Rollovers as Business Startups: A Guide to Using Retirement Funds to Start a Business
By Thomas R. Wechter
October 17, 2013
AICPA Tax Insider
Over the past 10 years, thousands of entrepreneurs have used their existing retirement savings held by a qualified retirement plan or IRA to finance the startup or acquisition of a new business. According to industry experts in 2010, since 2005, more than 10,000 business startups had been financed using arrangements whereby individual qualified plan accounts or IRAs were rolled over into a newly established 401(k) plan sponsored by the startup business and then used to purchase the new business's stock. These arrangements are commonly referred to as rollovers as business startups (ROBS). The arrangement allows entrepreneurs to purchase or capitalize a new business with previously untaxed retirement funds without incurring any taxes and penalties that normally apply to early distributions from these funds.
Promoters aggressively market ROBS arrangements to prospective business owners. In the franchise area, franchisors often refer prospective franchisees to ROBS promoters to finance the purchase of a franchise. In many cases, the franchisor pays an undisclosed referral fee to the ROBS promoter.
Although the IRS has not endorsed ROBS arrangements, which has led some commentators to conclude that the IRS is hostile to the arrangement, the IRS has said that it does not believe that the form of these arrangements "may be challenged as non-compliant per se" and that the Service will review ROBS arrangements on a case-by-case basis to determine whether an arrangement complies with the law (see IRS Tax-Exempt and Government Entities Division memorandum, "Guidelines Regarding Rollovers as Business Start-Ups" (10/1/08)).
This article focuses on the typical structure of a ROBS arrangement, the IRS's reaction, and the legal pitfalls to avoid.
The basic structure of a ROBS transaction consists of five sequential steps:
- The entrepreneur forms a new corporation, usually a C corporation.
- The corporation adopts a prototype 401(k) plan that specifically permits plan participants to direct the investment of their plan accounts into a selection of investment options, including employer stock; usually the plan allows employees to roll over or to execute a direct transfer from an existing qualified retirement plan account such as a 401(k) plan with a former employer or an IRA to the new plan and to use the rollover proceeds to purchase the employer's capital stock. At this point, the corporation usually has no employees, assets, or business operations, and may not even have received a contribution to capital to create shareholder equity.
- The entrepreneur becomes the corporation's only employee, elects to participate in the newly created 401(k) plan, and directs a rollover or trustee-to-trustee transfer of retirement funds from another qualified retirement plan account plan or IRA into the newly established corporate plan.
- The entrepreneur then directs his or her account to purchase the newly issued corporate stock at par value. Usually the employer stock is valued to reflect the amount of plan assets that the entrepreneur wishes to invest in the purchase of the new business. In early ROBS arrangements, the plan was amended after the purchase of the corporation stock to provide that other participants could not roll over their retirement funds from another qualified retirement plan and could not purchase the corporation's stock with their rollover funds. These types of amendments are no longer made since the IRS pointed out that the amendments may violate certain qualified retirement plan requirements.
- The entrepreneur then directs the corporation to use the funds from the sale of the stock to purchase a franchise or an existing business, or to begin a new business or venture.
Since the assets of the qualified retirement account have been moved from one qualified retirement account to another, the income taxes and penalties that otherwise might apply have been avoided. Normally, distributions from qualified retirement accounts are taxable as ordinary income at the individual's effective tax rate, with an additional 10% penalty under Sec. 72(t) for premature distributions. But these taxes do not apply to a qualified rollover.
2008 IRS memorandum
At the time the IRS issued its memorandum, it had become aware that thousands of qualified retirement accounts were being used to invest in new businesses that benefited the participant but excluded other employees, without incurring any taxes or premature distribution penalties (and that promoters were aggressively marketing ROBS). The memorandum addresses potential problems raised by ROBS and provides guidelines to address whether the arrangements will be considered abusive and whether plan qualification, prohibited transactions, and other issues are present. The IRS ultimately concluded that ROBS were legal and not abusive per se and that they could serve legitimate tax and business planning needs.
The memorandum noted that IRS compliance efforts would focus on the issues raised by being qualified plans, such as the lack of employee notice of the plan benefits under Regs. Sec. 1.401-1(a)(2) and the failure to file returns, such as Form 5500EZ, Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan,used to determine whether a plan remains "qualified." These issues apply equally to all qualified employee retirement plans.
Pitfalls to watch out for
The memorandum outlined several areas that would warrant increased IRS scrutiny to ensure that ROBS arrangements are not being abused. Included in those areas are whether the ROBS plan discriminates in favor of highly compensated employees in terms of benefits, rights, and features under Regs. Sec. 1.401(a)(4)-4, particularly the right to acquire employer stock; whether the employer stock is improperly valued, resulting in a prohibited transaction; whether the fees paid the ROBS promoter constitute a prohibited transaction; and whether the ROBS plan meets the permanency rule for tax qualification.
