A Rollover 401k Plan is a 401(k) Profit Sharing Plan with special enabling language allowing it to invest plan funds in a corporation which sponsors the plan for its employees. Other than this special enabling language, a Rollover 401k Plan looks and operates just like an ordinary 401(k) Profit Sharing Plan which has been adopted by thousands of small businesses.
Almost any active business that is a “C Corporation” can adopt a 401k Plan. The only restriction is that the business must not be a “passive” investment-only business. In technical terms, the business must be an “operating company” An “operating company” is an entity that is primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital.
The investment of retirement plan funds in stock of the corporation that sponsors the plan is possible only because of a special exemption from the so-called “prohibited transaction” rules of the Internal Revenue Code and ERISA. Under the law, this special exemption does not apply to plans established by LLCs, S Corporations, Partnerships of any kind, or any “pass through” type of business entity.
A C Corporation is a corporate entity formed under state law and is a completely separate tax and legal entity from its owners. Owners who work in the business are treated and taxed as employees of the corporation. The “C” in C Corporation refers to a subchapter of the tax code; C-corporations are one of the most common forms of corporations, and they are frequently referred to generically as “regular” corporations. Once a regular corporation is formed, you don’t have to do anything more to be considered a C Corporation – it’s the “default” status.
C Corporations are subject to corporate income taxes separate from the owners, whereas most other forms of business entity (LLCs, Subchapter S Corporations, LLPs, partnerships and sole proprietorships) allow for the business profits to “pass-through” to the personal income tax statements of the owners. As such, C Corporations are the most formal business entity and they have greater tax reporting responsibilities than other business entities. C Corporations allow for profits to be retained in the business, if desired, and frequently these profits can be taxed at a lower rate than personal income. C Corporations can also pay out after tax profits to its owners in the form of dividends, but this can also lead to double taxation.
There can also be a double taxation issue if your business will hold property, such as real estate, that’s likely to increase in value. That’s because C corporations and their shareholders are subject to a double tax (both the corporation and the shareholders are taxed) on the increased value of the property when the property is sold or the corporation is liquidated. By contrast, owners of pass-through entities avoid this double taxation because the business’s tax liabilities are passed through to them; these entities do not pay taxes on their income.
Absolutely! In fact, in many cases, the “two taxpayers” environment of a C Corporation can be advantageous. Under the federal tax code’s “progressive” tax rate structure, it is better to allocate taxable income among different taxpayers. For individuals, the nominal rates go from 10% to 15%, 25%, 28%, 33% and 35% with actual effective rates much higher due to the phasing out of so many tax breaks as income increases. With an S corp. (or any pass-through entity), all of the corporation’s income flows right onto the 1040 returns of the shareholders, pushing them up into higher tax brackets. A C corporation has its own progressive tax rate structure, ranging from 15% on the first $50,000 of net income, to as much as 39.6%. One way to manage the double tax structure to your benefit is to look at the overall tax picture for individuals and their companies by smoothing income over the personal (1040) and corporate (1120) tax returns.
Even in a situation where the C Corporation holds appreciating property, the potential double taxation on sale or liquidation can be managed by careful attention to such property holdings and, in most cases, by timely conversion to an S Corporation in advance of an “exit” transaction.
Yes. When you form a corporation, and don’t affirmatively elect “S Corporation” status you will be both a shareholder (owner) and a true “common law” employee. For most fringe benefit purposes, you are considered a true employee (just like non-owner employees) only in a C Corporation. The corporation can, for example, hire you to serve as its chief executive officer, pay you a tax-deductible salary, and provide fringe benefits as well. These benefits can include the payment of health insurance premiums and direct reimbursement of medical expenses. The corporation can deduct the cost of these benefits and they are not treated as taxable income to the employees, which can be an attractive feature of doing business through a C corporation. With an LLC, you can only deduct a portion of medical insurance premium payments, and other fringe benefits provided to members do not receive as favorable tax treatment. More than 2% shareholders in an S Corporation are similarly disadvantaged.
No, you can make a partial investment from any money you have in qualified retirement funds.
Yes, this is your company’s 401(k) plan and you are the Trustee of this new plan. As such, you are required to maintain accurate plan records.
There are two ways that a business can sell. The first is by transfer of STOCK and the second is by transfer of ASSETS.
A client that employs the 401k Rollover can sell their business by simply selling the stock of the C-Corporation to a new owner. In many circumstances, the 401k Plan owns a significant portion of the C-Corporation’s outstanding stock. When a Corporation sells its stock, the sales proceeds are apportioned to the shareholders. If one of those shareholders happens to be a 401k Plan, then that portion of the sales price goes to the 401k Plan on a tax-deferred basis. This can be a very tax-efficient way to sell a business if buyer and seller agree on using this strategy.
A client that employs the 401k Rollover can sell their business through an Asset Sale. If this approach is used, a client will likely need to redeem all shares originally issued to the 401k Plan. This redemption process can be completed over a number of years given that the annual stock valuation will determine the per-share price of the company stock. When the redemption has been completed, the client can convert their C-Corporation to an S-Corporation.
Once converted, the S-Corporation can sell its assets (furniture, fixtures, equipment, client list, etc.) to the new owner and will incur one layer of tax (Capital Gains Tax) for doing so. Currently, the Capital Gains Tax is 15% and the client will be subject to this tax for the portion of the sales price, which is greater than the step-up in basis that it incurred on the date of conversion from a C-Corporation to an S-Corporation.
As is the case in many tax-related issues, there’s rarely a simple answer to most issues, regardless of the sales methodology. Consult with your advisors.