Question:  Since I am the sole owner of my company and the sole participant in my company profit sharing plan, can I use profit sharing funds to hold a mortgage on the residence which I intend to purchase?

Answer:  The answer to your question is no.  You cannot use profit sharing or other qualified retirement plan funds to hold a mortgage on a principal residence which you occupy.

The Internal Revenue Code prohibits a qualified plan from engaging in prohibited transactions with a disqualified person.  Prohibited transactions include sales, exchanges, lending of money and other transactions.  Disqualified persons include the owner of an employer which sponsors the plan, the plan trustee, an officer, director or shareholder of the plan’s sponsor and other persons.  As the sole owner of your company which sponsors the plan, you are a disqualified person.  You would also be deemed to be a disqualified person if you are the trustee of your company plan or if, as is presumably the case, you are an officer or director of your company or hold similar status with an unincorporated entity.  Therefore the lending of money by your company profit sharing plan to you constitutes a prohibited transaction.

The consequences of engaging in a prohibited transaction are significant.  A tax of 15% is imposed on the amount involved in a prohibited transaction for each year the transaction remains in effect.  In certain circumstances, where the prohibited transaction is not timely corrected, the tax rate on the prohibited transaction increases to 100%.  This tax imposition should be avoided at all costs.

While your case is relatively clear cut, the prohibited transaction rules are broad in scope and could result in tax impositions in transactions which are not as overtly violative of the rules.  Given the punitive nature of the prohibited transaction tax, avoiding these situations and leaving profit sharing and other qualified plan assets invested in traditional financial instruments is recommended.

If your profit sharing plan permits participants to obtain loans from the plan, you can borrow money from the plan and use such funds for personal purposes.  A participant’s plan loan is limited to the lesser of $50,000 or one-half of the participant’s vested account balance.  This likely will do little in providing the home financing you need.  While plan loans generally must be repaid within five years of borrowing, a longer repayment period is permitted where the loan is incurred to acquire a principal residence.

Even if a plan loan is viable for you, plan loans are not the most efficient means of borrowing from a tax perspective.  The interest paid on plan loans is generally not deductible for a number of reasons.  Contrast that situation with that of a traditional home mortgage loan for which interest is deductible for income tax purposes, subject to certain limits.

Another avenue that may be available to you is to withdraw funds from the plan.  Plan distributions are subject to income tax and distributions made prior to the time a plan participant reaches age 59 ½ are subject to an additional 10% excise tax unless one of the several exceptions applies.  If you have reached age 59 ½, you can withdraw funds from the plan and use the after-tax funds to purchase your principal residence.

Even absent the statutory constraints, it is generally advisable to maintain qualified retirement plan funds for retirement, the primary purpose of profit sharing plans.  In some cases, it may be fruitful to embark upon aggressive tax planning.  This is not a situation where aggressive tax planning is recommended.

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter, you may contact Bruce at (312) 648-2300 or send an e-mail to [email protected].