Funding Your Business With Your 401(k)

Short on funding, but interested in starting a new business? One option is to take it tax free from your 401(k). Yes, you can do that. The U.S. Internal Revenue Service (IRS) calls it a Rollover to Business Start-Up, or ROBS arrangement for short. It's completely legal-despite the ironic abbreviation-but be aware the IRS carefully scrutinizes them.

Here's how it works: A prospective business owner forms a corporation and then immediately adopts a qualified 401(k) plan for that corporation. The entrepreneur then rolls his or her individual retirement account (IRA), 401(k) or monies held in another qualified plan into the newly created retirement plan. The new retirement plan purchases all the stock of the new corporation with the rolled over cash, giving the corporation money to fund its capital and startup needs.

The stock of the corporation is held as a self-directed asset of the newly formed plan for the benefit of the business owner. Usually the business owner is also the plan trustee and can act on behalf of the plan. This allows the owner, through the trust, the same rights and benefits they normally would have if they owned the stock directly (such as voting rights, and the ability to appoint directors). Consequently, if the business venture succeeds and the owner sells his or her stock at a premium, the transaction will be tax free since the sale of the stock is by a qualified plan, and proceeds are only taxed upon withdrawal.

Rollover with Care

Promoters of ROBS are usually investment professionals who heavily market them and set them up for a significant fee. Often the promoter will even apply to the IRS for a favorable determination letter to assure the client the IRS approved the arrangement. The IRS issues a determination letter based on the plan's terms meeting Internal Revenue Code rules. The letter protects plan sponsors as long as they follow the rules.

That leaves entrepreneurs responsible for keeping the arrangement in compliance as the company moves forward-a tall task when added to the demands of starting a new business. As a result, many arrangements fail to follow these rules, and that has caught the IRS's attention.

The IRS is concerned about these arrangements because they convert an individual's tax-deferred retirement savings into employer securities held in a new corporation's qualified plan. The IRS researched the arrangements and advised in a memorandum their intent to scrutinize ROBS plans carefully. One of the findings was that most businesses using ROBS arrangements failed. The IRS also found the fees paid to promoters may be classified as prohibited transactions if the promoter was considered a fiduciary and the fees were paid out of the newly created qualified plan. That could subject business owners to penalties of as much as 110 percent of the amounts involved.

When taking on a ROBS arrangement, an objective valuation must be done with detailed evidence backing up the newly formed company's stock value. The stock cannot just be valued at the amount rolled over into the new enterprise. The lack of a valuation by a qualified business valuation appraiser could lead the IRS to question whether the exchange is a prohibited transaction.

Another issue that these arrangements encounter is discrimination in favor of business owners over the rank and file employees. Once created, the rollover money is usually used to purchase company stock, the qualified plans are amended and no other employee has the ability to purchase the same stock. If a ROBS is successful and the stock's value increases greatly, this windfall is not shared by employees.

Dive Safely

ROBS arrangements are paperwork intensive to keep them legal and up to date. When assets are rolled over from a retirement plan to a ROBS plan, entrepreneurs must issue a Form 1099R, something many people fail to do, according to the IRS. Business owners don't understand that the qualified plan holding the company stock is a separate entity with its own requirements. Also, those qualified plans  must file the 5500 with Labor Department annually.

For all the warning and scrutiny, ROBS are attractive, especially in our current world of expensive and highly restrictive financing. I have personally seen successful ROBS arrangements. However, those firms that use them successfully understand the value of having the right team in place and being in compliance with the IRS code. If interested, take the following steps:

Make sure you are willing to risk your retirement savings.

Hire professionals to assist you in keeping the plan compliant, such as an attorney and CPA who understands these arrangements.

 Finally, understand that staying in compliance is an important part of your new venture and should be afforded as much attention as any other part of your new business.

Stephen F. Lawlor, CPA, is a principal with the firm Nathan Wechsler & Co. PA in Concord, and heads up the firm's Retirement Plan division. He can be reached at 603-224-5357 or slawlor@nathanwechsler.com.