When it comes to using retirement funds to buy or finance a business that you or another “disqualified person” will be involved in personally, there is only one legal way to do it and that is through the Business Acquisition Solution, also known as a Rollover Business Start-Up solution (ROBS). The ROBS solution takes advantage of an exception in the tax code under Internal Revenue Code (“IRC”) Section 4975(d) that allows one to use 401(k) plan funds to buy stock in a “C” Corporation, which is known as “qualifying employer securities”. The exception to the IRS prohibited transaction rules found in IRC 4975(d) requires that a 401(k) plan buy “qualifying employer securities”, which is defined as stock of a “C” Corporation. This is the reason why one cannot use a self-directed IRA LLC to invest in a business the IRA holder or a disqualified person will be personally involved in or why a 401(k) plan cannot invest in an LLC in which the plan participant or disqualified person will be involved in without triggering the prohibited transaction rules. Hence, in order to use retirement funds to invest in a business in which a disqualified person will be personally involve one needs a “C” Corporation to operate a business and adopt a 401(k) Plan. However, there are some Rollover Business Start-up disadvantages, as discussed below.
So How Does the ROBS Solution Work?
The structure typically involves the following sequential steps:
1. An entrepreneur or existing business owner establishes a new C Corporation;
2.The C Corporation adopts a prototype 401(k) plan that specifically permits plan participants to direct the investment of their plan accounts into a selection of investment options, including employer stock, also known as “qualifying employer securities.”
3.The entrepreneur elects to participate in the new 401(k) plan and, as permitted by the plan, directs a rollover or trustee-to-trustee transfer of retirement funds from another qualified retirement plan into the newly adopted 401(k) plan;
4.The entrepreneur then directs the investment of his or her 401(k) plan account to purchase the C Corporation’s newly issued stock at fair market value ( i.e., the amount that the entrepreneur wishes to invest in the new business); and finally
5.The C Corporation utilizes the proceeds from the sale of stock to purchase an existing business or to begin a new venture.
4 Rollover Business Start-up Disadvantages
1. The “C” Corporation Requirement: Prior to the Tax Cuts and Jobs Act of 2017, using a C Corporation for a small business was considered tax inefficient because of the 35% maximum corporate tax rate. However, the Trump tax plan lowered the corporate tax rate to 21%, which has contributed to the reemergence of the C Corporation as a popular business entity choice for some small business. Although, the C Corporation still maintains a double tax regime (21% corporate level tax and then a shareholder lever tax on dividends), the double tax burden has been significantly reduced by the Trump tax plan. In addition, there are advantages to establishing a “C” corporation, such as owner’s liability protection from the actions of the company, there are several Rollover Business Start-up disadvantages as well.
2. Double Taxation: Corporations, unlike other companies that are considered sole proprietorships and partnerships, file their own taxes separately from their owners at their own tax rates. After the company’s profits are taxed at the corporate level, they are then distributed to the shareholders who have to report the amount received on their individual tax returns. Under the Trump tax plan, the corporate tax rate has been reduced from a maximum rate of 35% to 21%. This isn’t the case for Sub-chapter S corporations or LLC, where the profits bypass being taxed at the corporate level and are distributed and taxed at the shareholder’s level. That is called pass-through taxation. For example, if we assume a 21% income tax rate for both corporation and individuals and a “C” Corporation earned $100 of profits, the “C” Corporation would be required to pay tax of $21 (21% of $100) and then the shareholder would be required to pay tax of $16.59 (21% of $79) on any dividend issued by the “C” Corporation to the shareholder. Whereas, in the case of an LLC or “S” Corporation, there is no entity level tax so the $100 would flow directly to the shareholder or LLC member and a tax of only $21 would be imposed at the shareholder level. Comparing this with the “C” Corporation example, by using a passthrough entity such as an “S” Corporation or LLC, the individual would save $16.59 in our example (total tax of $37.59 with a “C” Corporation versus $21 in the case of an LLC or “S” Corporation.
It is important to note that it can be argued that the disadvantage of double taxation bite does not impact retirement accounts (i.e. 401(k) plans) as much as individuals, since the dividend from the “C” Corporation to the 401(k) plan shareholder would be exempt from tax since a 401(k) plan is a tax-exempt retirement account. However, the double taxation is not eliminated but simply deferred until the 401(k) plan participant elects to take a 401(k) plan distribution, which would generally be subject to a second tax (the first tax would be applied at the “C” Corporation level). In contrast, if a 401(k) plan invested in an LLC, a passthrough entity for taxation, the income or gains from the LLC would generally flow back to the 401(k) plan without tax and the 401(k) plan participant would only be required to pay one tax when a distribution is taken.
