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folks,

fellow referred me over here; i'm a first time caller.

as background, i own an S corp where i'm the only employee, and am curious about the ability to treat employee elective 401(k) contributions as Roth IRA equivalents.

the following is the text of an email i sent recently, slightly edited.

not looking for legal advice, mind you; just looking for the catch in what seems like a natural strategy for attempting to game the system.

and before you ask: yes, i would indeed be willing to do 300 hours of paperwork per year in order to save $0.50, thank you very much.

trp

-------------


Can Trepanne Capital Management set up a Single-Participant 401(k), put Mrs. Trepanne & I both on the payroll, make zero employer contributions,allow each of Mrs. Trepanne and I to make elective contributions of $15,000 apiece, allow each of us to immediately borrow back half the money
contributed...

lather/rinse/repeat every year from 2006-2009, repay all the money
($30,000 apiece) at the end of 2009, and then roll the whole shebang
over into Roth IRAs?

So that, effectively:
1) we forgo a tax deduction we don't need right now while our earned income is relatively low (or can be caused to be so), and federal taxes are at historically favorable rates
2) we gain the right to make extra-large contributions that will wind up in Roth IRAs
3) we don't even lose use of half the liquidity in the meantime, except for a brief period of time while the combined contribution/reborrowing transactions are being processed


Somehow this sounds a little too good to be true.

What do you think?
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Hello trep:

Everything in your scenario works; except the middle part about loaning back 1/2 the money to yourselves. IRC §4975 effectively prohibits plan loans to owner-employees by considering you & your spouse as "disqualified persons".

TheBadger
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Can Trepanne Capital Management set up a Single-Participant 401(k), put Mrs. Trepanne & I both on the payroll, make zero employer contributions,allow each of Mrs. Trepanne and I to make elective contributions of $15,000 apiece, allow each of us to immediately borrow back half the money
contributed...


In addition to Badger's comment about the loans, let's make sure the Mrs. is actually working for the corporation doing something worth the salary. Otherwise her participation smacks of fraud.

You don't mention it, but I assume that you understand that you and the Mrs. will owe full income and employment taxes on the salaries, in addition to the corp's payroll tax liability.

Phil
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badger,

Everything in your scenario works; except the middle part about loaning back 1/2 the money to yourselves. IRC §4975 effectively prohibits plan loans to owner-employees by considering you & your spouse as "disqualified persons".

thank you for pointing me in the right direction.

if you please, have a look at IRC §4975(d)(1)

http://www.fourmilab.ch/ustax/www/t26-D-43-4975.html

(d)
Exemptions
The prohibitions provided in subsection (c) shall not apply to -
(1)any loan made by the plan to a disqualified person who is a participant or beneficiary of the plan if such loan -
(A)is available to all such participants or beneficiaries on a reasonably equivalent basis,
(B)is not made available to highly compensated employees (within the meaning of section 414(q)) in an amount greater than the amount made available to other employees,
(C)is made in accordance with specific provisions regarding such loans set forth in the plan,
(D)bears a reasonable rate of interest, and
(E)is adequately secured;


so it would seem that, if the loan were interest-bearing and adequately secured by plan assets, and provision were made for such in the plan documents, then the plan could indeed extend loans to disqualified persons without such transaction being classified as a "prohibited transaction".

pmarti,

In addition to Badger's comment about the loans, let's make sure the Mrs. is actually working for the corporation doing something worth the salary. Otherwise her participation smacks of fraud.

hoss, you are now cottoning on to a key element of the plan - tax advantages are just a fringe benefit. "honey, i'm so very sorry, but the tax man INSISTS that you have to keep all the books instead of me, or we're going to lose our roth eligibility"....

i married an accountant. mama trepanne didn't raise no fools.

i guaran-damn-tee you my company generates enough bookkeeping to justify $15,000 in wages - especially if we cobble up a 401(k) plan that's loaning money back to ourselves...

You don't mention it, but I assume that you understand that you and the Mrs. will owe full income and employment taxes on the salaries, in addition to the corp's payroll tax liability.

all too painfully aware, my friend; i cut those checks every quarter.

the income taxes are a wash, since it either runs through a W-2 or a schedule K, and gets taxed at the same rate either way (i think). the extra load comes from FICA & FUTA and all that fun stuff.

still, though, it seems like a decent idea to eat these costs up front on a one-time basis (and remember, we're just talking about the load on $15K extra salary) in order to enjoy tax-free compounding for the rest of our lives.

trp
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Greetings, trepanne, I am following your logic with intrigue but need help in understanding why you would wish to borrow back half the contributions between 2006 and 2009? What goal do you reach by doing so that isn't reached by leaving the proceeds alone in their intended investments (mutual funds, perhaps)?

xraymd
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Greetings, trepanne, I am following your logic with intrigue but need help in understanding why you would wish to borrow back half the contributions between 2006 and 2009? What goal do you reach by doing so that isn't reached by leaving the proceeds alone in their intended investments (mutual funds, perhaps)?

xraymd,

it's not entirely clear to me why the intended purpose of the funds would have any bearing on the propriety of these transactions.

but if you're simply satisfying your curiosity, well, consider it a form of cash management. the ideal situation would be to accrue maximum tax benefits without consuming any cash whatsoever. then, when you have surplus liquidity, you can call in the tax benefit that you have accrued.

in my situation, i have recently started up a business that is growing. it should generate much higher income in the future than in the present. presently, i need liquidity in order to invest in the business while continuing to fund our extravagant lifestyle.

