The law behind the ROBS solution may seem complicated to prospective clients who are interested in employing this unique structure. Although employing the Rollover for Business Startups (ROBS) solution may appear to result in triggering a prohibited transaction, the Internal Revenue Code clearly states that the structure is legal so long as participants and promoters remain IRC and ERISA compliant. In this article, we will explain the nuances of the law of the ROBS solution.
Exemption of the Prohibited Transaction Rules
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 a number of exemptions to the prohibited transaction rules. 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.
(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.
Pursuant to ERISA Section 406, the acquisition or sale must be for “adequate consideration.” Except in the case of a “marketable obligation”, adequate consideration for this purpose means a price not less favorable than the price determined under ERISA § 3(18), subject to a requirement that the acquisition or sale must be for “adequate consideration.” An exchange of company stock between the plan and its employer-sponsor would be a prohibited transaction, unless the requirements of ERISA § 408(e) are met.
The exemptions in 4975(d) shall not apply to items described in Internal Revenue Code Section 4975(f)(6). Section 4975(f)(6)(A) states that the exemption of 4975(d) shall not apply in the case of a trust described in Internal Revenue Code Section 401(a), which is part of a plan providing contributions or benefits for employees some or all of whom are owner-employees (other than paragraphs (9) and (12)) shall not apply to a transaction in which the plan directly or indirectly:
(i) lends any part of the corpus or income of the plan to (ii) pays any compensation for personal services rendered to the plan to, or (iii) acquires for the plan any property from or sells any property to any such owner-employee, a member of the family of any such owner-employee, or any corporation in which any such owner-employee owns, directly or indirectly, 50 percent or more of the total combined voting power of all classes of stock entitled to vote or 50 percent or more of the total value of shares of all classes of stock of the corporation.
Therefore, since the Plan will be purchasing “qualified employer securities” directly from the newly formed corporation, the purchase of corporate stock will not be treated as a prohibited transaction pursuant to Internal Revenue Code Section 4975.
ERISA Section 407(b)(1) generally places limitations on the acquisition and holding of Qualifying Employer Securities (normally 10% of plan assets). However, the Section includes an exception for “eligible individual account plans” (ERISA 407(b)(1)). As set forth in ERISA Section 407(d)(3), a qualified profit sharing plan is included in the definition of “eligible individual account plans”. In addition, pursuant to ERISA Section 404(a)(2), these plans do not violate ERISA’s diversification and, to the extent it requires diversification, prudence requirements.