Posts in: November

Is a 401K Loan a Viable Option to Fund Your Business?

November 24, 2015 Business planning, Retirement Planning Comments Off on Is a 401K Loan a Viable Option to Fund Your Business?

One of the greatest aspects of the American Dream is starting your own business.  Maybe you are a part-time entrepreneur that has the security of a “9 to 5” career while you transition into full-time self-employment.  Or maybe you are close to retiring and want to start a business that gives your more freedom and control in your gold years.  You might be a full-time entrepreneur.  Regardless of your situation, if you’re like many business owners, raising capital for your business can be challenging.  It can be difficult to get a business loan from your bank.  If you bring on other business partners who may have cash to infuse your business, that can come with a price.   You may decide to enter into the arena of private offerings as a way to raise capital for your business, but that too comes with a price.

If you’re like most Americans, your retirement account is your largest asset and your largest source of capital.  It’s a somewhat unconventional approach to business funding, but I have talked with many business owners who would love to use their retirement account to provide operating capital for their business.  Whether this is a good financial decision is something for you to decide.  You know more than anyone that running a business can be risky and using retirement funds towards your business could drain your retirement account, leaving you without the necessary funds when you retire.  The problem is that many small business owners in America have so much going on that they can only worry about today, much less when they retire.   If you’ve wondered if you can use your retirement account to infuse cash into your business, then keep reading.

One option is to take a distribution from your retirement account and use the distributed amount towards your business.  However, if you’re in a high personal income tax bracket, and depending on your age, the taxes and penalties could be expensive since the amount you take as a distribution is included in your personal gross income.  But if you are over 59 ½ or otherwise qualify to avoid the early withdrawal penalties, and you are in a lower personal income tax bracket, this may be a reasonable option.  Keep in mind that the distributed amount could push you into a higher income tax bracket.  It’s a good idea to run the numbers to be sure.

Don’t worry, I didn’t write an article to tell you to take a distribution from your retirement account.   However, if you don’t take a distribution from your retirement account to fund your business, but you want to nevertheless use retirement funds in this way, one problem you’ll encounter is that your business is a disqualified party to your retirement account, which means the general rule is that you cannot use your retirement account to provide working capital for your business.  However, one notable exception to this rule is the 401k loan.  You can use the 401k loan proceeds for virtually any purpose, including towards your business without triggering a prohibited transaction.

The 401k loan can be a great option for someone whose business is running low on capital.  But before you run out and get a 401k loan, here are 5 things to know before taking out a 401k loan to fund or continue operations of your business:

 

  1. Check your 401k plan documents to make sure your plan allows the 401k loan option. If you have your 401k with an employer, it is quite probable that the plan documents will have limitations on what the 401k loan can be used for.  Therefore, the best vehicle for using the 401k loan in your business is typically going to be the self-directed solo 401k.

 

  1. The maximum amount of the 401k loan is $50,000 or 50% of the 401k account balance, whichever is less. The maximum amount of the 401k loan is $50,000 or 50% of the 401k account balance, whichever is less. For example, if your 401k account balance is $25,000, the most you can take as a 401k loan is $12,500.  If your 401k account balance, is $1,200,000, the most you can take as a 401k loan is $50,000.

 

  1. It must be paid back within 5 years with interest – Payments must be made at least quarterly. Yes, you must pay it back.  Per IRS regulations, the interest rate should be 2% above the prime rate.  Payments must be made at least quarterly and the payments must be in accordance with an amortization schedule where each payment consists of principal and interest, i.e., no interest-only payments with a balloon payment at the end.  We’d all prefer to pay interest to our 401k than to a bank.

 

  1. 401k Loans Are Usually Only Available to Current Employees. In most situations, 401(k)s will require you to be an existing employee of the company in order to take or maintain a 401(k) loan. So, for example, if you have an old employer’s 401(k) then you will typically not be able to take a 401(k) loan from that plan as you are not longer employed there. Also, if you are working for an existing employer and you plan to take a loan and then leave that employer, most 401(k) plans will require re-payment immediately upon termination from employment. Because of both of these situations, a new business owner should rollover their current 401(k) funds a  new solo 401(k) in the new business. They would then take the 401(k) loan from the new self directed solo 401(k) created by the new company.

 

  1. Any amount of your 401k loans that is unpaid when due becomes distributed and taxable to you. If you don’t pay back the 401k loan when it’s due, the outstanding principal amount is distributed and must be included in your personal gross income for that year.

