Equity Injection Vehicles – 401(k) and other retirement plan rollovers per SBA SOP 50-10(5)
It’s no secret that documenting the capital injection for SBA loans can be a daunting task. In the past, borrowers often used home equity lines of credit as a source of injection. However, plummeting home values and the restrictions of the SBA rules implemented in SOP 50-10(5) have virtually eliminated this source. As a result, borrowers are increasingly providing a capital injection in the form of qualified rollovers from their current 401(k), profit-sharing plan, or other qualified retirement account (collectively referred to herein as QRA). To document this form of capital injection, lenders must perform a one-time analysis.
Lenders must first be able to identify a QRA rollover. In a rollover scenario, the QRA buys some percentage of the borrowing entity’s shares. If the QRA owns at least 20% of the borrowing entity, pursuant to 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 Financial Assistance Administrator (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 guarantee waiver, all principals and beneficiaries were required to pledge their personal and unlimited guarantees. Under SOP 50-10(5), lenders are no longer required to obtain a waiver from the SBA. However, lenders are still required to obtain the same documentation as if they were submitting a waiver application, including the unlimited collateral from all QRA principals and beneficiaries.
There are three scenarios in which lenders cannot document a waiver of collateral. First, a QRA cannot buy shares of an EPC. The AA/FA did not have the authority to waive guarantees in these cases and, by extension, the lenders do not have this authority. Thus, a QRA cannot own 100% of the borrowing entity’s shares. 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 its personal guarantee when the QRA owns 20% or more of the borrowing entity. Finally, the borrowing entity cannot be an S corporation. The practitioners setting these QRA rollovers have stated that to be eligible, the entities must be C-corporations. Lenders can verify this information with the professional firm that facilitates the rollover.
As long as none of the ineligible scenarios exist, lenders must confirm that several 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 equal the price paid by the QRA for their shares, and the resulting share must be proportional to the price paid. Lenders should verify these amounts with the professional firm arranging the QRA transfer and confirm that the funds were deposited into the C corporation’s bank account. Second, whether 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 owns at least 20% of the business; (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 came to be or will be “qualified.” If the Plan is already qualified, the attorney must provide documentation from the IRS showing how it achieved qualified status. If the Plan will be qualified in the future, the ERISA attorney must provide (1) a statement of when the application was submitted to the IRS to determine the “qualified” classification; (2) a statement that, in the attorney’s opinion, the application 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 above SOP was not simply to help lenders document the absence of 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 early withdrawal penalties. However, if a non-qualified retirement account were to purchase the borrowing entity’s shares, it would incur heavy 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 result in default on the loan. 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.