ROBS (Rollovers as Business Start-up)
Anyone contemplating a ROBS transactions will want to read this IRS memo.
ROBS (Rollovers as Business Start-up) is the acronym used to describe a somewhat questionable technique used for starting a business with 401k rollover. The ROBS technique is controversial both because the IRS tends to frown on the practice and because of the extreme risk involved in taking one’s retirement nest egg to start up a business.
Still, with bank financing for new businesses at a virtual standstill, ROBS has been heavily marketed as a legitimate financing plan particularly as a funding method to start a franchise operation. Several firms are marketing their services to walk entrepreneurs through the ROBS process – for substantial fees.
An IRS memorandum critical of the funding method describes the steps involved in a typical ROBS transaction:
- An individual establishes a shell corporation sponsoring an associated and purportedly qualified retirement plan. At this point, the corporation has no employees, assets or business operations, and may not even have a contribution to capital to create shareholder equity.
- The plan document provides that all participants may invest the entirety of their account balances in employer stock.
- The individual becomes the only employee of the shell corporation and the only participant in the plan. Note that at this point. there is still no ownership or shareholder equity interest.
- The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created qualified plan. These available funds might be any assets previously accumulated under the individual’s prior employer’s qualified plan, or under a conduit IRA which itself was created from these amounts. Note that at this point, because assets have been moved from one tax-exempt accumulation vehicle to another, all assessable income or excise taxes otherwise applicable to the
distribution have been avoided. 1- The sole participant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.
- The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise. Note that all otherwise assessable taxes on a distribution from the prior tax-deferred accumulation account are avoided.
- After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment option. Future employees and plan participants will not be
entitled to invest in employer stock.- A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to promoter.
The IRS makes it very clear in this memo that they cast a wary eye on ROBS and detail numerous potential violations that could be triggered by these transactions. ROBS are considered technically legal, but fraught with dangerous pitfalls that could potentially cost you not only your retirement savings, but also extremely stiff IRS penalties and fees.
It goes without saying, then, that the legal, tax, and personal finance implications of using ROBS makes it absolutely essential for anyone contemplating this technique to have competent legal and financial advisors at their disposal.
Notes:
- Distributions from tax-deferred accumulation accounts would generally be taxed under IRC § 72, which specifies treatment for various forms of annuity or non-annuity payments. In general, a single sum distribution would be taxed as ordinary income, at the individual’s effective tax rate. Of particular concern here, the distribution would generally also be subject to the 10% “premature distribution” penalty provided by IRC § 72(t), unless the individual was at least 59-1/2 years old on the transaction date, or met one of the other limited statutory exceptions. ROBS transactions effectively avoid all § 72 concerns. [↩]
First, I have never met an aspiring entrepreneur who wasn’t confident in their business idea. Most people hope that one day they can live the American Dream by starting their own business and retiring rich. If only it were that easy. The reality is that most small businesses don’t survive. I don’t say that to discourage aspiring entrepreneurs from starting a new business, but to remind you of the reality that the odds are really stacked against new entrepreneurs before they even start their business. This is why many first time entrepreneurs seek a franchise to launch their entrepreneurial careers.
Though many individuals have written that entrepreneurs are looking to access their retirement to start or finance a business because of the down turned economy, the truth is that the search for financing has always been a significant hurdle which entrepreneurs have had to overcome. Less seasoned entrepreneurs have turned to their retirement because they cannot secure debt financing from a bank, their business opportunity is not suitable to secure equity investors, and they don’t’ have savings.
Between ROBS Promoters and franchisors/business brokers, first time entrepreneurs don’t have a chance. ROBS promoters, like Benetrends, Guidant Financial Group, FranChoice, CatchFire, and others heavily market and promote the use of retirement money to start or purchase a business, typically, a franchise. More common than not, franchisors and business brokers refer entrepreneurs to ROBS promoters who pays the franchisor or broker a referral fee or offer the referrers client a discount on their ROBS transaction if purchased. The franchisor and business broker have a vested interest in the entrepreneur accessing their retirement to start or acquire a business because each will walk away with a chuck of the entrepreneurs money. ROBS promoters are not independent licensed advisors, but self-interested sales people who claim to be experts. In order to be experts the ROBS promoters would have to be an attorney since the ROBS transaction is predicated on several bodies of law.
