Worked Example — Cohort Bakery, LLC

NOT LEGAL OR TAX ADVICE. DRAFT — pending professional review. This research summary uses a hypothetical cohort member ("J") and an anonymized "Cohort Bakery, LLC." Numbers are illustrative; every path requires a licensed CPA and ERISA attorney. Circular 230 notice applies.

Synopsis#

A cohort member with an old-employer 401(k) wants to fund a small food business and grow personal wealth through what she calls a "tax-free network." Most of her instinct is right; the specific structures she has in mind are mostly wrong. This memo translates the legitimate version into a six-month sequence of acts, ties each act to a Code section, and quantifies — in illustrative numbers — what the same dollar can do under each path.

The single conceptual repair that drives every recommendation in this document:

Tax favor is a property of the vehicle holding the dollar, not the act of moving the dollar. Stack the structure, and a single dollar of business revenue can be deferred, reimbursed, excluded, compounded tax-free, and reduced 20% via QBI. Move the dollar between checking accounts and it is just taxable income wearing a different label.

1. Fact pattern (assumed, anonymized)#

| Variable | Assumption | |---|---| | Cohort member ("J") | Recently changed employers. Old-employer 401(k) with ~$80,000 illustrative balance. | | Age | Under 55 (Rule of 55 unavailable; § 72(t)(2)(A)(v)). | | Marital status | Single, for simplicity. | | Health coverage | HDHP-eligible under § 223(c)(2). | | Prior tax filing | W-2 employee; no prior self-employment income. | | Concept | Pre-formation single-member LLC bakery; intended retail + event catering. | | Capital need | ~$30,000–$50,000 (equipment, leasehold improvements, initial inventory, working capital). | | Stated goal | "Use my tax-free 401(k) money to fund the bakery and grow it through transactions with the cohort." | | Long-term goal | Profitable bakery + retirement savings + lawful transactions with HSN entities (e.g., catering The 7 Space events). |

These assumptions are illustrative. Real implementation requires actual numbers from J's financial records and a licensed professional engagement.

2. What J said vs. what's actually possible#

J's framing collapses three distinct legal questions into one. They have to be unbundled before any structure makes sense:

1. How can I access pre-tax retirement capital without triggering early-withdrawal tax? (Retirement-access question.)
2. What is the right entity for the bakery? (Entity-choice question.)
3. How do I run lawful, tax-efficient transactions with other cohort members and HSN entities? (Network-economics question.)

Each is addressed in turn below.

2.1. "I can use my 401(k) to fund the business."#

| Path | Mechanic | Tax cost at funding | Penalty | Right answer for J? | |---|---|---|---|---| | (a) Solo 401(k) participant loan after rolling old plan into Solo 401(k) | IRC § 72(p) loan up to $50K | $0 | $0 if repaid on schedule | Likely best fit. Repayment funded from earned bakery income or W-2 wages. | | (b) ROBS — Rollover as Business Startup | IRS Memo 10/1/2008; IRC § 4975 | $0 at rollover | 15% / 100% § 4975 excise tax + plan disqualification if mis-structured | Heavy. Forces C-corp election, ongoing nondiscrimination testing, annual Form 5500, valuation appraisals. | | (c) 72(t) SEPP | Substantially Equal Periodic Payments | Ordinary income on each payment | $0 if rules followed | Wrong tool. SEPP is a long-horizon income stream, not startup capital. | | (d) Outright early distribution | Take the money | Ordinary income on full amount + 10% § 72(t) penalty | 10% | Almost never. Combined ~32–37% federal-plus-penalty drag erases the principal advantage. |

Path (a) — Solo 401(k) participant loan, in detail#

The Internal Revenue Code permits a participant in a qualified plan to borrow from the plan up to the lesser of $50,000 or 50% of vested balance under IRC § 72(p) and Treas. Reg. § 1.72(p)-1. To use this path, J must first establish self-employment (form the LLC, begin operations) and adopt a Solo 401(k) plan; she then rolls her old-employer 401(k) into the Solo 401(k) by trustee-to-trustee transfer (IRC § 402(c)(1); Box 7 code "G" on Form 1099-R, not taxable), and finally borrows from her own plan.