i have other sources to make the contributions; i would prefer simply to move assets from our taxable accounts into roth IRAs. however, the timing isn't right. first, my cash-management plans depend on using the current income from those assets in order to fund our personal expenses. second, selling those assets & redeploying them into a tax-advantaged accounts would involve paying capital gains taxes.

it would be an advantage if i could start squirrelling away these tax benefits right now while still clutching the cash tightly in my greedy little fists, and then execute the cash flows later, funded either from business income or from the sale of assets at a time that is more convenient to me.

make sense?

if not, well, chalk it up to my being a congenital scofflaw.

i reckon that figuring out methods of abusing IRS regulations to the very limit of what might even possibly survive audit has GOT to have some sort of intrinsic goodness - just good clean american fun - whether or not it has any practical application.

trp
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Greetings, trepanne, I have something of the scofflaw in myself and was just wondering what you'd come up with that perhaps I had not thought of! I think that if you had need of the proceeds, say, for investing in the business, then it makes complete sense to figure out how to access them to your own maximum tax advantage. What I had not envisioned (I just did not imagine it) is that you would indeed have a definite use for the money and you have given me something to think about. I am presently a salaried employee and not a small-business owner so sometimes I still do only think inside the box. But I also LOVE to hear about clever, legitimate, workable financial strategies that others divine. Thanks! I will also be posting a question to the board about what a crossover point might be at which the traditional 401(k) has more (or fewer) advantages than does the Roth 401(k).

xraymd
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Hello trp:

You almost got it but not quite. The IRC giveth & the IRC taketh away; as follows:

1. §4975(a), (b) & (c) particularly (c)(1)(B) make the loan between the plan and you (or your spouse) a prohibited transaction.

2. §4975(d)(1) seems to (or temporarily) bring back the loan ability as long as the loan environment is level for all participants in the plan.

3. However, §4975(d)starts with "except as provided in (f)(6)" which is the "taketh away" part and says "shall not apply to a transaction which...(i) lends...to...any such owner-employee..."

Admittedly confusing as this is an "out-in-out" section of the IRC. Bottom line, you may not, under any circumstances, make a loan to yourself from the plan.


TheBadger

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badger,

drat!

i was using an outdated version of the code (that swiss link), because the HTML formatting makes it so much easier to parse. apparently these restrictions were inserted more recently, in order to thwart manipulations by unscrupulous operators such as myself.

getting it from the horse's mouth:

http://uscode.house.gov/download/pls/26C43.txt

i see exactly the language that you quote.

darn it. that means all my tax benefits will have to have real economic substance behind them.

curses! foiled again!

[3rd-person voiceover] at a young and impressionable age, the boy whom the world would later know as "trepanne" saw his father gunned down by an alternative minimum tax; upon settling the estate, the gummint confiscated most of what few assets he had accumulated during his tragically brief life. for years afterward, trepanne's mother toiled to raise him while struggling under the burden of having an unjust revenuer refuse to qualify her substitute payments in lieu of dividends for the reduced tax rates.

as he matured and his powers grew, this seed of rancor, planted in an innocent dewy hypothalamus, soon blossomed into a florid and twisted hatred that he unleashed recklessly against an unprepared treasury.

<low camera angle, pointing upward at trepanne striking dramatic pose and shaking fist> you haven't heard the last out of me, uncle sam!

thanks badger. it is much appreciated. i just KNEW it couldn't be that easy.

trp
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badger,

all right; here's a return volley in the giveth-ing and taketh-ing away:

1. §4975(a), (b) & (c) particularly (c)(1)(B) make the loan between the plan and you (or your spouse) a prohibited transaction.

2. §4975(d)(1) seems to (or temporarily) bring back the loan ability as long as the loan environment is level for all participants in the plan.

3. However, §4975(d)starts with "except as provided in (f)(6)" which is the "taketh away" part and says "shall not apply to a transaction which...(i) lends...to...any such owner-employee..."


drilling down further into §4975 (f)(6), it seems that the language from subparagraph A that you quote in your point 3 is a general rule.

however, subparagraph (B) introduces a special rule covering shareholder-employees, which would seem to govern this situation.

clause (iii) of subparagraph (B) deals with loans by the plan to shareholder-employees. this clause specifically exempts shareholder-employees from the definition of "owner-employee" used in subparagraph A.

subparagraph (c) goes on to elaborate upon the definition of "shareholder-employee":
For purposes of subparagraph (B), the term
"shareholder-employee" means an employee or officer of an S
corporation who owns (or is considered as owning within the
meaning of section 318(a)(1)) more than 5 percent of the
outstanding stock of the corporation on any day during the
taxable year of such corporation.


thus it would seem that officers of S corporation who own more than 5% of the stock - and that would be me - are shareholder-employees, and therefore NOT owner-employees. as such, they qualify for the exemption in §4975(d), and they may conduct "prohibited transactions" with the plan without suffering onerous tax consequences.

am i missing something in there?

trp
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a follow-up on this thread:

i consulted counsel, who assured me that officers of S corps who own more than 5% of the stock can indeed take out loans from the company 401(k) plan without getting totally screwed to the wall.

thanks to thebadger & others for the discussion.

i think the logical next step is to take a loan out of the roth subaccount, and cause the plan to charge you sky-high interest... say 20%. that would effectively increase the size of your annual roth contribution by up to two-thirds.

any problems with THAT?

trp
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