It is common for businesses to face cash flow issues from time to time. This can result from seasonality or unexpected expenses.
But what if a business must make a defined benefit plan contribution and the company does not have the funds? The owner might want to contribute personal savings or even personal stock or mutual fund holdings.
Is this legal? In this article, we’ll discuss this important topic. Let’s jump in!
Some background
Running a business can result in cash flow concerns for the business owner. In addition, if you have a defined benefit plan, the business has mandatory contributions. This can exacerbate cash flow issues.
Sometimes funds are tied up and cash is not available to make the required funding. In this situation, the owner might consider contributing investment funds (stocks, bonds, mutual funds, etc.) into the defined benefit plan in place of cash contributions.
Assuming you have an S-Corp, company retirement plan contributions are tax deductible business expenses. A such, any profit-sharing or cash balance plan contributions must be made from an S-Corp bank or brokerage account for tax deduction purposes. You can’t contribute the funds directly from your personal bank account and take the tax deduction for your business.
But there is a workaround. It could possibly trigger a tax bill. But at least it is an option.
Can you make an ‘in kind’ contribution of stock or mutual funds?
Unfortunately, the IRS does not allow a business to make an ‘in-kind’ contribution of stocks or mutual funds in lieu of cash contributions. The IRS and Dept of Labor have strict rules against making ‘in kind’ transfers for minimum contributions.
Stock or mutual fund holdings will generally have unrealized capital gains or losses. So, if they were allowed to be contributed into a plan, those gains or losses would essentially “disappear.” As such, the IRS does not allow such contributions.
In addition, even if you could do an ‘in kind’ transfer, it might not be tax advantageous to do so. If you had sizable capital losses, you would want to realize those losses first before you made a tax-deductible contribution into a plan. This way you could recognize the loss and also get a tax deduction for the contribution made.
Can I fund my S-Corp defined benefit plan with personal funds?
What if the business owner had a personal brokerage account that they wanted to use to fund the defined benefit plan? You can indirectly use these funds to contribute to the plan.
You can liquidate your positions within your personal brokerage account and then loan the proceeds or make a capital contribution to the S-Corp. You would then be able to contribute the funds directly from the S-Corp to the defined benefit plan account and then take the deduction on the S-Corp tax return.
Of course, if you sold the funds in the brokerage account you would have capital gains or losses that would be recognized on your personal tax return. You would want to work with your CPA or tax professional to calculate any tax liability.
Example #1 – S-Corp owned stock
Let’s assume you are the sole shareholder of an S-corporation. Let’s also assume you’re planning to fund your defined benefit plan with a contribution of $100,000. However, your business cash flow is a little tight right now, so you are considering options to make this contribution.
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Your S-corporation has an investment account that owns $100,000 of Apple stock. You would like to contribute this Apple stock into your defined benefit plan in lieu of a cash contribution. Let’s also assume that you paid $75,000 for that Apple stock. So, you have an unrealized gain of $25,000.
Many clients might want to use this stock to make this contribution. In their eyes, they would be able to avoid the $25,000 gain if they were to sell the stock and contribute the cash. In addition, they would of course get a tax deduction for the entire $100,000 contribution.
Unfortunately, as we have previously discussed, this is specifically disallowed. You must sell the stock and realize the $25,000 gain and then take the $100,000 in cash and contribute that directly into the plan.
Example #2 – personally owned stock
Let’s assume that that $100,000 of Apple stock is not owned by the S-Corp, but is owned personally by the sole shareholder of the S-Corp. In this case, the owner would need to sell the stock personally and be subject to capital gains tax on the $25,000 gain.
He would then need to contribute the $100,000 into the S corporation as a capital contribution or a shareholder loan. At that point, the owner can make the contribution of $100,000 to the defined benefit plan and take the tax deduction at the S-Corp level.
As you can see, in-kind contributions will not work when funding a retirement plan. Unfortunately, you’ll need to fund the plan with cash contributions. But the good news is that if you have personal funds, you still have an option to be able to get those funds into your corporation so you can make your defined benefit plan contribution.
What if I am a sole proprietor?
If you are a sole proprietor, then you and your business are essentially one of the same. So, if you’re doing business personally, then you can always liquidate personal funds and use those to contribute to your retirement plan.
Is a Cash Balance or Defined Benefit Plan Right For You?
In many situations, business owners will do business under an LLC as a disregarded entity. While this is a separate legal entity, it is still essentially attached to you. It is a disregarded entity, so it’s as if the entity did not exist from an economic and tax perspective.
I would still recommend contributions come from the LLC account. Even though they’re not included on the Schedule C as a business expense, they are reflected as an “adjustment to income” on your individual tax return.
It is important for business owners to ensure they properly separated business transactions from personal transactions so that they don’t commingle funds. This can result in bookkeeping errors and incorrect tax filings.
Bottom line
Business owners are often faced with cash flow concerns. This is especially difficult if they have mandatory defined benefit plan contributions. Unfortunately, the IRS does not allow in-kind transfers of securities in lieu of cash.
Before you sell any investments and contribute to your defined benefit plan, ensure that you carefully review the tax consequences with your CPA or tax professional. You might find that you have a large capital gain to report.
