August 16, 2017

Best Practices: Documenting 401(k) Funds Used as Equity Injection

by Katie O'Brien

When a Borrower wishes to use funds from a 401(k) plan (the “Plan”) as equity injection on SBA loans, lenders must make sure they are properly documenting the injection and that the loan structure remains compliant with SBA rules and regulations. See SOP 50 10 5(I), pages 157 and 158. SBA requires that all individuals and entities that own 20% or more of the borrowing entity provide a full guaranty of the loan. But if the Plan will own 20% or more of the borrowing entity, it can not, under IRS regulations, provide a guaranty. Instead, SBA requires that the Plan meet all applicable IRS eligibility requirements and that the owners of the Plan provide a full unconditional guaranty, regardless of their ownership interest in the borrowing entity. This guaranty must be a secured guaranty if SBA’s collateral guidelines require additional security from the personal guarantors.

An EPC/OC loan structure can not be utilized and the lender must verify the items below (lenders can typically verify this information with the professional firm that facilitated the rollover of the Plan funds into the borrowing corporation):

  • The Plan can not own 100% of the borrowing entity’s stock.
  • The borrowing entity (which will receive the rollover funds from the Plan) must be a C-corporation.
  • All shareholders, including the Plan and the individuals, have paid the same price per share.

The lender must also collect an opinion letter from tax counsel which (i) describes the Plan, (ii) sets forth the Internal Revenue Code (“IRC”) citation describing the Plan, (iii) sets forth the IRC citation describing why the Plan can not incur liabilities and (iv) provides a statement of how the Plan is qualified or will be qualified in the future. It is important for the Plan to be qualified so that it will not incur early withdrawal penalties. If the Plan is not qualified, it will incur large early withdrawal penalties which could affect Borrower’s cash flow and lead to an early default, ultimately jeopardizing the lender’s SBA guaranty.

If the Plan is qualified, lenders should require tax counsel to provide IRS documentation confirming the Plan’s qualified status. If the Plan will become qualified in the future, tax counsel should provide the lender with information as to when application was made to the IRS for qualified status as well as an opinion that the Plan will comply with IRC and ERISA regulations. Lenders should also obtain a copy of the IRS’ approval of the Plan’s qualified status once the IRS had made a determination.

Failure to properly document 401(k) rollover funds used as equity injection or to properly structure the loan when the borrower is owned by a Plan can impact a Lender’s guaranty so it is important to correctly structure the loan, collect the required documentation and consult tax experts when necessary. Lenders should also encourage borrowers to consult with the appropriate tax and financial advisors to make sure Plan funds are rolled over properly and in compliance with all applicable laws and regulations.

For guidance regarding SBA compliance matters, contact Katie at 267-470-1207 or at