The Advantages of the ROBS Solution vs. the Self-Directed IRA to Buy a Business with IRA or 401(k) funds
The Rollover Business Start-Up (ROBS) Solution is an IRS and ERISA approved structure. It allows an individual to purchase a new or existing business with their retirement funds. The individual can be active in the business without triggering the IRS prohibited transaction rules. The ROBS solution qualifies for a special exemption set forth under IRC 4975(d) to certain prohibited transaction rules. These do not apply to a Self-Directed IRA structure.
How Does the Rollover Business Start-up or ROBS structure work?
The Rollover Business Start-up (ROBS) arrangement typically involves rolling over a prior IRA or 401(k) plan account into a newly established 401(k) plan, which a start-up C Corporation business sponsors, and then investing the rollover 401(k) Plan funds in the stock of the new C Corporation. The funds are then deposited in the C Corporation bank account and are available for use for business purposes.
The following is how a typical Rollover Business Start-up structure works:
Business Start-up Structure
1. Jim, an entrepreneur or existing business owner, establishes a new C Corporation in the state where the business will be operating. The ROBS structure must involve a C Corporation and not an LLC or S Corporation because the exemption to the IRS prohibited transaction rules under IRC 4975(d) involves the purchase of “Qualifying Employer Securities”, which is defined as stock of a Corporation. Using an LLC would not satisfy this definition and only individuals can be shareholders of an S Corporation and a 401(k) Plan is a trust.
2. The new C Corporation adopts a prototype 401(k) plan that specifically permits the plan participants, including Jim, to direct the investment of their plan accounts into a selection of investments options, including employer stock, also known as “qualifying employer securities.
3. Jim elects to participate in the new 401(k) plan and, as permitted by the plan, directs a rollover of a prior employer’s 401(k) Plan funds into the newly adopted 401(k) plan.
4. Jim 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 Jim wishes to invest in the new business).
5. Jim also invests personal funds equal to more than 1% of the purchase price so that the structure is not considered an Employee Stock Option Plan (ESOP).
6. The C Corporation utilizes the proceeds from the sale of stock (the amount of rollover funds and personal funds used) to purchase the assets for the new business.
7. Joe would be able to earn a salary from the revenues of the business as well as personally guarantee any business loan.
What is the Difference between using a Self-Directed vs ROBS structure to buy a business?
In many respects, using a Self-Directed IRA LLC or a 401(k) Plan to purchase stock in a corporation should be subject to the same rules. However, as described above, using 401(k) Plan funds and not IRA funds allows you to take advantage of the prohibited transaction exemption. You can find this under IRC 4975(d) for “Qualifying Employer Securities.”
The recent U.S. Tax Court case Peek v. Commissioner, 140 T.C. No. 12 (May 9, 2013), highlights the risk and limitations when using a Self-Directed IRA to purchase business assets. In the Peek case, the taxpayers used IRA funds to invest in a corporation that ultimately purchased business assets. Because Mr. Peek went with an IRA and not a 401(k) Plan to purchase the C Corporation stock he’s unable to earn a salary or personally guarantee a business loan. Ultimately, this was the cause of the IRS prohibited transaction rule violation.
The limitation of using a Self-Directed IRA LLC to buy a business is that the individual retirement account business owner will not actively involve themselves in the business, earn a salary, or even personally guarantee a business loan. Whereas, if the business owner uses a Rollover Business Start-up strategy, that individual can actively involve themselves in the business and earn a salary. Additionally, the individual can personally guarantee a business loan without triggering the IRS prohibited transaction rules.
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What are the advantages of using the Rollover Business Start-Up solution to buy a new business?