The End of Small Business Financing with IRA and 401k Funds? (Part 3) October 21, 2009
Posted by Jeff Nabers in : Self Directed IRA Solo 401k , trackback
Ok, now it’s time to solve the mystery. (Final Post) [see previous here]
In 1978 Jimmy Carter reorganized the government with this order, and this took the issue of retirement account prohibited transactions away from the domain of the IRS and gave it to the Department of Labor (DOL).
This fact was unknown to (or possibly ignored by) the ROBS promoters who claimed the IRS ROBS letter confirmed the validity of the ROBS strategy. The truth is that the IRS letter did not say whether or not the ROBS strategy creates a prohibited transaction because the IRS didn’t have the authority to say it. It was the authority of DOL. Ah, what fun bureaucracy can be.
Speaking with the Proper Authority
Now, I’ve known about this transfer of authority ever since the creator of the IRA LLC (late attorney Debra Buchanan) told me about it back in 2004. So I’ve been in close contact with DOL employees for several years. Here’s where the bureaucracy gets funny (or scary, depending on how you look at it).
A couple of weeks after the IRS ROBS letter came out, I called my friendly DOL contacts to ask, “What do you think of the ROBS strategy that the IRS just wrote a letter about?” They responded with, “What letter? What is ROBS?”
[If my friends at the IRS and DOL are reading this now, don't take offense. Everyone knows that government agency intercommunication is kind of like Big Foot and the Loch Ness Monster. It's not your fault.]
So I faxed the IRS ROBS letter over to DOL. I was happy to do this for the IRS because I know they are really busy.
Finally… the Meeting
My annual trip to Washington, D.C. was scheduled for about six weeks later. So this gave DOL plenty of time to review the letter so we could discuss it at our meeting.
When the meeting came in December, all of the mystery surrounding ROBS collapsed with a couple of straightforward sentences out of the mouths of the decision makers at DOL (paraphrased):
The ‘qualifying employer securities’ exemption means that transaction of the plan acquiring stock from the C corporation is exempt. BUT, this exemption doesn’t throw the rules out the window for looking at the whole strategy. This whole strategy generally provides an ‘outside-of-the-plan’ benefit to the participant, who is a disqualified person. Thus this strategy creates a prohibited transaction.
Bear in mind this unofficial conversation is, well, not official. What would make it official is if I (or anyone else) submitted a written request for a DOL “Advisory Opinion” letter that explains whether the ROBS strategy is a prohibited transaction.
These DOL guys indicated that such a request would be met with an Advisory Opinion declaring ROBS illegal.
Don’t Kill the Messenger
There it is, folks. End of story. ROBS is a prohibited transaction. Many people and attorneys can disagree, but it comes down to 4 guys at this government agency in Washington, D.C. to provide the interpretation of the prohibited transaction law. In other words, it doesn’t matter what anybody thinks except for them. And they think you owe the government a 115% tax (on the amount of money involved in the scheme) if you do a ROBS.
Up until this meeting, I was just as hopeful as anyone that ROBS would come out of the gray area in a favorable conclusion. I don’t want to end this topic on an disappointing note, so I will be throwing out some ROBS alternatives in a future post.
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Jeff,
Thanks for the message! Always enjoy your timely and thorough reports. Keep up the good work.
Great post. I am not surprised. The ROBS strategy would be something I would stay from. Companies trying to make a fast buck will tell amyone just about anything to make a sale. Wall Street is proof of that. I think with the growing deficit, the revenue shortage at the IRS, the tax thristy administration coupled with the ROBS letter from the IRS should make it clear to any thinking person where the DOL is going to side on the ROBS issue once they flex their muscle. Again, I am glad you took the time to put these posts out on your blog.
There was some useful commentary on another page, so I’ll paste it here:
———————
Jeff,
I am receiving so much conflicting advice on the subject of financing a franchisee business from a self directed 401K attached to a C corporation that I would be the sole owner of – it is unbelievable. I was very interested in your series of articles – culminating in your 3rd article with the interpretation that the so called ROBS strategy is illegal and under such a strategy I would be fully liable for taxes and penalties on the 401K funds used toward the business.
Another advisor is telling me that your interpretation is clearly missing the fact that 401k rules allow an exception to the prohibited transactions rules for participant investment in employer stock and further does not reflect the fact that the strategy has been used by 1000’s of small business owners for more than 10 years. He says there has yet to be a single action brought forth against any employer or service provider.
