Capital injection vehicles – 401(k) and other retirement plan rollovers under SBA SOP 50-10(5)
It’s no secret that documenting your capital injection for SBA loans can be a daunting task. In the past, borrowers used to use home equity lines of credit as a source of injection. However, plummeting home values and the SBA rule restrictions implemented in SOP 50-10(5) have all but eliminated this source. As a result, borrowers are increasingly providing an injection of capital in the form of qualified rollovers from their current 401(k), profit sharing plan, or other qualified retirement account (hereinafter collectively referred to as QRA). To document this form of capital injection, lenders must perform a unique analysis.
Lenders must first be able to identify a QRA rollover. In a renewal scenario, the QRA buys some percentage of the borrower’s shares. If the QRA owns at least 20% of the borrowing entity, under SBA regulations, it must provide collateral. By definition, QRAs cannot provide guarantees. Since lenders cannot obtain collateral from a QRA, the previous SOP required lenders to apply to the SBA’s Associate Administrator for Financial Assistance (AA/FA) for a collateral waiver. Because an externally imposed legal restriction (ERISA) prevents QRAs from providing collateral, the AA/FA was able to waive the SBA collateral requirement. When the AA/FA granted a security release, all principals and beneficiaries were required to pledge their personal and unlimited security. Under SOP 50-10(5), lenders are no longer required to obtain a waiver from the SBA. However, lenders must still obtain the same documentation as if they were submitting a waiver request, including unlimited collateral from all QRA principals and beneficiaries.
There are three scenarios in which lenders cannot document a security release. First, a QRA cannot buy shares of an EPC. The AA/FA did not have the authority to waive collateral in these cases and, by extension, lenders do not have this authority. Therefore, a QRA cannot own 100% of the shares of the borrowing entity. ERISA rules state that neither a QRA nor its individual holder can incur debt, which prevents the beneficiary/principal from providing its collateral. This situation is ineligible because any beneficiary of a QRA must provide their personal guarantee when the QRA owns 20% or more of the borrowing entity. Finally, the borrowing entity cannot be an S corporation. The professionals who establish these QRA rollovers have stated that to be eligible, the entities must be C-corporations. Lenders can verify this information with the professional firm facilitating the rollover.
As long as none of the ineligible scenarios exist, lenders must confirm that various requirements are met. Most importantly, individual owners must pay for their shares in an amount proportional to their ownership percentage. In other words, the price per share paid by individuals must be equal to the price paid by the QRA for its shares, and the resulting participation must be proportional to the price paid. Lenders must verify these amounts with the professional firm arranging the QRA transfer and confirm that the funds were deposited in the C corporation bank account. Second, if a person’s spouse has any rights to QRA benefits , you must provide a full unlimited warranty. Finally, an individual’s collateral must be secured if the value of the business assets collateralizing the loan is less than the loan amount.
The final documentation that lenders must obtain is an ERISA attorney opinion letter that contains the following: (1) a description of the type of retirement account (the Plan) that at least 20% of the business owns; (2) the specific citation under the IRC that describes the type of Plan; (3) the specific citation under the IRC that describes why the Plan cannot assume any liability; and (4) a statement of how the Plan became or will be “qualified.” If the Plan is already qualified, the attorney must provide documentation from the IRS showing how the qualified status was achieved. If the Plan will be qualified in the future, the ERISA attorney must provide (1) a statement of when the application was filed with the IRS to determine the “qualified” classification; (2) a statement that, in the attorney’s opinion, the request will comply with IRC and ERISA regulations; and (3) a statement that upon final determination by the IRS, the Trustee of the Plan will provide the lender with a copy of the approval.
The reasoning behind the previous SOP was not simply to help lenders document the absence of an otherwise required collateral, but also to ensure that the Plan had or would have obtained “qualified” status from the IRS. A proper QRA transfer will not incur any early withdrawal penalties. However, if an unqualified retirement account were to purchase the borrowing entity’s stock, it would incur hefty early withdrawal penalties. These penalties are likely to be assessed against the borrower by the IRS within the first year of the loan and potentially cause the loan to default. Because the QRA funds are a part of the borrower’s capital injection, this early default could jeopardize the SBA guarantee. In conclusion, to preserve the SBA guarantee and facilitate the success of their borrowers, lenders must diligently document QRA rollovers.