenue Service (“IRS”) has repeatedly confirmed its legality, it continues to be on the radar of the IRS and Department of Labor (DOL) due to a lack of compliance in some cases.
The ROBS arrangement typically involves rolling over a pre-tax IRA or 401(k) plan account into a newly established 401(k) plan, which is sponsored by a “C” corporation and then investing the rollover funds in the stock of the “C” corporation. The individual retirement account holder can then earn a reasonable salary as an employee of the business.
The advantage of the ROBS solution is that it does allow one to use all their pre-tax IRA or 401(k) funds to buy a business that they will be involved in personally as an employee without tax or penalty.
The primary downside of the ROBS structure is the use of a C corporation as the business entity, an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs. Corporations are known to have double tax, first, when the company makes a profit, and then to the shareholder on their personal return when dividends are paid. The highest corporate income tax rate is currently at 35%. A sole proprietorship, LLC, or “S” Corporation is treated as a pass-through entity for tax purposes. In other words, a “C” Corporation would impose two taxes on corporate earnings: a corporate level tax and a shareholder tax on the dividends received.
In comparison, for a pass-through entity, such as an LLC, the profits bypass taxation at the corporate level and are distributed and taxed at the owner’s level. For example, assuming a corporate and personal income tax rate of 25%, a C Corporation earning $100 would be subject to a tax of 25% ($25) at the corporate level and then the individual shareholder would be subject to a tax of $18.75 on the dividend received ($75 dividend multiplied by a 25% tax rate) for an overall tax of $43.75. In the case of an LLC, there would be no corporate tax rate and the individual member would be required to pay just $25 in taxes ($100 of allocated profits multiplied by a tax rate of 25%). Therefore, clearly the use of a C Corporation has been a big reason why many individuals have walked away from using a ROBS solution to buy a business with retirement funds and have instead opted for a taxable distribution. However, that may all change in 2017 and beyond.
A reduction in the corporate tax rate to 15% as President-elect Trump has promised would certainly make C Corporations a more attractive form of doing business from a tax standpoint than before and should make the ROBS solution a far more attractive option for people looking to use retirement funds to buy a business in 2017 and beyond.
For more information about using your retirement funds to start a business, please contact us @ 8900.472.0646.