Color me confused. Can you please address this other advisor’s rebuttal to your interpretation.
Thanks,
Jeff (reader)
——–
Jeff,
Sure. It sounds like there are 2 rebuttals.
1) MISSING THE EXEMPTION – If you read my 3 part post carefully, I am not missing the exemption at all. In fact it is clearly addressed in Part 1. The exemption is for “qualifying employer securities” and this exempts the acquisition of the stock as an isolated transaction. It does not exempt the entire scheme from ERISA or IRC 4975 (prohibited transactions). Check out the DOL Advisory Opinion 2006-1A. This set the precedent that 4975(c)(1)(D) and (E) are always applicable to retirement plan strategies regardless of exemptions and staying within certain % ownership amounts in an attempt to create loopholes.
2) THE STRATEGY HAS BEEN USED THOUSANDS OF TIMES – Unfortunately, whether something has been done a lot has absolutely no effect on whether it is illegal. It all comes down to the written law and how the government applies it. The reason there has yet to be a single action is because nobody has asked DOL to give an official opinion on it. ROBS firms don’t ask because they are afraid of an unfavorable answer. The important thing to note is that the ball is in THEIR (the government’s) court. If they have not gone after thousands of people who have broken the law, it doesn’t mean that the law wasn’t broken. And they can choose to go after these entrepreneurs whenever they want, resulting in 115%+ taxation.
– Jeff (author/blogger)
p.s. The “this has been used thousands of times” argument is possibly a bad thing. If a tax law has been abused and broken through a certain strategy, the more the strategy is used the closer it comes to reaching a point where it is “worth it” for the IRS to allocate resources to cracking down on it.
If ROBS was used 10 times and the IRS could only collect a couple million dollars in tax revenue, they couldn’t really afford to assemble an effort to do so. On the other hand if ROBS was used 5,000 or 10,000 times, there are hundreds of millions of dollars (possibly over $1 billion) in tax revenue for the IRS to collect by creating a program that goes after the scheme.
Furthermore, the more ROBS setups a particular firm has done in the past, the more likely they will be a primary target of the eventual enforcement efforts.
It’s a weird situation. The DOL makes the rules (or at least interprets them) and the IRS enforces them. Lack of agency intercommunication is part of the reason that ROBS hasn’t been totally shut down, but this zero enforcement phenomenon isn’t likely to last.
Jeff — What statutory provision did the DOL folks use as their basis for concluding that 4975(d)(1)(C) and (E) “always apply”, notwithstanding the fact that 4975(d)(13) unconditionally exempts QES transactions from the prohibited transactions rules? The statutory language seems to simply remove 4975(d) in its entirety with respect to QES purchases by a plan.
Thanks, Mike
Nice work Jeff. It should give people pause when it obviously works around the spirit of law (our plans are to invest for 59.5 and beyond – not benefit us now. Far better to stay focused on clearly permissable wealth building strategies in IRA LLC and Solo 401k vehicles. Keep up the good work.
John
Mike,
(d)(13) exempts “any transaction that is exempt based on [certain ERISA sections]”
ROBS promoters claim that these exemptions exempt EVERYTHING.
DOL says that they exempt the transaction rather than the transactions. In other words, what (d)(13) exempts is the acquisition of the stock. It doesn’t put the whole retirement plan and the adopting employer and the participants and the entire scheme into a realm of no regulation, no rules, and no prohibited transaction law.
If a person used their plan to acquire “qualifying employer securities” and then didn’t do anything else in any way to use their retirement plans to benefit themselves outside of growing the plan value, then ROBS would be compliant. But, the fact is, most ROBS users then receive compensation from their company which is a clear benefit to themselves.
Also, in addition to the plan’s ownership, most ROBS users personally/directly own a small percentage of the corporation in order to avoid the corporation being considered a “plan asset.” The problem here is that the co-ownership of the corporation between the plan and the disqualified person gives the DOL/IRS even more grounds for considering there to be a prohibited transaction because DOL Advisory Opinion 2000-10A essentially says that “if a plan and a disqualified person co-invest in a venture, it is prohibited if the capitalization of the venture could not have occurred without the inclusion of the plan’s investment.” What this means in the case of ROBS is that “if the retirement funds were needed in order to fund the business, it is a prohibited transaction” according to DOL AO 2000-10A. And, of course the retirement funds are needed to fund the business… that’s why they would be used in the first place!
