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Your retirement plan as your venture capitalist?

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Like many professionals, a Minnesota lawyer had a little business on the side; a 57 percent interest in a corporation that owned a bowling alley. He had a self-directed profit sharing plan at his law firm. He needed some financing in the bowling business, so he directed his plan to make a loan to the bowling alley.

That went badly. The IRS assessed "prohbited transaction" penalties on the plan for making the loans.  These penalties, which start at 5 percent and can go as high as 100 percent, apply when a plan "fiduciary" makes engages in a "prohibited transaction" with "disqualified person."

The IRS said that his ability to control plan investments made him a fiduciary, and that his 57 percent ownership made him a disqualified person. 

Things went to court, and both the Tax Court and the 8th Circuit Court of Appeals sided with the IRS.  

This doesn't mean that one can never use qualified plan investments to finance a closely held business.  It does mean that if you want to do so, you need to be extremely cautious. Such investments can have baleful results; everything from punitive prohibited transaction taxes to income taxes within an otherwise tax-exempt retirement plan to plan disqualification and severe income taxes on the plan balance. 

The qualified plan rules are very tricky, which is why the tax court didn't hit the bowling, er, kingpin with additional penalties.  The court noted that the lawyer/bowler hired another

...lawyer with extensive experience in the area of retirement plans. He was fully aware of all of the relevant facts. He researched the issue and advised petitioner that he believed the loans would not violate any of the provisions of ERISA or cause any tax liability under section 4975. The ERISA provisions involved are highly complex, and the fact that his conclusion was erroneous does not mean that petitioner's reliance was not reasonable.

If an experienced ERISA lawyer can make a mistake, you can too.  

Worse, the IRS is very skeptical of taxpayers who use retirement plan funds in their businesses.  "Abusive" retirement plan arrangements are among the IRS's "dirty dozen" tax abuse schemes.

Even if you negotiate the retirement plan rules and safely tap plan funds for your business, you still should ask yourself whether it's really a good idea. Usually you are only tempted to tap these funds because there aren't other savings to tap.

It's not always a great idea to put the last of your savings into the always-risky world of small business. 

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