There are many retirement asset-funded investment and business schemes that run from taking loans to “rollover as business startup” (ROBS) plans. They have been around for many years and typically they are generally a bad idea. I discourage most would-be investors due to the legal and financial liability involved. I have had people come to my law firm from Fort Worth and Dallas looking for information about these types of 401k plans and as an employment attorney, I rarely find these plans a good idea.
What are 401k rollover as business startup plans (ROBS plans)?
These plans are concocted by financial professionals as a way to access retirement funds. While typical investments may not be perfect it is easier to understand the risks in mutual fund shares than a new business. The risk to your retirement savings is obvious. If your investment venture falls flat and you lose money not only will your retirement savings evaporate. Because retirement accounts are tax-deferred you cannot deduct losses against your income.
There are two very common investment types these schemes promote: property investing and new business ventures. There are several ways you can access your retirement assets to finance these ventures.
The information below is general. Should you decide to further explore these investment schemes you should consult a competent accountant or certified financial planner (CFP). You may also need to speak with an employment attorney experienced in handling business affairs or real estate law.
Understanding Rollover as a Business Startup Plan
Definition of Rollover as Business Startup (ROBS)
ROBS, also known as the ROBS 401(k) plan, is a legal and IRS-sanctioned method that allows entrepreneurs to invest their retirement funds in their own business without incurring early withdrawal penalties or taxes. It enables individuals to roll over funds from their eligible retirement plans, such as 401(k)s or traditional IRAs, into a new C corporation that sponsors a qualified retirement plan.
How ROBS Works
The process of implementing a ROBS plan involves several steps. First, the entrepreneur establishes a C corporation for their new business. Then, they create a qualified retirement plan for the corporation. Subsequently, the entrepreneur rolls over their existing retirement funds into the newly formed plan. These funds can then be utilized to purchase stock in the corporation or provide working capital for the business.
Advantages of ROBS
ROBS offers several advantages for entrepreneurs seeking startup capital. Firstly, it allows individuals to access their retirement funds without incurring early withdrawal penalties or taxes, providing a valuable source of capital. Secondly, it eliminates the need for external financing, which can be difficult to obtain for new businesses. Moreover, ROBS allows entrepreneurs to maintain control over their business without diluting ownership or involving outside investors.
Eligibility and Requirements for ROBS
To take advantage of ROBS, certain eligibility requirements and considerations must be met.
Eligible Retirement Plans
ROBS primarily involves the rollover of funds from eligible retirement plans, including 401(k)s, traditional IRAs, and certain other retirement accounts. It’s important to note that not all retirement plans are eligible for a ROBS transaction. For instance, Roth IRAs are generally excluded from this type of plan.
Qualifications for the Business
The business for which the funds are being used must qualify for a ROBS plan. It should be a legitimate C corporation and operate a qualified retirement plan. Additionally, the business must adhere to all IRS regulations and guidelines related to ROBS.
Compliance with IRS Regulations
ROBS transactions must comply with various IRS regulations, such as those outlined in the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. Failure to comply with these regulations could result in penalties and potential legal consequences.
Steps to Implement ROBS
Implementing a ROBS plan involves a series of steps that entrepreneurs must follow carefully.
Forming a C Corporation
The first step is to establish a C corporation for the new business venture. This involves registering the corporation with the appropriate state authorities and fulfilling all legal requirements for incorporation.
Establishing a Retirement Plan
After forming the C corporation, the entrepreneur must create a qualified retirement plan that complies with IRS regulations. Professional assistance from a retirement plan provider or attorney is highly recommended to ensure compliance and proper plan administration.
Rollover of Funds
Once the retirement plan is established, the entrepreneur can proceed with rolling over funds from their eligible retirement account(s) into the newly formed plan. This process typically involves initiating a direct rollover or trustee-to-trustee transfer, which ensures the funds are transferred without incurring any taxes or penalties.
Using the Funds for the Business
Once the funds are transferred into the ROBS plan, the entrepreneur can use them to purchase stock in the corporation or provide capital for the business. It’s important to follow the guidelines set by the retirement plan and ensure that all transactions are conducted in compliance with IRS regulations.
Risks and Considerations of ROBS
While ROBS can be a viable option for financing a business startup, it’s crucial to be aware of the risks and considerations associated with this strategy.
Legal and Compliance Risks
ROBS transactions involve complex legal and compliance requirements. Non-compliance with IRS regulations or improper administration of the retirement plan could lead to penalties, disqualification of the plan, or potential legal issues. Entrepreneurs considering ROBS should consult with legal and financial professionals to ensure full compliance.
Investing retirement funds in a new business carries inherent financial risks. Entrepreneurs should carefully evaluate the business’s potential for success and consider diversifying their investments to mitigate risk. It’s important to be aware that not all businesses thrive, and there is a risk of losing the invested funds.
Potential Tax Implications
While ROBS allows entrepreneurs to access retirement funds without incurring early withdrawal penalties, there may still be tax implications. It’s advisable to consult with a tax professional to understand the specific tax implications based on individual circumstances.