Check out this Advisory Opinion too:
http://www.dol.gov/ebsa/regs/aos/ao2006-01a.html
If you want more info about DOL’s logic process:
“See 29 C.F.R. § 2509.75-2(c); Opinion No. 75-103 (Oct. 22, 1975); 1978 WL 170764 (June 13, 1978). Further, prior to the promulgation of the Department’s plan assets regulation, 29 C.F.R. § 2510.3-101, the Department had issued Interpretive Bulletin 75-2 which discusses certain prohibited transactions under section 406 of ERISA or section 4975 or the Code. As indicated in the preamble to the plan assets regulation, part of Interpretive Bulletin 75-2 was revised to coordinate it with the final regulation (51 Fed. Reg. 41278). The remainder of the Interpretive Bulletin 75-2, published at 29 C.F.R. § 2509.75-2(c), remains in force and was not affected by the plan assets regulation. Regulation section 2509.75-2(c) sets forth that a transaction between a party in interest and a corporation in which a plan has invested may constitute a prohibited transaction under certain circumstances. Such transactions are prohibited regardless of whether or not they meet the plan assets regulation.”
The logic can be confusing, and that’s why it’s possible for some attorneys to feel that ROBS is compliant.
All in all, if anyone wants an unquestionable final answer, all they need to do is have their attorney request an opinion letter on whether ROBS creates a prohibited transaction. I have had mixed feelings about doing that myself because I don’t promote ROBS. I think most ROBS promoters haven’t done this because they fear an unfavorable answer that puts themselves out of business.
– Jeff
Very enlightening. You are doing a good service running this down. Thanks.
Mike
Mike,
Well I don’t really want to run people out of business. That’s why I’ve been reluctant to tell this story and why I’ve been on the fence about writing in for a DOL Advisory Opinion request. But all in all, at the bare minimum I figured this information should be out there for anyone who wants to get to the bottom of the matter rather than jump at the first cool sounding scheme.
Thanks for your support
Jeff
Jeff,
Two questions.
The IRS published the ROBS letter in October/November 2008. You visited your DOL friends in Washington six weeks later – I’m assuming January 2009. Why wait until October 2009 to post your comments?
The following quote is from the body of the post above:
“The ‘qualifying employer securities’ exemption means that transaction of the plan acquiring stock from the C corporation is exempt. BUT, this exemption doesn’t throw the rules out the window for looking at the whole strategy. This whole strategy generally provides an ‘outside-of-the-plan’ benefit to the participant, who is a disqualified person. Thus this strategy creates a prohibited transaction.”
If a participant uses funds from a SDIRA, or SDIRA LLC, to acquire listed shares of the participant’s employer, does this provide an ‘outside-the-plan’ benefit to the participant who is a disqualified person?
If a participant owns shares of his employer in a traditional IRA would that be a prohibited transaction according to your DOL contacts? Many thousands of people own equity of their employers in IRAs and it sounds like the DOL folks you spoke to would find that the salary the participant earns ‘outside the plan’ would make this a prohibited transaction.
Tad,
Good questions
1) As I alluded to earlier I have had mixed feelings about sharing this information because of how it might effect other people. It would obviously be harmful for some people and helpful for others. It’s not that I made a conscious decision to not tell this story for a year; instead, I just wasn’t sure about it and because of my busy schedule almost a year passed.
2) I don’t know what you mean by “listed shares.” The question on whether the acquisition of QES shares provides an outside-the-plan benefit to the participant is dependent on circumstances. But the general circumstances of the people to whom ROBS is promoted make for a PT if ROBS is used.
ESOP plans have been around for a long time. Employees of big corporations have commonly used 401k funds to buy stock in the corporation. In those cases, the percentage of the company’s capitalization that came from one participant’s QES purchase is insignificant. Example: Joe works for a $5 billion company and invests $10k from his 401k into buying company stock. He has bought around 0.002% (two thousandths of one percent) of the company. His purchase did not keep the company from going under and thus increase his job security. His purchase did not enable him to get a raise or bonus. His purchase did not have a significant impact on the company’s ability to grow. His purchase did not launch the company. In short, his purchase is insignificant and unlikely to truthfully provide an outside-the-plan benefit to himself.
