Using Deferred Income to Fund Your Startup Business Could ROB Your Future

One of the most difficult aspects of starting a business is obtaining proper funding. While banks have begun lending again, loans for startup businesses are still difficult to obtain. They require credit checks and substantial collateral, such as a home or other personal assets. That’s what makes using deferred income, meaning assets in an IRA or employer plan, so attractive. Several “promoters” have sprung up offering services that do exactly that; using retirement dollars to fund startup businesses on a tax-free and penalty-free basis. But is it a good idea? The IRS’s name for the transaction, Rollovers as Business Startups or “ROBS,” should give you an idea of their opinion on the matter. But whether you heed the IRS words of caution or look further into success stories, understand that we are talking about a complicated and controversial tax strategy. 
The Basics
The first step in this multi-step process is to establish a C Corporation. Second, the client adopts a qualified retirement plan; usually what’s called a prototype 401(k) plan. That’s because prototype plans are widely sold and among the cheapest qualified retirement plan options. The plan is then amended to allow investment in employer securities. At this point, our deferred assets come into play. The third step is to roll IRA or 401(k) funds (and sometimes both) into the new employer plan. The new company then issues stock certificates based on its underlying value. These stock certificates are promptly bought up by the newly adopted retirement plan. Finally, the plan assets used in the sale (i.e., money rolled into the plan) are transferred to the new company’s capital account and presto; we’ve turned retirement dollars into a business investment. Even better is that no taxes or penalties were paid because a distribution never took place! Sounds good, right?
The IRS View
As you can imagine, the IRS has always been skeptical of this tax strategy. In fact, the IRS has stated that “Theoretically, there could be a ROBS that is completely compliant operationally. However, in the field we are finding that does not happen often.” In other words, the IRS is looking for ways to attack a ROBS transaction. The multiple steps (not to mention tax code provisions) involved in a ROBS transaction create plenty of opportunities for taxpayers to get it wrong.
For example, the IRS can accuse the new qualified retirement plan of being discriminatory since only the owner can purchase the company stock. Under the tax code, a qualified retirement plan cannot discriminate in benefits, rights, or features offered under the plan. The ability to purchase company stock is one of these features. Many promoters have claimed that this problem is non-existent when the only participants in the plan are the owner and/or the owner’s spouse. However, the IRS has suggested that these plans could still be discriminatory from an operational standpoint.
There’s also the potential for a prohibited transaction. If the multi-step process isn’t followed to a tee, you could find yourself with a self-dealing prohibited transaction. However, even if you completely follow the process, the IRS may challenge the valuation of the new company. In order to execute the stock sale, the new company has to be valued. All too often, that value equals the assets in the qualified retirement plan right before the sale. While that may make sense in some situations, this convenient coincidence has also drawn the focus of the IRS. Under both ERISA and the Tax Code, a qualified retirement plan can invest in employer securities that have a “fair market value” and are sold in an arms-length transaction. In other words, you’ve got to show the IRS that the value used in the sale is the same value you could get on the open market for those shares. If you cannot, we have a prohibited transaction.
Finally, the IRS has noted that there is almost universal confusion regarding the annual filing of IRS Form 5500. There is an exemption for the Form 5500 filing requirement if plan assets are less than $250,000 and the plan has deferred compensation for only the business owner and the spouse who wholly own the business. However, in a ROBS transaction, the company retirement plan owns the business, not the individual. The penalties for late filings of Form 5500 are stiff; the IRS imposes a $25 per day penalty, with a cap of $15,000 and the Department of Labor imposes a penalty of $1,100 per day with no maximum!
Final Thoughts
It should be evident that this process is complicated and fraught with peril. If the plan is found to be discriminatory or the IRS concludes that a prohibited transaction took place, the entire arrangement will be invalidated. The result is a bill for taxes and penalties going back to the date of the initial ROBS transaction! There’s an old saying that says if it’s too good to be true, it probably is. Therefore, before jumping head first into a ROBS transaction, consult with an experienced advisor to weigh the pros and cons of this strategy.