When you want to use your retirement funds to buy or finance a business that you or another disqualified person will be involved in, there is only one legal way to do so: the Rollover Business Start-up Solution (ROBS).
The ROBS solution takes advantage of an exception in the tax code. It allows you to use 401(k) plan funds to buy stock in a “C” Corporation. This exemption 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 stock of a “C” Corporation.
Self-Directed IRA or 401(k) to Purchase a Business
You cannot use a self-directed IRA LLC to invest in a business that you or another disqualified person will have personal involvement in. Additionally, you cannot use a 401(k) plan to invest in an LLC in which you or a disqualified person will be involved in. The reason for this is, you will trigger the prohibited transaction rules.
Therefore, for you to invest in a business using your retirement funds, you must purchase a C Corporation and adopt a 401(k) plan. However, there are some ROBS drawbacks, which we discuss below.
How Does the ROBS Solution Work?
The structure typically involves the following 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. This includes employer stock, also known as “qualifying employer securities.”
3. Next, the entrepreneur elects to participate in the new 401(k) plan. As permitted by the plan, he/she 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. For example, the amount that the entrepreneur wishes to invest in the new business.
5. Finally, 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%. This 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.
What You Should Know About The New 20% Pass-Through Tax Deduction
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 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 taxation 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 earns $100 of profits, the “C” Corporation must pay tax of $21 (21% of $100) and then the shareholder is 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. As a result, the $100 flows directly to the shareholder or LLC member and a tax of only $21 is 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 saves $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.
Double Taxation for Individuals
It is important to note that the disadvantage of double taxation bite does not impact retirement accounts (i.e. 401(k) plans) as much as individuals. This is because the dividend from the “C” Corporation to the 401(k) plan shareholder is exempt from tax since a 401(k) plan is a tax-exempt retirement account.
However, the double taxation is not eliminated. It’s simply deferred until the 401(k) plan participant elects to take a 401(k) plan distribution. This is generally subject to a second tax – the first tax is applied at the “C” Corporation level.
In contrast, if a 401(k) plan invests in an LLC, a passthrough entity for taxation, the income or gains from the LLC generally flows back to the 401(k) plan without tax and the 401(k) plan participant must 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. 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 we’ll discuss below, 401(k) plans cost money to administer because there are many compliance issues that have to be monitored.
Additionally, there are many ongoing services and administration functions that have to be provided.
There are a host of education and communication services that must 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, a popular type of 401(k) plan for small businesses, offers employees who participate in the plan a 3% matching contribution the employer makes.
For example, if the employee earns $40,000 in salary during the year and contributes 3% of the salary or $1,200 to the 401(k) plan, the employer will contribute an additional $1,200 (3% of the salary) to the individual 401(k) plan account.
Taking this a step further, if the business has five employees and each employee makes $40,000 a year, the employer now has to make $6,000 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. This could impact the cash flow of a new small business.
4. Compliance Matters
Dating back to around 2005, the IRS began focusing some attention on the ROBS solutions and some abuses they perceived were occurring.
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.
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 lack of disclosure of the adopted 401(k) Plan to the company’s employees
- Establishing an independent appraisal to determine the fair market value of the business being purchased.
In sum, the IRS concerns were that people were using their retirement funds to buy a business and the business was not being purchased and the individual then used the funds for personal purposes. As a result, they avoid tax and potential penalties. Another concern was that 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.
2010 IRS Public Phone Forum
On 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 the use of 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 reaffirmed 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 IRS’ concerns with these types of transactions is that the promoters offering these transactions have not had the expertise to develop structures that are fully compliant with IRS and ERISA rules and regulations.
Additionally, a large percentage of the transactions they reviewed were in non-compliance largely due to the following non-compliance issues:
- 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.
- The failure to require that the client 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. Although legal, the ROBS solution is something the IRS and Department of Labor are looking at.
Again, the structure must be set-up properly. If you plan is audited by the IRS or DOL, you will have no issues if you follow the set-up is done properly.
- Use the funds to buy a business
- The 401(k) plan is offered to all eligible employees
- A valuation of the stock purchased is performed,
- The plan is compliant with all annual testing and IRS filing requirement
While it is a fantastic structure to use, Rollover Business Start-up drawbacks do exist and should be considered.
Get in Touch
Do you still have questions regarding the ROBS drawbacks that we didn’t cover in this article? Get in touch with IRA Financial Group directly at 800-472-0646. We’ll be available to answer all of your questions regarding the ROBS solution. You can also fill out the form to speak with a ROBS specialist.