On the other end of the spectrum, the application of the ROBS scheme is almost always a matter of setting up a new company and having the plan fund the majority of it. Usually one or more disqualified persons work for the company. Usually one or more disqualified persons own at least 5% of the company outside of their retirement plan. In short, the plan’s ownership of company stock is significant and the disqualified person’s non-plan ownership of the company stock is significant… and the decision to invest the plan has a significant impact on the participant’s ability to work for the company and the participant’s future value of his personally (directly) owned stock.
To an entrepreneur thinking of promoting/selling ROBS or to an entrepreneur thinking of setting ROBS up to fund a small business, there is a tendency to really want ROBS to be PT-compliant and to find a little bit of favorable logic and close the case and move forward with ROBS. Unfortunately, digging deeper results in an unfavorable conclusion that says ROBS is generally in violation of prohibited transaction rules.
I hope this answers your two questions and provides further clarity.
– Jeff
Tad,
I just re-read your 2nd question and I may have totally missed it. I responded as if you were asking
“Is ROBS really illegal? Really really? Are you sure?”
…when you were basically asking a totally different question (I suspect), relating to IRAs rather than ROBS and 401(k) schemes.
First, the employer of an IRA participant is a disqualified person, according to IRC 4975(e)(2)(C). So what you described would be a blatant prohibited transaction.
Second, the exemption that ROBS promoters unsuccessfully attempt to claim is an exemption that is only for qualified plans (like a 401k) and not for IRAs.
[...] IRA Business Financing. http://jeffnabers.com/2009/10/21/the-end-of-small-business-financing-with-ira-and-401k-funds-part-3/ [...]
Jeff,
Like yourself my concern is simple, asking DOL for an Advisory Opinion could be the straw that breaks the camels back. That can of worms could devistate 10’s of thousands of retirees, current 401’s, & IRA’s. My vote is to avoid the ROBS and try to guide our efforts to safer structured investments.
thanks for your dilligence.
DRJ
Not to mention the name of the company that set up my 401k to fund my C corporation, but they showed me a letter from the IRS specifically approving their plan. This would seem to protect my plan, even if future plans are not permitted.
As I read the original letter from the IRS I take it to mean that the general concept of funding a C corporation from a 401k is completely legal. The issue they bring up is that many plans have not been implemented in compliance with the law.
What about Grandfathering? If there is a negative interpretation by the IRS, what happens to the existing plans? The IRS has accepted tax returns etc. for many years.
There was a period of a year or so after the IRS letter asking for comment and inviting the companies who sell these plans to discuss the issues. This must have helped resolve the concerns on both sides.
The companies that have been selling these plans are still selling them. If they are doing this knowing the plans are not permitted by the IRS then they could be setting themselves up. Having talked to them they feel confident that their plan is legal.
Please post comments.
Ric,
I think you’ve missed the bottom line of this 3-part post, so allow me to reiterate:
The IRS does not have the authority to rule or opine on this matter.
I know that sounds strange, but it’s the truth. The question is a matter of compliance with Prohibited Transaction law (IRC 4975). Presidential Reorganization Act No. 4 (1978) took the power away from the IRS to interpret IRC 4975 and gave it to Department of Labor.
If you have an IRS letter, it probably just states that your plan is a qualified plan. That kind of “opinion letter” doesn’t touch on what can be done with it.
If you take a qualified plan and enter into a scheme that DOL considers a prohibited transaction, then applying the letter of the law would usually mean 115%+ taxation on the amount involved.
Another read of this 3-part post probably won’t hurt if you really want to get to the bottom of this and fully grasp it.
I hope this reiteration of the main confused point was helpful to you.
Jeff
So basically, no one has bothered to get a ruling yet from the DOL?
Peggy,
That’s right. Interestingly enough, ROBS promoters don’t want to commit business suicide!
As for whether IRC 4975(c)(1)(D) and (E) endure in all situations, DOL Advisory Opinion to Debra Buchanan answered that in 2006.
Here’s the previous sentence restated in human speak:
In 2006, the government answered the question of whether or not loophole-type schemes could get around the prohibited transaction rules and the answer was “no.”
Smart attorneys get this. Sloppy attorneys don’t. ROBS promoters that aren’t attorneys only get that selling stuff makes them money.
What about the Pension Transfer Trust, where there is a multiple employer plan has a seperate from the company administrator?
Jimmy,
I have no idea what you’re talking about.
ROBS is a fairly specific structure and that’s what these 3 posts are about. I hope you found them helpful.
Jeff