Updated: Jan 31, 2019
Ever thought about starting up a business but were stymied as to where to get the funds to do so? One potential methodology is to use your retirement assets. This is known as a Roll Over Business Startup plan (ROBS).
The concept behind ROBS, is to form a new C-Corporation and adopt a 401(k) plan.
Once the C-Corporation and 401(k) plan have been established, you can then roll over your IRA into the 401(k) plan. The 401(k) plan will then purchase stock in the new corporation. The result being the funding of the corporation is done with the former IRA account. It is important to note that even though the ROBS plan will satisfy the retirement plan rules initially, any failure to comply with the rules will result in the deemed distribution of the entire retirement plan, which will then be subject to the 10% penalty tax if the plan participant is under age 59 ½ as well as a complete taxable distribution for tax purposes.
Before embarking upon using a ROBS, one should get specific written guidance from a qualified tax and/or ERISA lawyer. The C-Corporation will be taxed as a corporation and burdened by compliance, which we will discuss below and possible future restrictive legislation even though it is owned in the 401(k) plan.
Personal guarantees of corporate loans
The use of a personal guarantee of a corporate loan was thrown out in James E. Theissen et ux. v. Comm’r and Peek v. Comm’r tax Court cases. The result was the taxpayers IRA ceased being an IRA the first day of the taxable year in which the personal guarantee occurred. The tax payer was then deemed to have received a distribution of the entire value of the IRA assets fully taxable at that time.
While these cases involve IRA’s and not a 401(k) or ESOP, it is not a far stretch to assume the same reasoning would apply to a ROBS plan. Due to this uncertainty, the owners and parties of the related entities should strictly avoid any type of personal guarantee of loans. This may create a setback, as traditional lenders may be reluctant to lend to ROBS due to the concern of the tax impact of disqualification.
Payment of reasonable compensation to business owner
A 401(k) or ESOP may pay compensation to the owner of the plan, provided compensation is reasonable. This is different from a self-directed IRA. As a matter of fact in Elis, et. ux. v. Comm’r, the IRA owner purchased a business inside of his IRA and ran the day to day operation of the business. The IRA owner was payed a reasonable compensation as manager of the business, but the tax court held the compensation paid to the IRA owner was a prohibited transaction and thus resulted in the indirect use of plan assets for the benefit of the individual. In the end the IRA was deemed to have distributed to the owner, who was immediately liable for the taxes on the entire value, plus a 10% excise tax penalty and interest.
Providing direct or indirect services to an IRA
It is critical to roll over the funds from the IRA to the 401(k) or ESOP prior to providing any services to company. This is due to the fact that providing a service to an IRA owned business, may constitute furnishing services to the IRA and thus disqualify the plan.
Lack of notification of plan existence
A 401(k) plan must have a definite written program communicated to employees, in order to avoid a violation. It is mandatory that future employees, as well as current employees, are notified of the existence of the ESOP or 401(k) plan. Not notifying the employees could cause disqualification.
In addition, one is cautioned against using independent contractors to avoid offering the stock to the employees. If at a later date the independent contractor is reclassified as an employee, this could disqualify the entire plan, as well as causing other problems.
Plan Assets used for Personal Expenses
The disqualification of the plan came about because the corporation purchased a recreational vehicle for the shareholder. The purchase used some of the money received in exchange for the stock of the corporation in a ROBS plan.
Stock sale must be a transaction for adequate consideration
In order to avoid a prohibited transaction dealing with the purchase price of the stock, it is imperative that an evaluation of the business be made proving that the stock sale as part of the ROBS was for adequate consideration.
Improper use of funds to pay for promoter fees
This is an area that the IRS has been scrutinizing. When a corporation uses part of its cash raised from the sale of the stock to pay the fee of the promoter of the ROBS plan, this can be seen as an indirect use of plan asset and thus a prohibited transaction.
Discrimination in favor of highly compensated employees
A well-known ERISA attorney, Natalie Choate, reports the IRS’s best argument in disarming a ROBS plan which has employees, is to disqualify the plan if the stock was not offered to the rank and file.
Failure to issue a form 1099-R when the asset are rolled over into the ROBS plan
As with all qualified plans, it is imperative that the proper tax returns and forms are all filed on a timely basis including the form 1099-R.
Failure to file 5500’s
As above, it is also imperative to have a reputable qualified pension plan attorney and/or actuary to assure the appropriate plan rules and formalities are being followed including the preparation of form 5500.
The IRS to date has not issued any specific adverse rulings but, the IRS does scrutinize these types of arrangements and even though not issuing any adverse rulings, has issued literature as to the technical reasons why they might be seen as problematic. As with all sophisticated planning, it is important to consult with the appropriate advisors in order to comply with the complex rules involved in a ROBS plan. It is very easy to make a simple mistake and have the entire plan disqualified.