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Is ROBS 401(k) Legal?

Key Points
  • ROBS is the only legal way to use your retirement funds for a business
  • Disqualified persons cannot participate
  • IRA Financial can help you

There is only one legal way to use retirement funds to buy or finance a business that you or a “disqualified person” will be involved in personal and that is the Rollover as Business Start-Up (ROBS).

The Internal Revenue Code and ERISA have firmly codified the ability to use retirement funds to invest in the stock of a sponsoring company as long as certain IRS and ERISA rules are followed.

Internal Revenue Code Section 4975(c) includes a list of transactions that the IRS deems “prohibited”. However, Internal Revenue Code Section 4975(d) lists several exemptions to the prohibited transaction rules under IRC 4975(c). Specifically Internal Revenue Code Section 4975(d)(13) lists an exemption for any transaction which is exempt from section 406 of the Employee Retirement Income Security Act of 1974 (ERISA) by reason of section 408(e) of such Act.

Section 408(e) provides that section 406 shall not apply to the acquisition or sale by a plan of qualifying employer securities (as defined in section 407(d)(5), provided that: (1) the acquisition or sale is for adequate consideration; (2) no commission is charged with respect to the acquisition or sale; and (3) the plan is an eligible individual account plan (as defined in section 407(d)(3)). A 401(k) plan fits in to this definition.

The IRS first examined the legal standing of the ROBS solution back in the early 2000s and summarized their findings in an October 2008 Memorandum.   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. The IRS believed that in too many instances the promoter was establishing a 401(k) Plan that was not adequately disclosed to all employees. Internal Revenue Code Section 401(a)(4) provides that under a qualified retirement plan, contributions or benefits provided under the plan must not discriminate in favor of highly compensated employees. In addition, the promoters were encouraging the business owner who had used their retirement funds to purchase company stock to not provide the same benefit to their employees.

The second non-compliance area of concern the IRS highlighted in the “Memorandum” was establishing an independent appraisal to determine the fair market value of the business being purchased.

Then 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 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.

In sum, the ROBS solution is an IRS approved solution for using retirement funds to invest in an active trade or business.  The IRS has repeatedly stated that the ROBS solution is not illegal or a tax shelter, but one must be cautious to make sure that when the structure is established it is maintained in full IRS compliance and satisfies the areas of concern highlighted in the October 2008 Memorandum. 

Related: What is the Rollover as Business Startup Solution?

How Does The ROBS Solution Work?

The ROBS solution is the only IRS approved way one can use retirement funds to invest in a business the 401(k) plan participant will personally be involved in.   Although a self-directed IRA allows one to make passive investments with retirement funds it does not permit one to use IRA funds to invest in any business that the IRA holder or any disqualified person will personally control. 

The ROBS solution typically involves the following sequential steps: (i) an entrepreneur or existing business owner establishes a new C Corporation; (ii) the C Corporation adopts a prototype 401(k) plan that specifically permits plan participants to use 401(k) funds to invest in “qualifying employer securities.” (C corporation stock); (iii) the entrepreneur transfers his or her IRA or former employer 401(k) funds to the new 401(k) plan; (iv) the entrepreneur then directs the investment of his or her 401(k)-plan account to purchase the C Corporation’s newly issued stock based on the business’s the fair market value; and finally (v) the C Corporation utilizes the proceeds from the sale of stock to purchase an existing business or to begin a new venture.

Learn More: What is a C Corporation?

Final Thoughts

The ROBS solution has been in legal use for over 20 years and its legality is based on IRC 4975(d)(13). The ROBS solution is really the only way one can use their IRA or former employer 401(k) funds to invest in a business they will personally be involved in. However, it is important to be mindful of the matters the IRS referenced in the 2008 Memorandum, such as offering plan benefits to all employees, use of 401(k) funds for business purpose, and the purchase of the employer stock for FMV, when establishing your ROBS.  As a result, working with a company such as IRA Financial, which literally wrote the book on the ROBS, is a great start.


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