Retirement Funds Financing When Buying or Selling a Business

Executive Summary

Most small transactions are financed using an SBA loan, a bank, or the seller. One additional source of financing to acquire small businesses includes rollovers of retirement funds and seller financing. The buyer can avoid a small-business loan altogether and use their retirement funds to finance the purchase of a business. Because the buyer is buying stock as an investment in their own company, the buyer doesn’t have to take a taxable distribution.

Creative use of financing has allowed us to finance million-dollar transactions with as little as $20,000 cash down. A buyer can invest in a business or franchise through this process by utilizing existing retirement funds without taking a taxable distribution or getting a loan. This arrangement allows an individual to invest up to 100% of their eligible assets to finance their venture debt-free.

Although retirement funds have several advantages to both the buyer and the seller of a business, bank financing should not be discounted. In the absence of other forms of financing, bank financing is critical.

Advantages of financing the purchase of a business

• The buyer can acquire a larger business with higher earnings.
• The seller receives cash at closing, which can increase the buyer’s negotiating leverage with the seller.
• Interest on the debt is tax-deductible.

Read on to see how the process works and why we love this strategy.

Note: This article applies only to small to mid-sized businesses valued at $10 million or less. This source of financing is available only to individuals; companies use alternative sources of financing to finance acquisitions.

Advantages of Using Retirement Funds to Buy a Business

Retirement funds are easy to access. For the buyer, retirement funds can be accessed quickly and with a high success rate, whereas bank financing is often difficult to access. Sellers are more likely to accept an offer that is contingent on a buyer accessing retirement funds to buy a business due to the high success rate. Many offers are contingent on the buyer receiving bank financing to purchase a business. Most sellers are reluctant to accept these offers because of the traditionally high failure rate of obtaining a bank loan to purchase a business.

The seller cashes out at closing. Using retirement funds creates a win-win situation for the buyer and the seller. The buyer can easily access funds to purchase the business, and the seller receives all cash at closing.

Streamlined process. The process of accessing a 401 (k), IRA, or other retirement funds to purchase a business is quick and easy. Contrast this to the process of obtaining a bank loan, such as an SBA 7(a) loan, which is time-consuming for buyer and seller. These strict requirements are not present when one accesses funds from their retirement kitty to purchase a business.

High success rate. Once an initial screening takes place, the likelihood of accessing retirement funds to purchase a business is well above 90%.

Low cost of funds. Using retirement funds to purchase a business can be less expensive than using bank money to purchase a business. Banks charge interest. A buyer can easily pay more than $100,000 in interest on a $500,000 loan over the life of that loan. Contrast this to the use of retirement funds as a source of financing — your retirement funds are your own money, and there is no interest to pay. While there are fees associated with administering a retirement fund, they are likely to be significantly less than the cost of interest charged on a bank loan.

Creative deal structures. The use of retirement funds allows for creative deal structuring. This structure can be combined with other sources of financing, such as traditional or SBA bank loans, without causing complications. Because the retirement funds are treated as your own money, there is no issue with subordination.

Can be used as a down payment. Your retirement funds can be used as a down payment on a business. This can be combined with other forms of financing, such as seller or bank financing. For example, we recently sold a business where the buyer used $100,000 in his retirement funds as a down payment, the bank financed $700,000, and the seller carried a note for $100,000. The deal would have been impossible without access to the buyer’s retirement funds.

No credit score required. Your credit score does not matter when accessing your retirement funds. It is your money. You are not borrowing money from a bank, and therefore, no minimum credit score is required.

Can be used for multiple purposes. The funds, once accessed, can be used for a multitude of purposes, including working capital and purchasing new equipment or other corporate assets.

No debt. Some people seek to avoid debt at all costs. Using your own money, such as your retirement funds, is not creating debt.

Maximizes cash flow. Less interest to pay equates to higher cash flow for the buyer. This can help justify a higher purchase price if cash flow is strained when preparing financial models that incorporate some form of bank financing.

Tax benefits. The use of retirement funds presents many tax benefits for the buyer of a business, including the ability to set aside additional tax-deductible funds post-acquisition.

Requirements and Other Criteria

Applies only to individuals. This source of financing is available only to individuals. Companies must use alternative sources of financing.

Bank financing should not be discounted. This is a valuable form of financing. In the absence of other forms of financing, bank financing is critical.

Costs. If you have less than $50,000 in your retirement funds, it’s often more practical to simply take the distribution and pay the associated taxes and penalties.

Qualifications. While numerous qualifications exist, plans should be fully accessible and should be enabled to roll over into another plan.

Penalties. If done correctly, there are no penalties when using your 401(k) or IRA to buy a business.

How the Process Works

The buyer creates a new entity, typically a C Corporation. The C Corporation creates (not issues) stock. The corporation then forms a profit-sharing plan, and the buyer rolls over the retirement funds into the new retirement account. The funds are then exchanged for the newly issued shares in the new entity. The cash in the corporation can then be used to purchase a business or other corporate assets.

Warning: do not do this alone. Always use the advice of a professional when setting up this type of account. ERISA and IRS penalties apply if you don’t comply with all of the rules.

It is a common misconception that you can only use your retirement plan to purchase investments like publicly traded stocks, bonds, or mutual funds. You are not borrowing against your 401 (k). Rather, you are rolling over your funds from your existing retirement plan to your new retirement plan. Your new retirement plan has simply invested in your business instead of investing in another company’s stocks or bonds.

Why We Love This Strategy

It’s a win-win for both the buyer and seller. There are many benefits for the buyer, including ease of access and low fees. For the seller, it creates a simplified and streamlined process with a high success rate. This means a buyer can make an offer without worrying about the ability to obtain financing.

Frequently Asked Questions

Who can use a rollover plan, and what are the limitations?

Most retirement plans qualify for this type of funding structure. However, Roth IRAs do not qualify and it is important to point out that most employers require termination of employment if you are looking to access funds from the company’s retirement plan.

What can the rolled-over funds be used for?

The rolled-over funds, once they become a corporate asset, can be used for any legitimate business purpose, including the purchase of an existing business.

Is there a minimum amount you can roll over?

There is no set minimum amount. However, we suggest entrepreneurs use a rollover plan only if accessing at least $50,000 from their retirement funds unless there are extenuating circumstances, such as needing the funds to secure additional funding. Other than extenuating circumstances, if an entrepreneur needs to access less than $50,000, it may make sense to withdraw the money and pay whatever taxes/penalties are tied to the transaction.

Do the buyer’s attorneys and accountants need to be involved in the process? If so, how so?

You do not need an attorney or an accountant in order to roll over funds from an existing retirement plan. However, you will need your accountant or CPA to complete the corporation’s fiscal year-end filing.

Are most accountants and attorneys familiar with this type of rollover plan?

Yes and no, and that is the problem. Those who are aware of it typically support it. However, there are those who have no idea it exists. The problem arises when it is dismissed as a prohibited transaction rather than learning about this specific structure. The IRS permits the rollover of funds to qualified plans without taxes or penalties.