For example, here’s Johnny.  He works full-time for a Fortune 1000 company but he also has a business he started last year.    He needs more capital for his business but his business hasn’t built up corporate credit to get a business loan, even with personal guarantees or personal financing.  He has a 401k from a former employer that he rolled over to an IRA last year.  He decides to set up a self-directed solo 401k that would be adopted by his business and he rolls over his IRA to this solo 401k, which has about $175,000.  He then takes out a 401k loan of $50,000, which he uses for marketing, and to outsource other business operations that he doesn’t have time for right now.  He is hopeful that this will get his business in a better situation and put him one step closer to transitioning out of his full-time corporate job.  As long as Johhny makes his quarterly payments of principal and interest and pays back the $50,000 within five years, he won’t pay any taxes, and who else to pay interest than to his own 401k.  Johnny is one step closer to living the American Dream thanks to the 401k loan.

Remember, the 401k loan option is not for everyone.  But it is one of many benefits and options that come with setting up a self-directed solo 401k.  Our firm can help with setting up a self-directed 401k plan.  Our fees are reasonable, and in fact, we are running a promotion on our solo 401k until November 25th.  If you want to setup a solo 401k and make tax deductible contributions for the 2015 tax year, you’ll have until December 31th to form and adopt your solo 401k.  For more in depth articles on 401k deadlines, contribution limits, etc., please check out our law firm blog as well as www.navbrs.com, www.sdirahandbook.com,  and www.markjkohler.com.

Tips From Your Lawyer on Handling Property Management Companies

November 17, 2015 Business planning, Law Comments Off on Tips From Your Lawyer on Handling Property Management Companies

Most experienced real estate investors decide to use a property management company to handle the leasing and maintenance of their real estate investment. For many of our passive real estate investors, having the right property manager is a key component to generating smooth and profitable passive income from your rentals.   Although most property managers are genuinely knowledgeable and ethical, we have definitely heard instances where the wrong property manager creates nothing but havoc for the real estate investor.

Conducting the proper due diligence on your property manager is one step to ensuring you have the right person taking care of your rental.  In virtually all instances, a property manager should be a licensed real estate agent and should be interviewed to get specific details as to their business practices, which should then be confirmed in a written management agreement.  For example, we believe the right property manager will have established policies and procedures governing aspects of property management which may include, but certainly are not limited to:

WHAT YOUR PROPERTY MANAGER SHOULD BE DOING

  • periodic monitoring and inspections of the property;
  • accounting for rents, expenses and security deposits and regularly reporting the same to the owner;
  • advertising and marketing plans for obtaining the right tenants;
  • procedures for qualifying tenants and background checks;
  • making repairs and correcting adverse conditions on the property;
  • documenting and responding to tenant inquiries, requests and reporting such inquires to the owner; and
  • handling tenant defaults and evictions.

As with any contract, it is important to be as specific as possible with respect to the duties and responsibilities of each of the parties so that the expectations are set from the beginning, and then confirmed in a written agreement.  Moreover, any action you expect the property manager to perform on your behalf should be clearly and specifically set forth in the written management agreement so that the agreement is clear as to the rights and responsibilities of both the owner and the property manager.

For example, if you expect that the property manager will keep you informed about the condition of the property, it may be prudent in your agreement to have the property manager responsible for conducting annual or periodic inspections of the property to document the condition of the property and to report the results to the owner.  Not only could this ward off potential minor defects from becoming major repairs, but it could also be used as evidence of the condition of the property to rebut any contradictory claims from tenants.  Other issues that you may want to consider include:

WHAT YOU SHOULD REQUIRE OF YOUR PROPERTY MANAGER

  • Requiring the manager to report who performs major repairs on the property and how much they charge so that you can confirm that major repairs are performed professionally and to code;
  • Provide monthly or quarterly accounting of the income and expenses with sufficient detail so you know where your money is being spent;
  • Requiring the manager notify you of any defect on the property, or condition either on the property or in the surrounding neighborhood that affects the safety or security of the tenants;
  • Ensuring that property condition reports are completed when appropriate (e.g. upon signing the management agreement, upon a vacancy, move in, or termination of the management agreement);
  • Termination of the property management agreement. Given that a property manager could be a long term service provider for you, what are the appropriate conditions and compensation arrangements when either the owner or property manager wish to terminate the agreement?

Finally, keep in mind that every contact is negotiable.  Contracts are frequently drafted with an eye towards solely protecting the party that requested it to be drafted.   Do not assume that because terms of a contract appear in a standard form, even in a standardized realtor’s form, that those terms are necessarily “written in stone.”    Of course the custom in the industry will be a factor in what will be acceptable in the industry, but keep in mind that it is your responsibility to make sure your expectations are met in any written agreement and remember that in many cases when you get to court, if it does not appear in the contract, it doesn’t exist.