ROBS plans must meet the permanency requirement described in Regs. Sec. 1.401-1(b)(2). Although an employer may reserve the right to amend, change, or discontinue a plan, abandoning a plan for other than business necessity within a few years after it has begun will be evidence that the plan was not a bona fide program for the exclusive benefit of the employees in general.
Although ROBS arrangements themselves do not violate the permanency requirement, the IRS cautioned that facts will be considered on a case-by-case basis, such as failure to communicate the plan to the employees or failure to make contributions to the plan, which tend to support the lack of permanency.
A primary area that the memorandum focused on as warranting scrutiny is whether the ROBS plan discriminates in favor of highly compensated employees in terms of benefits, rights, and features. Since at the outset in a ROBS arrangement, when the business is being created, there are no highly compensated employees or employees that own 5% or more of the corporation's stock, the discrimination rules probably do not apply.
However, a ROBS plan allowing only the entrepreneur to purchase corporate stock or disallowing all rollovers after the entrepreneur's initial rollover may violate the "current availability" or "effective availability" requirements of the nondiscrimination regulations. Under the regulations, a benefit, right, or feature of a plan must be effectively available to non-highly compensated employees on the basis of all facts and circumstances.
The "current availability" standard, which requires non-highly compensated employees to be able to invest in the employer's securities, is satisfied in the initial year of the ROBS arrangement since there may be no highly compensated employee or no other employee than the entrepreneur.
The "effective availability" test, which requires that other employees receive benefits under the plan, must also be satisfied. If a ROBS plan was amended immediately after the initial transaction to take from future employees the rollover right and the right to purchase corporate stock, then those rights would not be considered "effectively available," even though at the time there were no highly compensated employees.
To avoid an IRS challenge, most ROBS plans no longer are amended immediately after the initial transaction to remove other employees' right to roll over other retirement accounts into the plan and purchase corporate stock. As a result, under most ROBS plans, all participating employees are allowed to roll over their retirement accounts and purchase employer stock with their rollover funds.
Prohibited transactions: Valuation of assets
An exception to the prohibited transaction rules exists when a plan purchases employer securities if certain requirements are met. One of those requirements is that the plan must purchase the employer's stock for no more than adequate consideration. The memorandum questions whether the lack of a bona fide independent appraisal raises the issue whether the purchase of the employer's stock was for adequate consideration. The IRS notes that in many cases its examiners have been handed a single sheet of paper, signed by a "purported valuation specialist," claiming to certify the value of the company's stock. Lack of adequate consideration could result in a prohibited transaction, the IRS says.
The law contains no such requirement, and it is questionable whether an independent appraisal is necessary to value a business when the only asset of the business is the cash contributed for the stock. However, the IRS does not seem inclined to accept this and will require some other analysis of the value of the business beyond the cash contributed for the stock.
In addition, to avoid the purchase of the employer's stock being classified as a prohibited transaction, no commission can be paid by the employer.
Prohibited transactions: Promoter fees
The memorandum is also concerned about whether the payment of promoters' fees is a prohibited transaction. When the plan purchases the employer's stock and the employer pays professional fees to the promoter from the proceeds, these fees may be a prohibited transaction if the promoter meets the definition of a fiduciary under the regulations, which includes a person who renders investment advice for a fee (Regs. Sec. 54.4975-9(c)).
Effect of prohibited transactions: Peek case
Even if a ROBS arrangement passes muster under the memorandum, the arrangement still has to satisfy the other qualified plan requirements. In Peek, 140 T.C. No. 12 (2013), two business partners had directed their IRAs to purchase the stock of a corporation that they had formed to acquire the assets of a corporation. The partners personally guaranteed a promissory note to the seller of the assets as part of the purchase price. A couple of years later the partners rolled over the corporation's stock from their traditional IRAs to Roth IRAs, including the value of the stock in income. After the stock had appreciated substantially, the partners directed their Roth IRAs to sell the stock. The partners' personal guarantees of the loan were in effect up to the date of the sale.
The Tax Court held that the personal guarantees constituted an indirect extension of credit to the IRAs, which was a prohibited transaction, resulting in the partners' accounts' failing to qualify as IRAs throughout the time that the loan guarantee was in effect. As a result, the partners were taxed on the capital gains realized on the sale of the stock of the corporation because the IRAs were not valid.
The Peek opinion did not address any of the issues raised in the memorandum, and it does not appear that the IRS raised any of those issues while litigating the case. It can only be assumed that the IRS examined the ROBS arrangement in accordance with its examination guidelines in the memorandum and did not find any violations of those guidelines.
As the IRS concluded, ROBS arrangements are not tax shelters or unlawful, and they are not noncompliant per se. Properly structured and administered ROBS arrangements can satisfy both the requirements and spirit of the tax law and can serve a legitimate tax and business purpose.
Thomas R. Wechter, J.D., LL.M. (Tax), is a partner with Duane Morris LLP in the Chicago office and concentrates his practice in tax planning for individuals, corporations, and partnerships and in tax controversy matters in front of the IRS and before the Tax Court, U.S. Court of Federal Claims, and the district courts.
Reprinted by permission.