BACKGROUND: We recently received a few questions from someone interested in our Selfstarter plan. As we often receive similar questions, we wanted to share our response here.
After reading thru your website, I want to confirm some information.
In the section where it talks about 401K small business financing, it explains that 401K funds can be used as startup capital for new business.
I understand it is not a loan or a distribution from the 401K.
My question is this:
QUESTION 1: Since 401K is funding the business, do all business profits go to the 401K, or can business owner (me) use the profits from the business for personal use? I am under impression that all profits go back into 401K. But it does say that I can draw a reasonable salary from the 401k owned business.
QUESTION 2: In that case, would I be able to use the salary for personal use, like any other salary? I assume the salary would be treated as ordinary income, subject to all applicable taxes.
QUESTION 3: What defines a reasonable salary?
ANSWERS: Referred by the IRS as rollover as business startup (ROBS) and by others in the industry as 401k business financing, if you elect to fund your business via the ROBS arrangement, your 401k will ultimately own shares in a C-Corporation (which corporation will operate your business). Besides your 401k there will need to be at least one other owner of the C-Corporation. The other owner can be you. Typically, all owners of the Corporation will own shares with equal rights to profits. For example, your 401k may own 95% of the Corporation and you may own 5%. While the Corporation may elect to retain profits (e.g., to invest in the business), in the event that the Corporation distributes profits to its shareholders the 401k would receive 95% of the distributed profits and you would receive 5% of the distributed profits. While you would be free to use the portion of the profits that are distributed to you as a shareholder for personal use, you would not be able to use for personal use any portion of the distributed profits that are distributed to your 401k or the profits that the Corporation has elected to retain.
If you elect to rollover your retirement funds into your own business via the 401k business financing arrangement, you will need to be an employee of the business. As an employee of the business you may draw a reasonable salary provided that the business is generating operating income to justify the salary. For instance, if you are looking to start a new business, you should not take a salary on Day 1 as the business will presumably not have operating income on the first day. While whether a particular salary is reasonable will depend on the particular facts and circumstances, you should be guided by the operating income limitation that I just described as well as what is considered a reasonable salary for a comparable position in the market generally. You will be free to use your reasonable salary for personal use.
While the tax treatment of your salary is ultimately a question for your accountant or other personal tax adviser, any salary you draw will typically be taxed as ordinary income.