Lee Chen is an attorney at the Irvine, California office of Kyler Kohler Ostermiller, and Sorensen, LLP (“KKOS Lawyers”) and helps clients daily around the country with real estate, contracts, and and litigation. Lee has advised hundreds of real estate investors and professionals. In addition to advising clients in his legal practice, Lee is a real estate investor and a licensed real estate broker. Lee can be reached at lee@kkoslawyers.com or by phone at (888) 801-0010.

The Operating Agreement: An LLC Owners Best Friend

November 10, 2015 Asset Protection, Business planning, Law, Small Business Comments Off on The Operating Agreement: An LLC Owners Best Friend

Perhaps no other innovation is as indicative of America’s particular devotion to (and knack for) creative capitalism as the limited liability company (“LLC”). Born in America’s smallest state (Wyoming) in 1977, the LLC combines the pass-through taxation of a partnership or sole proprietorship with the limited liability protections of a corporation.

This unique combination of liability protection and pass-through taxation explains why the LLC was quickly adopted in all 50 states, and why it is easily America’s most popular corporate form today. In 2012, more than 2.2 million LLCs filed partnership tax returns, and current estimates are that 55% of LLCs are single-member entities that file no tax returns at all, which means that there are probably somewhere in the neighborhood of 5 million LLCs in existence in America today. Approximately 3,000 new LLCs are created each month … in Utah alone (our home-office state and one of the best LLC laws in the country!).

The big mistake!! Another reason why LLCs are so popular is that they are easy to form, however, this can also be their downfall. Unfortunately, there are thousands of entrepreneurs who believe hitting “submit” and receiving back stamped Articles of Organization from the state completes the formation of the LLC.

In most states an LLC can be established by clicking through a government website and paying a filing fee. Technically, that puts the LLC on the ‘radar’ of the State. However, smart business owners and investors know this is really where the formation process begins.

Every LLC, whether it has one member, five members, or 100 members, should have an Operating Agreement and there are several important reasons why.

First, the Operating Agreement establishes the asset protection veil and the ‘formality’ of signing the Operating Agreement and the initial minutes is critical to show a court and a plaintiff that you took the LLC formation seriously.

Second, is the fact that your LLC Operating Agreement is your chance to write the “law” for your LLC. This is why the LLC is such a great choice for partnerships. The Operating Agreement gives partners the ability to delineate roles, rights, and responsibilities for the LLC owners, and to make specific plans for what happens if a partner dies, becomes incapacitated, or gets divorced.

What happens if you don’t have an Operating Agreement? Well, in their wisdom, the various state legislatures have planned for this, and each state LLC statute provides a set of “default rules” for how LLCs are to be governed if and when the LLC owners don’t take the time or effort to make those decisions for themselves.

However, awith most statutory language, these default rules can be difficult to decipher. In addition, the rules can and do change when the LLC statutes are amended, and all 50 states have different rules within the same framework. To boot, sometimes a state’s particular default rules just don’t make sense.

To illustrate, Utah adopted a new LLC statute in 2013. This statute becomes fully operational, applying to all existing and newly-formed LLCs, on January 1, 2016. While I’m sure the legislature and the governor had good intentions in passing the law, it certainly contains some provisions that create surprising outcomes.

For example, the new statute says: “A manager may be removed at any time by the consent of a majority of the members without notice or cause” (U.C.A. §48-3a-407(3)(d)). It does not say “a majority of the ownership” or “a majority of the profits interests.” This means that in an LLC with three owners, where one owner is the manager and owns 90% of the company, and the other two owners each own 5% of the company, the two 5% owners can get together and vote out the 90% owner as manager … as long as the LLC has no Operating Agreement and the statutory default rules apply. If the LLC does have an Operating Agreement, then the provisions of the Operating Agreement trump the default rules from the statute.

The moral of the story is that if you don’t want your LLC to be subject to potentially odd default rules that can be adopted and changed at the whim of state legislators who have never owned or run their own business, then your LLC needs an Operating Agreement and you need to know what that Operating Agreement says.

Do not create an LLC that does not have an Operating Agreement, and if you have already made that mistake, fix it by having one drafted and adopting it retroactively to the date your LLC was established.

Jarom Bergeson is an associate attorney with Kyler Kohler Ostermiller, and Sorensen, LLP (“KKOS Lawyers”) in its Cedar City, Utah office and has extensive experience in helping client register their trademark and protecting their brand identity. He can be reached at jarom@kkoslawyers.com or by phone at (888) 801-0010.