Currently, the law does permit a retirement plan to purchase employer securities. The idea behind this law was to provide employees opportunity to take a vested interest in their employer. The law was not created to allow entrepreneurs to access their retirement to start or purchase a business. (See http://www.RainsExchange.com for more on this topic). There are all sorts of fiduciary issues that arise when a company offers employer securities to its retirement plan as an investment option, but ROBS promoters won’t tell you about those issues because it may discourage you from purchasing their transaction.
Also, when you purchase a ROBS transaction from a promoter, all you are buying is a corporation and a retirement plan for a heavy premium. Today, registering a corporation is as easy as 123. Save your money and consult with a qualified employee benefit attorney instead. Attorneys are required to provide independent advice and failure to do so could result in disbarment. Though at least one ROBS promoter is owned by an attorney, the company he owns is not a law firm. It would be an ethics violation for this attorney to advise prospective clients on the transaction because of the inherent conflict of interest between the prospect and the attorney (namely he is trying to sell the prospect his company’s ROBS transaction).
Listen, the short of it is this…BUYER BEWARE. Don’t rely on advice from self-interested persons who have a vested interest in you accessing your retirement to start or purchase a business. Though it is perfectly legal for a retirement plan to purchase employer securities, ROBS transactions are fraught with many issues that you (not the ROBS promoter or franchisor) will pay for. There are good franchise businesses out there and great business brokers but if either discourages you from getting independent legal advice run the other way.
Great information. Just as you mentioned, i was referred to a ROBS promoter by a business broker, hummm. Very interesting. Thank you.
Thank You for this information. I was just starting to research this through one of the companies you mentioned. I certainly will be more prepared after reading this.
Yes, this is interesting; in that, the intent under ERISA has finally caught up with the implication of ROBS. It is not, in my opinion, a wrongheaded capital strategy but simply not commonly implemented to the extent a prudent person would expect. The odds of the person starting a business also possessing such prudence in order to fully appreciate such a compressed arrangement are quite high. Beyond the stresses of a business start up one would almost surely experience, comes the layer of prudence, and prudence is always preceded by experience.
This said, by definition, entreprenaurialism requires risk (not prudence). Risk is a purely mathmatical term reflecting the possibility of an outcome based on several variables. However, those who succeed at their business understand what needs to be done and do it when it is necessary. There are those who will attempt to succeed at a business and those who will succeed.
By laying out a capitalization plan which includes this arrangement is quite necessary. Anyone who explores their funding options must consider this as well as other such sources.
There is a much safer and better way to use your current 401k to start your own successful business.
I received training on how to roll my 401k into a self-directed 401k without penalty, start my own LLC and use that to invest in Real Estate. With the previous history of the stock market, I was tired of earning .5% to 2% return on “my” money in addition to someone else having control.
With the Real Estate market in the condition it is in, I am now acquiring houses ridiculesly low, doing moderate repairs and selling them below (current) market value and making money.
Now my 401k is seeing from 10%-12% returns on my investment. 888.292.1406
That’s exactly what I was thinking about doing, but with rental property. Any further insight would be helpful. Thanks!
oh yes good idea the real estate market has done so well!!!!! you are palying with fire…
Thank your Emily Sharp Rains, Esq.,
How timely it is to read this article. About three years ago, I was receiving about four calls per month from one of the ROBS marketing firms you mentioned. They wanted me to open my book of business to ROBS marketing reps and earn commissions from facilitating sales with my clients.
Although I believe in the American entrepreneurial spirit as an owner of a marketing consulting firm and regularly encourage people to pursue opportunities after extreme due diligence, I took a pass on the ROBS program. The potential IRS headaches are tremendous even if just the smallest thing goes wrong, in my opinion…namely the business going bust during the first year.
The problem that I see with most startup investments is the lack of well-developed marketing plans. In my consulting practice to help existing business owners, the first remedy to get them back on track is to ask for initial and ongoing marketing plans, which normally do not exist. The next step is to perform a thorough S.W.O.T. analysis of current operations, human resources capabilities, cash flow, competitors’ analyses, current and future trends, etc.
The point to all of this is most people making ROBS or self-directed IRA financial commitments, raiding their portfolios, have very little business knowledge to possibly see ventures generate a profit.
However, I do feel that, due to the debilitating condition of the America’s economic system, some degree of risk must be taken for people to create wealth and/or retire with financial dignity after working so long and hard for 40 to 50 years.
Whichever decision is made, make it a wise, well-thought one.