Five conditions must hold for the loan to remain a loan (and not be deemed a taxable distribution):

1. Written promissory note signed by J as borrower and the plan as lender.
2. Stated interest rate at or above the rate a commercial lender would charge for a similar loan; the published Applicable Federal Rate (AFR) is a defensible floor under IRC § 7872.
3. Level amortization with payments at least quarterly. Interest is paid back to J's own plan account.
4. Maximum 5-year term, except for a primary-residence purchase (longer term permitted; not applicable here).
5. Default cure if a payment is missed: cure within the calendar quarter following the missed-payment quarter or the loan converts to a deemed distribution (Treas. Reg. § 1.72(p)-1, Q&A 10).

Failure on any of these converts the outstanding balance to a deemed distribution — taxable as ordinary income, and subject to the 10% § 72(t) early-withdrawal additional tax if J is under 59½. The deemed distribution cannot be rolled over to undo the tax (Q&A 13).

The loan proceeds are paid to J personally and may be used for any purpose. Direct plan-to-business loans (where the bakery is the borrower) hit the prohibited-transaction rules of IRC § 4975 and would disqualify the plan; this is the trap that catches many do-it-yourself ROBS imitators.

Path (b) — ROBS, in detail (and why it's almost certainly wrong here)#

A Rollover as Business Startup uses a C-corporation's qualified profit-sharing plan to purchase newly issued employer stock with rolled-over retirement funds, capitalizing the C-corp without triggering distribution tax (mechanics from the IRS ROBS Compliance Project memorandum dated October 1, 2008). It is not a per se abusive transaction, but the IRS audits two recurring failures:

• BRF nondiscrimination violations under Treas. Reg. § 1.401(a)(4)-4 — when the plan offers stock purchase only to the founder and the company later hires rank-and-file employees who are excluded from the same Benefits, Rights, and Features.
• Deficient stock valuation at issuance. The valuation must be by an independent appraiser; overstating value triggers a § 4975 prohibited transaction.

Tax-court flags include Peek v. Comm'r, 140 T.C. 216 (2013), and Ellis v. Comm'r, T.C. Memo 2013-245, aff'd, 787 F.3d 1213 (8th Cir. 2015) — both holding that owner conduct (personal guarantee in Peek, salary from IRA-owned LLC in Ellis) was a prohibited transaction that disqualified the plan.

For a single-location food business with $30K–$50K capital need and no near-term employee plans, ROBS imposes structural costs (C-corp double tax; annual Form 5500; valuation reappraisals; nondiscrimination testing once an employee is hired) that exceed the benefit. The Solo 401(k) loan accomplishes the funding with a small fraction of the compliance burden. ROBS is reserved for capital-intensive ventures (≈$75K+) where the entrepreneur is willing to operate as a C-corp and will not exclude employees from the plan.

ROBS is never advised in this module without engaged ERISA counsel. The escalation gate is non-negotiable.

Path (c) — 72(t) SEPP, and why it's the wrong shape#

A Substantially Equal Periodic Payment under IRC § 72(t)(2)(A)(iv) is a stream of equal annual distributions that escapes the 10% early-withdrawal penalty by following one of three approved calculation methods (Required Minimum Distribution, Fixed Amortization, Fixed Annuitization; Rev. Rul. 2002-62). Once started, the stream must continue for at least 5 years OR until age 59½, whichever is later; modifying it before then triggers retroactive 10% penalty plus interest on every prior SEPP withdrawal.

For an $80K balance and a 30-year-old participant, the annual SEPP would be roughly $2,500–$3,500 — far below the $30K–$50K capital need and locked in for 25+ years. SEPP fits a different problem (steady income from age 50–59½ for early retirees), not bakery capitalization.

Path (d) — Outright early distribution, the worst answer#

A withdrawal of the full $80K balance for a 30-year-old in a 22% federal bracket would generate roughly:

• Ordinary income tax: ~$17,600
• 10% early-withdrawal additional tax (§ 72(t)): $8,000
• State income tax (varies; ~3–9% typically): ~$2,400–$7,200
• Total federal+state drag: ~$28,000–$32,800 on $80K (35–41%).

The same $80K, accessed via a Solo 401(k) loan, costs $0 in tax at funding (the loan is not income) and is repaid with after-tax dollars — a fundamentally different proposition.

