Capital injection vehicles: 401 (k) and other retirement plan transfers per SBA SOP 50-10 (5)

It’s no secret that documenting capital injection for SBA loans can be a daunting task. In the past, borrowers used home equity lines of credit as a source of injection. However, the plummeting home values ​​and SBA rule restrictions implemented in SOP 50-10 (5) have all but eliminated this source. As a result, borrowers are increasingly providing capital injection in the form of qualified rollovers of their existing 401 (k), profit-sharing plan, or other qualified retirement account (collectively referred to herein as the QRA). To document this form of capital injection, lenders must conduct a unique analysis.

Lenders must first be able to identify a QRA transfer. In a refinance scenario, the QRA purchases a percentage of the borrower’s equity. If the QRA owns at least 20% of the borrowing entity, in accordance with SBA regulations, it must provide a guarantee. By definition, QRAs cannot offer guarantees. Since lenders cannot obtain a QRA guarantee, the previous SOP required lenders to apply to the SBA’s Associate Financial Assistance Administrator (AA / FA) for a guarantee waiver. Because an externally imposed legal restriction (ERISA) prevents QRAs from providing guarantees, the AA / FA was able to waive the SBA’s guarantee requirement. When AA / FA granted a warranty release, all directors and beneficiaries were required to pledge their personal and unlimited warranties. Under SOP 50-10 (5), lenders are no longer required to obtain an exemption from the SBA. However, lenders must still obtain the same documentation as if they were filing an exemption application, including obtaining unlimited collateral from all QRA principals and beneficiaries.

There are three scenarios in which lenders cannot document a warranty release. First, a QRA cannot buy shares in an EPC. The AA / FA did not have the authority to waive the collateral in these cases and, by extension, the lenders do not have this authority. Subsequently, 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 guarantee. This situation is not eligible 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 transfers have stated that to be eligible, the entities must be C corporations. Lenders can verify this information with the professional firm facilitating the rollover.

Provided that none of the ineligible scenarios exist, lenders must then confirm that various requirements are met. Most importantly, individual owners must pay for their shares in an amount commensurate with their percentage of ownership. In other words, the price per share paid by individuals must equal the price paid by the QRA for their shares, and the resulting ownership interest must be proportional to the price paid. Lenders should verify these amounts with the professional company 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 the benefits of the QRA. QRA, must provide a full unlimited warranty. Finally, an individual’s collateral must be secured if the value of the business assets securing the loan is less than the loan amount.

For final documentation, lenders must obtain an opinion letter from ERISA’s attorney 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 quote under the IRC that describes the type of Plan; (3) the specific quote under IRC that outlines why the Plan cannot assume any responsibility; 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 IRS documentation showing how it achieved qualified status. If the Plan will qualify in the future, the ERISA attorney must provide (1) a statement of when the request was submitted to the IRS for determination of 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 Plan administrator 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 collateral that would otherwise be required, 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 buy the shares of the borrowing entity, it would incur heavy penalties for early withdrawal. The IRS would likely assess these penalties against the borrower 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 transfers.