Federal Equity-Based Crowdfunding is Here! (Almost)

November 3, 2015 Business planning, Small Business Comments Off on Federal Equity-Based Crowdfunding is Here! (Almost)

Last week, the Securities Exchange Commission finally adopted regulations to permit equity-based crowdfunding at the federal level.  These regulations will be effective in 6 months.  This is a monumental change in federal policy that many entrepreneurs and business owners have been waiting on for years and will allow small businesses across the country to solicit to the masses AND receive funds from the masses in exchange for equity ownership in their business.  Equity-based crowdfunding at the federal level began as part of Title III of the Jumpstart Our Business Startups (“JOBS”) Act of 2012.  In 2013, the SEC proposed regulations to implement equity-based crowdfunding but it took them almost three years to adopt the regulations.

Earlier this year, the SEC approved and ratified Title IV of the JOBS Act, which implemented Regulation A+.  Some commentators had been referring to this as equity-based crowdfunding at the federal level – that simply was not true.  Other versions or forms of crowdfunding have been utilized for a number of years, including rewards-based crowdfunding, donation-based crowdfunding, and debt-based crowdfunding, but those versions of crowdfunding are inherently different than equity-based crowdfunding.  With equity-based crowdfunding, an investor provides capital in return for an equity or ownership in the business/company that received the capital.  Equity-based crowdfunding has been approved by various states over the last few years, but that was only helpful for a business owner who was not going to cross state lines to solicit investors in a state that approved equity based crowdfunding.  At the federal level, prior to this crowdfunding exemption, the only SEC exemption that allowed a business owner to solicit to the masses was under what’s called a Rule 506(c) offering, but funds could only be received from what is known as an accredited investor.  The reality is that very few qualify as an accredited investor.  Now, a business owner can solicit to AND receive from funds from the masses.  This is a huge opportunity for a small business owner to raise capital for their business.  Here are some details of the benefits and requirements of the recently adopted rules governing SEC approved equity-based crowdfunding.

Under this crowdfunding exemption, a business can solicit investors across the country and receive capital up to $1 million per year.  However, each individual investor also has annual investment limits that range from $2,000 to $100,000 per year, depending on their net worth and/or annual income.  It should be noted that this individual investor limit is an investment limit into all crowdfunding offerings during the year.  So a business could use this exemption to raise up to $1M per year without being limited to issuing ownership/equity only to accredited investors.  The main requirements in order to solicit for and receive capital through federal equity-based crowdfunding are:

  1. Funding Portal. You may only solicit for and receive capital through an SEC registered crowdfunding portal that is a member of the national securities association.  You will want to do your due diligence in selecting a crowdfunding portal because currently there are portals that assist business owners either under one of the state exemptions, or that offer a different form of crowdfunding, e.g., rewards-based, donation-based, or debt-based, rule 506(c) offerings for accredited investors, or that offer federal equity-based crowdfunding even though it hadn’t been officially adopted by the SEC until just a few days ago.  Therefore, you will want to make sure you use a crowdfunding portal that is authorized to offer federal equity-based crowdfunding and that is registered with the SEC.  Funding portals will be able to register with the SEC effective January of 2016.
  1. Formation and Disclosure Documents. You will need to have the appropriate documentation in place for your business AND the appropriate disclosure documentation to be able to solicit for and receive funds through SEC approved equity-based crowdfunding.  This will include:
    1. Formation documents to establish your business, including the details surrounding how an investor would obtain ownership in your company. For example, the document that will govern your business, e.g., operating agreement, will need to be drafted in a manner that contemplates and allows investors to receive partial ownership in your company.
    2. The price of the security (ownership in your company), the total amount of capital you intend to raise, the deadline to reach the target offering amount, etc.
    3. Disclosure of your company’s financial condition, including financial statements of your company.
    4. A description of your business and how the raised capital will be used including potential risks and other disclosures associated with your business.
    5. Disclosure of the owners and officers of your company.

Note:  We don’t recommend that you go through an online company or even a funding portal to obtain these documents as neither should be giving legal advice that would often be necessary in connection with these documents. Additionally, on-line document companies do not offer documents that will comply with the rules outlined above.

  1. Independent Financial Review. Depending on the amount being raised, the financial documents for your company would need to be accompanied by information from the company’s tax returns and reviewed by an independent public accountant or audited by an independent auditor.  However, first time offerings of between $500,000 and $1M would be permitted to provide accountant reviewed financials rather than audited financials.
  1. Annual SEC Filing. A company that is relying on this federal crowdfunding exemption will be required to file an annual report with the SEC and provide it to its investors.

For business owners who have previously raised capital under what is known as a Regulation D exemption, e.g., Rule 505, 506(b), or 506(c), they will welcome the ability to solicit AND to receive funds from non-accredited investors.  Our office is available to help you through the process of raising capital through this newly adopted federal crowdfunding exemption. We can assist in structuring the offering and can provide the documents and filings necessary to appropriately rely on the new crowdfunding exemption.