2.2. "I can send tax-free money to other cohort members."#

What this can lawfully be: legitimate trade. The bakery sells products and services to cohort members and HSN entities at fair market value. Income is recognized; expenses are deducted; the net flows through to J via the structure she chooses.

| Transaction | Form | Tax effect for bakery | Tax effect for buyer | |---|---|---|---| | Bakery caters a 7 Space event for $2,500 | Invoice + payment | $2,500 ordinary income; deduct ingredients, labor under § 162 | $2,500 § 162 deduction at The 7 Space | | Bakery sells custom cakes to a cohort member's launch party for $500 | Invoice + payment | $500 income | Personal expense (not deductible) unless cohort member's own business event | | Bakery contracts with a cohort member's marketing LLC for $1,000/mo | 1099-NEC at year-end if cumulative ≥ $600 (IRC § 6041) | $12,000/yr deductible | $12,000 income to marketing LLC | | Bakery accepts ingredient supply from a cohort farmer in exchange for catering services | Barter — Treas. Reg. § 1.61-2(d)(1) | FMV of ingredients = ordinary income to bakery | FMV of catering = ordinary income to farmer |

This is a "network." Money moves among cohort members. None of it is "tax-free." All of it is tax-efficient because each entity uses its own structure to optimize what tax falls on its share.

The barter row is the trap: many cohort members imagine an unreported swap is "free." Treas. Reg. § 1.61-2(d)(1) treats both legs as taxable income at FMV. Organized barter exchanges file Form 1099-B (IRC § 6045(c)(3)). For tax purposes it is no different from each party paying cash, then immediately spending the cash on the other's services.

2.3. "It's tax-free money so it grows exponentially."#

Tax-favored growth happens inside specific vehicles, not in transit between checking accounts:

• The Solo 401(k) trust corpus, under IRC § 501(a) — all dividends, interest, capital gains accumulate without current tax (real exponential growth via compound returns and zero tax drag).
• A Roth Solo 401(k) component (IRC § 402A) — designated Roth contributions grow tax-free and are tax-free on qualified distribution.
• An HSA (IRC § 223) — same triple-advantage on the medical-spending side.

What does NOT grow tax-free: J's bakery checking account; her personal account; payments between people for "services."

The intuition repair. "Tax-free money" is not a property of the dollar — it's a property of the vehicle holding the dollar. Move the same dollar into a Solo 401(k) and it compounds tax-deferred; leave it in a checking account and it earns 0–4% taxed at ordinary rates.

Illustrative compounding — the $24,500 question#

Suppose J defers the 2026 § 402(g) limit ($24,500; IRS Notice 2025-67) into a Solo 401(k) at age 30 and the account earns 7% annualized over 35 years. The single-year contribution alone grows to roughly $261,000 by age 65 — entirely within § 501(a)'s tax exemption while held in trust. The same $24,500 deposited into a taxable brokerage and earning the same 7% gross return, but with 15% long-term capital-gains drag on annual realized gains, ends at roughly $200,000–$215,000 (depending on turnover).

The compounding gap is not the difference between "with tax" and "tax-free dollars sent between people." It is the difference between two wrappers holding the same dollar.

3. A lawful 12-month plan#

| Month | Action | Statute / authority | |---|---|---| | 1 | Form Bakery LLC; obtain EIN; open business bank account; CPA engagement letter | State LLC act; IRC § 7701; Treas. Reg. § 301.7701-3 | | 1–2 | Direct rollover: old 401(k) → Traditional IRA | IRC § 402(c)(1); Form 1099-R code G | | 2 | Adopt Solo 401(k) plan; complete adoption agreement; open custodian account in plan trust name | IRC § 401(a), § 401(k); pre-approved plan document | | 2–3 | Trustee-to-trustee transfer: Traditional IRA → Solo 401(k) | IRC § 408(d)(3) / direct trustee transfer | | 3 | Execute promissory note for participant loan up to $50K; level-amortization schedule; market-rate interest | IRC § 72(p); Treas. Reg. § 1.72(p)-1 | | 3–6 | Deploy loan proceeds: lease, equipment, initial inventory, working capital | § 162 / § 263A / § 195 startup-cost rules | | 6 | Bakery operating; first revenue; bookkeeping in Xero/QuickBooks; monthly P&L | § 6001 recordkeeping; Pub. 583 | | 6–9 | Begin Solo 401(k) employee elective deferrals (Roth or Traditional or split) from bakery W-2 wages (S-corp) or net SE income (sole prop / disregarded LLC) | IRC § 402(g); 2026 limit $24,500 (IRS Notice 2025-67) | | 9 | Evaluate S-corp election for next tax year if net profit consistently > ~$50K | IRC § 1361; Form 2553 by 3/15 of target year | | 12 | Year-end: maximize employer profit-sharing contribution; document accountable plan adoption; review § 199A QBI deduction; assess HSA eligibility | IRC § 415(c) ($72K total); Treas. Reg. § 1.62-2; § 199A; § 223 |

