Full or Partial Redemption (e.g. buy back) of Stock
A redemption of stock occurs when the C Corporation buys some or all of its stock back from the Plan. This exit strategy is most often deployed by an entrepreneur who wants to convert the C Corporation to S Corporation status.
The decision to have the C Corporation buy the stock back, from the 401(k) Plan, is often a very strategic one. This is a decision that should be made based on several factors including 1) priorities of the business, 2) priorities of the business owner(s), 3) retirement savings needs, 4) tax deduction needs, 5) business expansion/financing needs and more! Given the tricky nature of this strategy, it’s best to work with a Third Party Administrator, an ERISA attorney, and a tax advisor when exiting a ROBS business financing strategy.
- The C Corporation engages in a partial or full stock buy back from the 401(k) Plan.
- The C Corporation needs to come up with the money to buy a certain amount of stock/shares back from the Plan at the current fair market value of the stock. It is a common misconception that the stock can be bought back for the original price that the Plan paid for the stock.
- Full or partial redemptions are allowed however, the C Corporation cannot be converted out of C Corporation status until all stock has been redeemed from the Plan.
- There are various ways a Corporation will generally raise cash for this kind of buy back, including, obtaining a traditional bank/SBA loan, retaining revenue, accepting a loan from a 3rd party (in limited instances the 3rd party can be the same individual who runs the company).
- This buy back must be done based for the current fair market value of the C Corporation stock, not the value of the stock when the Plan originally made its investment(s) into the C Corporation.
- The company stock should be valued by an outside, independent firm; this may generally include an informal valuation from your CPA, if he/she does them or a formal valuation from a valuation firm.
- A corporate resolution should be drafted, authorizing the redemption of stock between the C Corporation and the Plan.
- The proceeds from the redemption need to be returned back to the Plan based on its rightful share, by sending the monies back to the Plan account.
- Stock certificates should be “redeemed”, the stock that is purchased back usually becomes unissued stock for the time being.
- The stock ledger needs to be revised, reflecting the updated ownership (the Plan is no longer a shareholder or has a lesser amount of ownership).
- The monies, including earnings that are returned to the Plan can be invested in more traditional investments, like mutual funds. You could also use the monies + earnings for other non-traditional or business financing needs in the future.
- Once all stock is fully redeemed by the C Corporation, from the Plan, the C Corporation can convert to S Corporation status and the Plan can either continue to exist or the Plan can be terminated.
Partial Redemption (e.g. buy back) of Stock
A partial redemption of stock occurs when smaller amounts of stock are purchased back by the C Corporation, from the Plan, in multiple transactions, over time.
For a partial redemption, if the company valuation is higher than cash on hand, the Plan and C Corporation can enter into an amortized payment schedule to settle the buyout. This allows for controlled distribution of the profits to the Plan. It also can help mitigate the impact of being taxed as a C Corporation. This method extends the amount of time that the business remains a C-Corporation.
There are requirements related to valuing corporate stock each time a partial buyback is completed. Generally, you must value the stock each time you engage in a partial buyback although the facts and circumstances of your partial buybacks may allow for utilizing a prior or historical valuation.
Partial buybacks can end up being a rather expensive approach to buying back the stock as additional costs apply each time there is a redemption and this approach is rarely utilized as a result.