Rollovers as Business Startups (ROBS) are a way to optimize the use of money in your retirement account as a funding mechanism to start a business. It works if you have a 401(k) or other qualified retirement plan account with a balance that’s sufficient for your funding needs and you adhere to the tax rules.
Here’s how a ROBS operates: You incorporate your new business and have that corporation set up a qualified retirement plan (usually a profit-sharing plan permitted under the terms of the plan to invest in employer stock). Then you roll over your 401(k) or other retirement account to the new retirement plan (the rollover is tax free). That plan then buys shares in your corporation (i.e., the plan becomes an owner of your business). What ROBS does:
- Avoids immediate taxation on retirement plan funds. If you wanted to use the funds without the rollover, the distribution from the 401(k) would be immediately taxable, leaving you less after tax to invest in your company.
- Provides funding for the new company. Regardless of your credit rating or any other factors, you gain access to the money needed to get started.
Downside to ROBS. While there are benefits to this funding mechanism, there are drawbacks to consider:
- Putting retirement savings at risk. All of your eggs are in one basket; if the business fails, you lose your livelihood and your retirement savings.
- Increased IRS scrutiny. The IRS’ Employee Plans Compliance Unit ran an audit project that concluded in 2010 to help identify sponsors (promoters) of ROBS that may be noncompliant with tax rules. Since owners of many of the new retirement plans examined by the IRS did not make any new contributions to the plans, these arrangements were dubious. If the IRS can successfully challenge the ROBS, all of the funds rolled over would be a taxable distribution.
- Costs. You should use a company that specializes in ROBS. Such a company usually charges a hefty fee for helping to set up and administer the arrangement. And there’s annual reporting for the plan.
Annual filing. Qualified retirement plans, such as the new plan set up in the ROBS, are required to file an annual information return in the Form 5500 series. There is an exemption in the requirement to file if the assets of the plan are less than $250,000. However, this exemption does not apply to ROBS. The exemption applies to plans of businesses owned by an individual (or individual and spouse). In the case of ROBS, the plan, not the individual, owns the business. Thus, you must see to it that the plan files annually, regardless of the amount of assets within the plan.
Use a ROBS? While the IRS has concluded that ROBS are not abusive tax avoidance transactions per se, they can be disqualified if they are not properly administered. If you are considering a ROBS, be sure to have your own tax advisor review a sponsor’s program.
ROBS are not the only way to own stock in a company you control. You can use a self-directed IRA for this purpose. The IRA can own stock in any publicly-traded or closely-held corporation. But watch for traps that can be viewed as prohibited transactions. These transactions cause the IRA to become disqualified and all of the funds in it immediately taxable to you. Before you do any transaction in your IRA, run it by your tax advisor, something one IRA owner, who was the subject of a recent Tax Court case, failed to do.
In the case, an IRA owner had his account buy shares in a corporation that he set up. That corporation (“corporation A”) then bought shares in another corporation (“corporation B”) with cash and a note guaranteed by the IRA owner. B flourished and A sold the shares for a considerable profit. According to the Tax Court, the personal guarantee of the A’s debt amounted to an indirect extension of credit to the IRA, which is a prohibited transaction. The result to this IRA owner was that all of the gain that A reaped was taxable to him (and not tax-deferred in the IRA).