Rick at: http://www.e-chamberconsulting.com
I am really torn on this issue. On the one hand I agree that people should have the liberty to use their retirement capital to start a self directed business. On the other hand any business like this with franchises being sold and people being led to ROBS 401K firms can lead to some bad decisions.
If a client of mine was asking whether it is a good idea to to a 401K ROB then I would first have to gauge the safety of the investment. If they wanted to buy a know fast food franchise it might make sense. If they were buying a more risky type business I would have to advise against it.
http://www.BleifeldCPA.com
You you should edit the post subject Starting a Business with 401k Rollover | 401k Planning to something more suited for your subject you write. I liked the the writing however.
What is the cost of a ROBS with an attorney and CPA to begin a Corporation with my 401K? Is it a percentage or are there flat fees?
Jim: In general, an attorney will charge less than a ROBS promoter because the attorney does not incur the “acquisition” cost (i.e, doesn’t pay a referral fee. Attorneys are under an ethical obligation to charge reasonable fees for their work and not to split fees with third parties, especially individuals who refer business. As has been well stated above, an individual contemplating a ROBS transaction has a lot to think about and needs some disinterested guidance – that’s what lawyers do. My guess on a fee range would be between $2500 and $4000.00 by an experienced ERISA and tax lawyer.
To Roger L.,
You may well have unrelated-business-income and debt-financed-income issues. Better find a really good accountant to help you before you get an audit.
To all.
The prohibited transaction rules sate that any “direct or indirect” transaction involving a plan or a party in interest (that’s you) constitutes a prohibited transaction. I’ve never heard anyone adequately explain how to get around the “indirect” issue and I don’t believe any of the ROBS plans, unless they can produce an on-point revenue ruling, will work.
There is a strategy that may work to access these funds if structured properly, but you have to have the right facts and the right people (to avoid a step-transaction challenge). And the documentation has to be impeccably.
The best strategy is to revamp the tax code. But word has it that the current administration in Washington is looking for ways to pull existing retirement funds into the social security bucket, in effect nationalizing them. That is not a far-right conspiracy theory, either. I wish it were. There have been very active discussions about this for the last 15 years.
If you want to sleep and night, it’s my opinion that you should take the money, pay the tax and start your business.
Besides being a lawyer (who practices tax law), I’ve built several businesses, so, I understand capital needs and the entrepreneurial spirit. If you do decide to do a ROBS strategy, find the best ERISA tax lawyer you can find, and let him do it for you. Stay away from the companies promoting themselves on the Internet. And if a broker is involved, have your business lawyer put a clause in where the broker warrants that he/she is not getting any referral fees from anyone.
Finally, if you do go with one of the ROBS companies, insist that they produce revenue rulings or cases that explicitly sanction this strategy, and ask them if they will guarantee the process will survive any challenge by the IRS, and they will pay the defense costs if that happens and indemnify you against any loss. If they are promising you this strategy works, ask them to put their money where there asking you to put yours. If you do that, you will probably never get a call back from them. Although on some scam strategies I’ve seen companies who will issue these guarantees, but 5 years from now, they and the principals will have disappeared off the face of the earth.
Best of luck to all you folks with the entrepreneurial spirit. It’s a worthy challenge to build a business.
C
What if I were to form a C Corp as a new business entity, use a portion of my 401k to capitalize the Corp through ROBS, essentially purchasing the initial stock, then operate the C Corp as the investment vehicle for real estate using the capital acquisition from my 401k? I’m not trying to break any laws, just access some initial operating capital. Could this be kosher?
I have helped over 1,200 individuals create corporations using their own retirement funds under the ROBS process. This is a legal option when certain rules are followed. There is no single revenue ruling that states how to do a ROBS. Instead we have a series of rules that comprise all of the parts of such a transaction. Several clients have been audited by the IRS and all of the ROBS transactions have been upheld as valid (not creating a prohibited transaction or distribution). A true ROBS investment should be done because the individual believes the investment represents a reasonable expectation of return. I am not going to outline all of the rules here but if you are interested look me up.
Yet, another scam concocted by Wall Street with the corporate government doing the PR for it. However, all I have to say is that faced with the prospect of either losing all my money to the high rollers in Wall Street or 40% of the mafiosos at the IRS, I’d rather roll all of the money over and start my own business. Either way it’s coming back to me and at least in these hard times that’s a way to have a job. Heavens knows that the 1% ain’t gonna give me one or take care of me!