- Tom Thompson, Finance and Strategy Specialist -

Working with a client through Chase Bank recently, I was introduced to a unique method for the client to use their 401K to assist with the business purchase price.

The process is called a Business Owners Retirement Savings Account (BORSA), and it works by taking your existing plan proceeds and setting up a new 401K retirement account that purchases stock in the business being purchased. This stock is then invested in the new company 401K retirement account BORSA, helping fund the business purchase/setup.

The basic mechanics are illustrated below:

This method came about because entrepreneurs were raiding their retirement accounts to start new business ventures. Unfortunately, by doing this, they were paying an early withdrawal penalty of 10%, and additional taxes on the distribution…thereby losing value in their retirement savings.

Other new business owners were taking loans against their employer 401K accounts. There are however, strict rules as to amounts available to borrow, coupled with 60 day repayment time frames once you have left your employer, (to start your new venture), making this an almost insurmountable task.

Many clients also incorrectly thought they could borrow against the value of their retirement accounts using them as collateral through a bank or lending institution. 

Under the laws of the Employee Retirement Income Security Act (ERISA), doing so would be considered a distribution, and taxes and penalties apply.

Regarding the distribution of your old 401K to fund the new business structure, the new structure must be a C Corporation entity. The new company is creating a new retirement fund in which the new 401K is purchasing stock and rolling it into the new retirement account. IRS rules describe interest and penalties for early withdrawal which is bypassed by purchasing and investing in qualified securities, (company stock).  LLPs, LLCs, and Sole Proprietor business ownership structures do not issue stock. S Corporations, in order to retain its flow through provisions to the taxpayer, can only be owned by an individual or a qualified Subchapter S trust. Since a 401K retirement fund is not an individual or qualified Subchapter S trust, it cannot own stock.

The final consideration when using your 401K to purchase a business is that your employees would also be investing in the same fund you created.  It is not a very liquid method if you wish to get out of the business quickly. Annual filing requirements and charges apply just like any other retirement fund.

A MI-SBTDC client from the Flint-area, Ron Veenhuis, of 1-800 Water Damage of Mid-Michigan, contacted his counselor, Harry Blecker, from Kettering University about using this financing method. He noted to Harry that “he thought it was the only way to finance his business….I don’t have enough liquid cash from existing sources.” Ron went on to note that “I was constantly looking at my 401K statement on a quarterly basis with dread…sometimes up and often down. I believed that I should invest in myself…instead of the stock market”.

Ron did some due diligence on how to do this and discovered that a number of companies in the U.S. specialize in managing this service/product. He contacted one, Tenet Financial Group (one of several similar firms in the U.S.), who walked him through the process. This analysis led Ron to conclude that he would much rather spend about 5% of his pension’s value on upfront fees and nominal monthly fees rather than the 30% or so (for taxes and penalty) he would have to pay if he took a simple draw of his pension.

Having made this decision, Ron was able to obtain enough financing to pay for his franchising fee, equipment costs, office setup and other items. He paid Tenet their fees and has to pay them a reasonable monthly charge. In exchange for this, Tenet set up the new C Corporation, manages the new 401K program, files the required tax forms, prepares the Corporate Records Book, and other items.

Ron knows this financing mechanism still involves plenty of risk. Critically, he must make his business profitable to rebuild his initial pension, but as Ron’s wife noted to him “that while I was initially scared of the plan, I have now warmed to it.”

Overall, it is an interesting concept that is perfectly legal under federal and state guidelines, and can be structured in just a few short weeks for a few thousand dollars.  In some business funding situations, it could be worth the effort to ask your bank or lender if they participate in any such programs to help fund your lending needs.

The MI-SBTDC believes that any kind of financing carries its own risks and opportunities.  Consult with a CPA or attorney before taking any of these actions.  This method is another one that must be judged on its own merits, with appropriate due diligence.