The sequence is not arbitrary. Step ordering matters because:

• The Solo 401(k) loan (month 3) cannot exceed 50% of the vested balance, which means the rollover (month 1–3) must complete first to put balance in the receiving plan. Plans that lend before rollover violate § 4975.
• The S-corp election decision (month 9) requires meaningful operating data; making the election prematurely produces payroll and reasonable-comp obligations the bakery's cash flow cannot yet support.
• The accountable plan adoption (month 12, or earlier if S-corp elected) requires an operating entity with a written plan document; reimbursing oneself before the entity exists is a Schedule C deduction, not an exclusion from wages.

4. The capital stack — what each lever contributes#

| Lever | Statute | Year 1 illustrative contribution | Year 2 illustrative contribution | |---|---|---|---| | Solo 401(k) participant loan (one-time capital) | § 72(p) | up to $50,000 | n/a (paying back) | | Solo 401(k) elective deferral | § 402(g); IRS Notice 2025-67 | up to $24,500 (proportional to wages earned) | up to $24,500 | | Solo 401(k) employer profit-sharing | § 415(c) | up to ~25% of compensation, total annual additions ≤ $72,000 | same | | HSA contribution (if HDHP) | § 223 | ~$4,150 self / $8,300 family (verify 2026 Rev. Proc.) | same | | § 199A QBI deduction | § 199A (sunset post-2025; verify) | up to 20% of QBI | same | | Accountable plan reimbursement (after S-corp) | Treas. Reg. § 1.62-2 | actual qualified expenses, no statutory cap | actual qualified expenses | | § 280A(g) Augusta Rule | § 280A(g) | up to 14 days × FMV rate | same |

The stack composes. A bakery generating $80,000 of net income could plausibly defer $20,000–$30,000 into the Solo 401(k), reimburse $5,000–$10,000 of business expenses through an accountable plan after S-corp election, deduct $4,000–$6,000 via the § 199A QBI deduction (subject to sunset), exclude up to $5,000–$10,000 of legitimate Augusta-Rule rental income — and grow each remaining dollar of plan balance under § 501(a)'s zero-tax wrapper indefinitely.

That is the architecture. It is fully legal, completely public, and disciplined.

5. Pivots required from J's framing#

5.1. LLC vs. S-corp vs. C-corp#

| Form | Year-1 fit | Year-2+ fit if profit is volatile / low | Year-2+ fit if profit > ~$50K stable | |---|---|---|---| | Single-member LLC, default disregarded entity, Schedule C | Yes — simplest | Yes | No — paying full SE tax (15.3% on first ~$168,600; verify 2026 SS wage base) is leaving money on the table | | S-corp election (LLC taxed as S-corp via Form 8832 + Form 2553, OR a state-law corporation electing S-corp) | Premature — payroll burden exceeds benefit | No — election adds payroll cost without payoff | Yes — Watson-reasonable W-2 wage; remainder distribution avoids SE tax | | C-corp | No (unless ROBS) | No | Generally no for a small bakery — double tax + no QBI |

Election deadline: Form 2553 must be filed by the 15th day of the 3rd month of the tax year for which it applies (March 15 for a calendar-year filer), or within 75 days of LLC formation for retroactive year-of-formation effect.

5.2. Accountable plan#

Once J becomes a W-2 employee of her own S-corp, an accountable plan under Treas. Reg. § 1.62-2 lets the entity reimburse legitimate business expenses (home office, cell phone / internet at business-use percentage, mileage at the IRS standard rate, professional development, equipment) without those reimbursements becoming wages to J.