Alternatives to ROBS
While ROBS can be a suitable option for some entrepreneurs, there are alternative methods for obtaining startup capital.
Entrepreneurs can explore Small Business Administration (SBA) loans, which offer government-backed financing options for new businesses. SBA loans often have favorable interest rates and longer repayment terms, making them an attractive choice for many entrepreneurs.
Traditional Financing Options
Traditional financing options, such as bank loans or lines of credit, can provide the necessary capital for starting a business. However, these options typically require a strong credit history, collateral, and may involve higher interest rates.
Bootstrapping refers to self-funding a business using personal savings, revenue generated from the business, or support from friends and family. While it may require personal financial sacrifices, bootstrapping allows entrepreneurs to maintain complete control over their business and avoid debt or equity obligations.
Background on 401k business rollover plans (ROBS 401k plans)
The property investing schemes were very popular during the housing boom in the mid-2000s. Plans were cast about to get people to use their 401ks and IRAs to buy their home as well as vacation homes, timeshares and investment properties. Sometimes these strategies worked out well but not always.
Some of the more permanent options include forming corporations that own the properties and then the retirement money is rolled into an IRA where the funds become free from the limited investment options of the 401k. You can then hold stock for your operating company that owns the underlying properties. These accounts created some real problems for people. If the property would not sell or rent, that lost income is unavailable for deduction. There are also concerns over where money for repairs, insurance and taxes come from.
When tax-deferred and after-tax money mingle by the owner it creates complicated tax situations that can result in as little as paying extra taxes or penalties to as much as potentially losing the tax-deferred status of the assets. Often you will want to consult with tax professionals and legal professionals about these decisions.
Other 401k plan options available under ERISA
Less permanent options saw people taking 401k loans or withdrawals from IRAs with the intent of returning the money in sixty days as a “rollover”. A plausible idea if you planned on flipping the house within a very short time period but as happened as the housing market cooled, those houses did not sell. If you took a loan, you had to pay through your salary plus pay the costs of keeping a house, taking a double hit on your income. If you took the IRA withdrawal, you likely saw those funds become taxable and possibly incur the 10% penalty. Employment lawyers familiar with 401k issues may advise avoiding these moves.
Business ventures tend to only follow more permanent retirement-based financing because most people do not flip businesses and rarely have the opportunity to keep a 401k loan active when they leave to form their own business. Rather, people tend to start new businesses, buy existing businesses or buy franchises as either their full time employment or as a side venture.
Franchise-based businesses are especially keen on promoting these arrangements, especially ROBS discussed below. The obvious concern here is the business risk. Many new businesses and franchises fail and end up bankrupt. The result is again, losing that retirement money and having no way to deduct the loss. Tying your money in a single venture means you lack diversification which increases the damage caused by a single investment.
One common technique, like property investing, is to roll your money into an IRA, form the corporation and then buy the shares of your corporation with your IRA funds. This can create a tricky tax situation and if you go this route, you should seriously consider hiring a qualified accountant to help you navigate the taxes. Like property investing, you can create serious tax problems when you mix taxable and tax-deferred funding in a business. Employment lawyers or other legal professionals may be helpful to consult before making a decision.
Differences between 401k and IRA options
A bizarre and generally dangerous idea is the rollover as business start up (ROBS) technique. In this scheme, you use your business’s 401k plan to finance the company. This is slightly different than funding through an IRA. In a ROBS you form your corporation and then the business creates a 401k plan. You then roll your retirement funds into the 401k plan and make the investment available shares of the corporation. You then “buy” the shares and transfer your retirement money to corporate assets while the shares remain in the plan.
The benefit is you avoid the tax pitfalls of investing in the IRA. Plus, your 401k assets are inaccessible by creditors in bankruptcy. However appealing it may sound, it has serious problems. In addition to the business risk, you have to deal with running a 401k plan. To invest in the 401k without executing prohibited transactions you have to very carefully execute several steps. Then you have to complete various tax forms, disclosures, etc. to keep the plan running viably.
The effect of improperly operating the 401k can run from penalties to a 110% penalty. That effectively means you owe the IRS all your 401k money plus 10%. Ouch. Of course, you can pay an administrator to assist you. That will be expensive and your business may not have the finances to support it. Unsurprisingly, the IRS and DOL pay careful attention to small 401k plans because business owners sometimes abuse plans to avoid taxes.
As you can see, there are many financial and legal concerns in these schemes. Rather than take the likely unqualified advice of the person hawking this idea to you, you should carefully discuss these concerns with legal, tax and financial planning specialists who can help provide you with accurate information relevant to your situation. Employment attorneys help clients with 401k and other retirement plan issues.
Get help from an employment attorney specializing in employee benefits
ROBS plans can create headaches if not developed within ERISA, IRS, DOL and DOT regulations. There are more opportunities to create problems for years than opportunities to build businesses. Before you put your retirement savings at risk to IRS and other penalties you should talk to an employment attorney specializing in employee benefit plans. Few law firms deal with ERISA and employee benefit laws but you should find one to review your situation and wither a ROBS plan is right for your 401k saving.