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The IRS Scrutinizes 401(k) Cash for Small Business

Amy Feldman

As the credit crisis has made it tougher for small businesses to get funding, some would-be entrepreneurs have exploited a loophole that lets them finance a startup with 401(k) retirement funds without facing any taxes or penalties. Now the technique is catching the attention of the IRS, which plans to step up audits of such transactions. "We are seeing problems," says Monika Templeman, acting director of employee plans at the IRS. "It is open to abuse."

The transactions typically require an entrepreneur to create a new corporation, establish a 401(k) plan for it, and move existing 401(k) funds into the plan. Money from the new 401(k) is used to buy shares in the new company, and that provides the business with capital while retaining the tax advantages of the 401(k). Without such a rollover, funds withdrawn from a 401(k) are subject to income taxes. A 10 percent penalty applies if the funds are withdrawn by a person under the age of 59 1/2. Templeman says the IRS has seen questionable valuations for the new stock, and in a few cases the money was used to buy recreational vehicles and other personal assets.

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