The three required tests:

1. Business connection — the expense must be deductible by the employer under § 162.
2. Substantiation within a reasonable time (60-day safe harbor) — amount, time, place, business purpose.
3. Return of excess within a reasonable time (120-day safe harbor) for any advance exceeding actual expenses.

Sole proprietors take these expenses directly on Schedule C; the accountable plan adds value once the entity is an S-corp because the post-TCJA suspension of unreimbursed employee expense deductions otherwise leaves the owner-employee unable to deduct them at all.

5.3. § 280A(g) — Augusta Rule#

Once the bakery is operating, the LLC/S-corp can rent J's home for up to 14 days per year for legitimate business purposes (board meetings, recipe-development sessions, vendor strategy days, training). The rental income is excluded from J's gross income; the entity gets a § 162 deduction for the rent paid.

Documentation is the entire ballgame:

• Written rental agreement between the entity and J (the homeowner).
• Defensible FMV rental rate — supported by quotes from comparable hotel meeting rooms or event venues. The IRS scrutinizes inflated rates, especially when the only renter is the owner's own business.
• Meeting minutes or agenda documenting the legitimate business purpose of each rental day.
• Paid invoice with check or wire trail.
• Day-count tracker so total days across all renters do not exceed 14.

The same building cannot be rented under § 280A(g) and used as a deductible home office in the same year without careful coordination with a tax professional.

5.4. HSA#

If J's coverage is HDHP-compatible (and she is not enrolled in disqualifying coverage like Medicare or a non-HDHP FSA), opening an HSA gives her the only triple-advantage account in the Code:

1. Contributions are deductible.
2. Growth inside is tax-free.
3. Distributions for qualified medical expenses are tax-free.

For a self-employed cohort member, after the Solo 401(k) this is the second-most-powerful lever.

5.5. § 199A QBI#

A bakery is not a Specified Service Trade or Business under IRC § 199A(d)(2). It qualifies for the 20% QBI deduction without phase-out (unlike consulting, law, accounting). Currently scheduled to sunset post-2025; verify current law before any 2026 cohort communication that relies on it.

If § 199A is allowed to expire, the bakery's effective tax rate rises by approximately 20% × marginal rate (e.g., 4–5 percentage points at a 22% marginal bracket). Year-end planning in the final QBI year typically accelerates income recognition where defensible.

6. The "network" J actually wants — translated#

| What J pictured | What it actually is | |---|---| | "We all send each other tax-free money for nothing." | Sham; § 7701(o) penalty plus possible § 7201 evasion. | | "We all do real business with each other and each of us optimizes our own tax structure." | Fully legal. Each cohort member runs their own LLC / S-corp; each has Solo 401(k), accountable plan, HSA, § 199A; each transacts with the others at market rate. |

HSN's role in the network:

• Be a hub of catering, venue, consulting, and education business that creates real demand for cohort members' services.
• Offer cohort education on (lawful) tax architecture, with strong escalation gates to licensed CPAs / tax attorneys for actual implementation.
• Build a vendor preference list so cohort members get first look at HSN purchasing.
• NOT be a conduit for "tax-free transfers." Especially not the nonprofit (§ 4958 / inurement risk; loss-of-exemption exposure).

7. Walled-off anti-patterns J specifically asked about#

These are listed here because J asked about them by name. The answer to each is "no, and here is why."

7.1. "We pay each other for services we don't actually deliver."#

This is paper circulation. The transaction has no economic substance under IRC § 7701(o); the codified test is conjunctive (objective economic-position change AND substantial non-tax purpose). A 20% strict-liability accuracy-related penalty applies (IRC § 6662(b)(6)); 40% if not adequately disclosed (§ 6662(i)); no reasonable-cause defense (§ 6664(c)(2)). Repeated and willful conduct is criminal under § 7201.

7.2. "We make zero-interest loans to each other."#

IRC § 7872 imputes interest at the Applicable Federal Rate. Below-AFR loans between related parties are recharacterized: foregone interest is treated as compensation, gift, or distribution depending on the relationship. A "loan" without note, interest, or repayment schedule is not a loan; it's a transfer the IRS will recharacterize.

