The End of Small Business Financing with IRA and 401k Funds? (Part 1)

road_block

Guidant calls it Audeo. Benetrends calls it Rainmaker. SDCooper calls it ERSOP. It goes by many names and it’s gotten a lot of attention from the franchise industry and, as of about a year ago, the IRS. The IRS calls it “ROBS” for Roll-Over Business Startup.

What is it?

It’s a strategy where a person with retirement funds:

  1. Forms a C corporation.
  2. Uses the new C corporation to adopt a 401(k) or profit-sharing plan.
  3. Performs a rollover from existing retirement funds (IRA, 401k, etc) into the new 401(k) plan.
  4. Directs the new 401(k) plan to invest into the new C corporation by purchasing shares of stock.
  5. Now this person has a C corporation with some or all of their retirement funds in it, and they are told they can use the funds to run the corporation, launch a venture, buy a franchise, and even pay themselves a salary.

Special Powers – For Good or Evil?

This is a tremendously powerful strategy. The problem? Many attorneys think it’s illegal because of the prohibited transaction rules. Those rules say that the accounthoder (a.k.a. plan participant) is classified as a “disqualified person,” meaning that the retirement plan can’t transact with him or do things designed to benefit him outside of growing the plan.

To complicate matters, many other attorneys think it’s legal and on very solid ground. Why the disagreement? The pro-ROBS attorneys say that a special exemption throws the prohibited transaction rules out the window when you classify the transfer of the C corporation stock as “qualifying employer securities.”

A Quest for the Final Answer

About a year ago, my phone was ringing off the hook from people saying, “Some say it’s legal, some say it’s illegal. What’s the truth? I don’t want to risk my retirement fund on something sketchy!”

So I set out to get to the bottom of it, and the outcome will surprise you. Stay tuned for the tale of my trip to Washington, D.C. to meet with the guys with whom the buck stops.

Continue to Part 2 of this post

Reader Interactions

Comments

  1. Why is the 401(k) buying an interest in your corporation rather than forming a corporation directly? The latter, as you know, is a very common scheme with LLCs.

  2. Bob,

    If a 401k forms its own corporation, then that corporation is considered to be “the plan” itself for purposes of prohibited transaction. This means that it would be obvious that a disqualified person (such as the plan participant or his/her family members) cannot work for or transact with this corporation.

    The intent of a ROBS structure is to enable the plan participant to run the business and derive compensation from it.

    Jeff

  3. Many people work for their plan-owned companies, in the sense they manage and direct its activities. Are you saying the mere act of management, without a transaction (like being paid a salary or exchanging assets between plan beneficiary and the company), is forbidden? Hundreds if not thousands of people have formed and run plan-owned companies on the assumption this was kosher.

  4. Bob,

    Aside from ROBS issues (which are to be explained through this 3-part post) the IRS doesn’t like people to work for free, especially for companies they control or have some other interest in.

    – Jeff

  5. Since receiving a salary in those cases would be a clear self-dealing violation, is the IRS really going to put you in a “damned if you do, damned if you don’t” situation?

  6. After an18 year career as a Retirement plan TPA, dealing with the prohibited transaction rules with trustees, I am very surprised to hear about these solutions being marketed.

    A good friend of mine is being sold a franchise and informed me of this really great way to fund his own franchise with his franchise’s new 401k . At first I thought , A loan is acceptable at a max of 50k, then he said it wasn’t a loan.

    Now after observing this strategy being hyped by Franchisors and vendors who are trying to find money as they are selling people franchises, I see a nice sized lawsuit on the horizon.

    I cant see anyway this deal will turn out good. If this is allowed every business owner will be able to use their own plans retirement assets at any time to satisfy any type of cash flow issue for their company.

    What a great precedent!
    We could pay a majority of earnings, not as compensation to the woner but to the plan as the shareholder through dividends then turn around and repurchases additional shares of the company through the plans new liquid assets and thus completey avoiding all taxation of income while using all proceeds at 100% of non taxed value to grow the business. This is now avaiable based on the ROBS concept.

    as a kicker,
    Then the plan participant, the owner transfers the stock, at age 591/2 at a basis (assume for this example) 200k to a roth IRA. We take the tax hit of 200k in a year we show no other income, since all of the potential income is paying the Shareholder”401k plan” as dividends.
    Then we sell the business for 5 times net 200k, for a million and get the whole gain tax free after 59 1/2.

    sign me up!!!!!!!!!!

  7. LOL, Brent. Wouldn’t it be great?

    In a perfect world, there would be no income taxes, but that’s another conversation.

    In our real world, one can choose to protest/challenge taxes or to aim to be compliant as to avoid being kidnapped by the government.

    This blog is obviously about the latter. That said, the only precedent is DOL AO 2000-10A which says the prohibited transaction rules D&E trump all other rules and potential loopholes.

    I was good friends with the attorney who requested that advisory opinion and I also regularly communicate with the DOL agents who wrote the opinion. It’s pretty darn clear. ROBS = not compliant.

  8. Hi Jeff
    I’m looking into setting up a Solo 401K in order to take a 50k loan out to finish a renovation on my house which is already started and mostly paid for. Once I finish I will refi with a traditional Heloc and pay back the loan to my 401K. You are not referring to my case in any of your ROBS talk above are you?
    Would you be able to manage this transaction for me and what would it cost?
    Thanks, Jeff

Trackbacks

  1. […] Authors Jeff Nabers and Phoebe Chongchua (Five Steps to Freedom: How to Cut Your Dependence on Institutions and Escape Financial Slavery) suggest that using an investment structure known as Rollovers As Business Startups (ROBS) to fund a business startup or franchise is an IRA prohibited transaction. […]

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