Unfortunately, the IRS rules require a “C” Corporation be used when a retirement account holder wishes to use retirement funds to invest in a business they or another disqualified person will be involved in. The issue of double taxation is certainly one disadvantage of the ROBS solution, but it is generally perceived as better than paying tax and potentially a 10% early distribution penalty on a distribution from your retirement account.
Regulations and Formalities
Sub-chapter C corporations generally involve more corporate formalities than LLCs, for example. In general, “C” Corporations have to report annually to the states in which they’re incorporated, and the states in which they do a lot of business, on an annual basis. Also, “C” Corporations must observe certain formalities to be considered corporations. This includes holding regular board and shareholder meetings and issuing stock. Also, the names of corporate officers are made public, which is not required by businesses formed under different organizational structures.
401(k) Plan Administration
Even though 401(k) plan administration costs have come down significantly over the years, there is still a cost of offering a 401(k) plan to employees. In addition to having to make a 3% safe harbor contribution, which will be discussed below, 401(k) plans cost money to administer because there are many compliance issues that have to be monitored, there are many ongoing service and administration functions that have to be provided, and there are a host of education and communication services that are required to be offered to plan participants. It is not uncommon for a small business 401(k) Plan to cost anywhere from $750-$1500 annually for a third-party administration company to administer as well as file the annual IRS Form 5500 .
3. Matching Contributions: A safe harbor 401(k) Plan, which is a popular type of 401(k) plan for small businesses, offer employees who participate in the plan a 3% matching contribution made by the employer. Thus, for example, if the employee earns $40,000 in salary during the year and contributes 3% of the salary or $1200 to the 401(k) plan, the employer would contribute an additional $1200 (3% of the salary) to the individual 401(k) plan account. Taking this a step further, if the business has 5 employees and each employee makes $40,000 a year, the employer now has to make $6000 in employer matching contributions. Although the contributions are tax deductible to the employer, it is still additional funds that are being removed from the company and could impact the cash flow of a new small business.
4. Potential IRS Audit: Dating back to the 2005 or so, the IRS started focusing some attention on the ROBS solutions and some of the abuses they perceived were occurring. To this end, on October 31, 2008, Michael Julianelle, Director, Employee Plans, signed a “Memorandum” approving IRS ROBS Examination Guidelines. The IRS stated that while this type of structure is legal and not considered an abusive tax avoidance transaction, the execution of these types of transactions, in many cases, have not been found to be in full compliance with IRS and ERISA rules and procedures. In the “Memorandum”, the IRS highlighted two compliance areas that they felt were not being adequately followed by the promoters implementing the structure during this time period. The first non-compliance area of concern the IRS highlighted in the “Memorandum” was the lack of disclosure of the adopted 401(k) Plan to the company’s employees and the second non-compliance area was establishing an independent appraisal to determine the fair market value of the business being purchased. In sum, the IRS was concerned that people were using their retirement funds to buy a business and either the business was not being purchased and the individual then used the funds for personal purposes, thus avoiding tax and potential penalties, or the business that was purchased closed, and the retirement account liquidated, thus, leaving the IRS without the potential to tax the retirement account in the future.
The IRS did not publicly comment on the ROBS solution again until August 27, 2010, almost two years after publishing the “Memorandum”, the IRS held a public phone forum open to the public which covered transactions involving using retirement funds to purchase a business. Monika Templeman, Director of Employee Plans Examinations and Colleen Patton, Area Manager of Employee Plans Examinations for the Pacific Coast spent considerable time discussing the IRS’s position on this subject. Monika Templeman began the presentation reaffirming the IRS’s position that a transaction involving the use of retirement funds to purchase a new business is legal and not an abusive tax-avoidance transaction as long as the transaction complies with IRS and ERISA rules and procedures. The concern the IRS has had with these types of transactions is that the promoters who have been offering these transactions have not had the expertise to develop structures that are fully compliant with IRS and ERISA rules and regulations. The IRS added that a large percentage of the transactions they reviewed were in non-compliance largely due to the following non-compliance issues: (i) failure by the promoters to develop a structure that requires the new company to disclose the new 401(k) Plan to the company’s employees and, (ii) the failure to require the client to secure an independent appraisal to determine the fair market value of the company stock being purchased by the 401(k) Plan. The IRS concluded by stating that a transaction using retirement funds to acquire a business is legal and not prohibited so long as the transaction is structured correctly to comply with IRS and ERISA rules and procedures.
So does the ROBS solution trigger an audit? No one knows what factors trigger an IRS audit, but although legal, the ROBS solution is something the IRS and Department of Labor is looking at. Again, if your structure is set-up properly and the funds are used to buy a business, the 401(k) plan is being offered to all eligible employees, a valuation of the stock purchased is performed, and the plan is compliant with all annual testing and IRS filing requirement, there is nothing to be concerned with if your plan was audited by the IRS or DOL.
While it is a fantastic structure to use, Rollover Business Start-up disadvantages do exist and should be considered.