7.3. "We run cohort tuition through HigherSelf Nonprofit so it's a charitable contribution."#

This requires donative intent (IRC § 170) and reduces the deduction by the FMV of any benefit received (quid pro quo, IRC § 6115). A closed cohort program where members pay to receive individualized business consulting fails both. It also exposes the nonprofit to § 4958 excess-benefit transaction tax (25% on disqualified person, 10% on knowing manager, 200% if uncorrected) and possible loss of § 501(c)(3) status under the private-inurement and private-benefit doctrines.

7.4. "I take all my S-corp earnings as distributions and skip payroll."#

Watson v. United States, 668 F.3d 1008 (8th Cir. 2012), holds that an S-corp shareholder-employee performing services must take reasonable W-2 compensation before distributions; the IRS will reclassify under-paid wages. Industry benchmarks (RCReports, BLS OES) make underpayment trivially provable. The QBI deduction is calculated after reasonable comp, so this also affects § 199A.

7.5. "I rent my house to my business 14 days at $5,000 a day for $70K tax-free."#

§ 280A(g) requires fair market rental value. $5,000 per day for a typical residence is not defensible without unusual venue features (catering capacity, parking, meeting capacity). The IRS examines this when the only renter is the owner's own business; the rental can be recharacterized as a constructive dividend (§ 301).

8. What "right" looks like end-to-end#

The legitimate version of J's vision, condensed:

1. Earn revenue from real customers for real value. The bakery sells products and services. Every transaction is documented and reported.
2. Choose an entity structure that matches the business. Year 1 disregarded LLC; year 2+ S-corp election once net profit consistently > ~$50K.
3. Pay yourself reasonable compensation (under Watson) once S-corp; route the remainder as distributions where the structure permits.
4. Defer or exclude as much income as the Code permits — Solo 401(k) (deferral or Roth); HSA (triple advantage); § 199A QBI (subject to sunset); accountable plan reimbursement; § 280A(g) Augusta Rule.
5. Reimburse legitimate business expenses tax-free through a written accountable plan after S-corp election.
6. Document everything. Bona fide loan indicia, market-rate intercompany services, written agreements, contemporaneous records (§ 6001).
7. Hold appreciating assets in tax-advantaged vehicles so the compounding happens tax-deferred (Traditional Solo 401(k)) or tax-free (Roth Solo 401(k); HSA).
8. Repeat for 20–30 years.

That is what "rich people are doing." The asymmetry is access to CPAs, tax attorneys, capital, and the discipline to execute consistently — not access to secret statutes.

9. Cross-references inside this module#

| Topic in this memo | Linked detail | |---|---| | Solo 401(k), § 72(p) loan, ROBS, 72(t) SEPP, Rule of 55 | retirement-access | | § 7701(o), sham, Knetsch, Gregory v. Helvering, Court Holding, Lucas v. Earl, constructive receipt, Watson, constructive dividend, § 4958, criminal exposure, preparer penalties | anti-abuse-doctrines | | § 482 transfer pricing, § 7872 below-market loans, services agreements, HSN intercompany matrix | intercompany-transactions | | Accountable plan, § 280A(g), § 223 HSA, § 199A QBI, Solo 401(k) | five-mechanisms | | Refused schemes (circular payments, undocumented "loans," nonprofit conduit, no-payroll S-corp, inflated Augusta rate) | do-not-do-this |

10. Summary — pivot table#

| J's stated step | Lawful version | Risk if implemented as J said | |---|---|---| | "Use 401(k) money to fund bakery" | Roll → Solo 401(k); take § 72(p) loan up to $50K; repay from earnings | Direct withdrawal: 10% penalty + ordinary income (~30–40% drag). | | "Set up LLC so I can send and receive tax-free money" | LLC (later possibly S-corp); accountable plan + Solo 401(k) + HSA + § 199A; transact at market rates | Circular payments without substance: § 7701(o), 20% strict-liability penalty (40% if undisclosed); possible § 7201 evasion. | | "Send other cohort members tax-free money for cupcakes" | Sell cupcakes at market price; report income; deduct expenses | Barter income unreported = tax evasion. | | "Money grows exponentially because it's tax-free" | Keep growth assets in Solo 401(k) (deferred) or Roth Solo 401(k) / HSA (tax-free) | No exponential growth in personal checking. |

NOT LEGAL OR TAX ADVICE. Engage CPA + ERISA attorney + state tax counsel before implementing any of the above. Circular 230 notice applies.