Rollover as Business Startup Compliancy Rules

Rollover as Business Startup Compliancy

The Employee Retirement Income Security Act of 1974 (otherwise known as ERISA) and the Internal Revenue Code clearly allow for the use of retirement funds to acquire or invest in a new or existing business as long as the transaction complies with IRS and ERISA rules and regulations. Business owners have legally been using retirement funds via ROBS to help acquire or invest in a business for a number of years.

A number of promoters have promoted these types of transactions under the name “ROBS”. Even though this type of transaction is permitted under IRS and ERISA rules, the IRS believed a significant number of the promoters were not taking the necessary steps to structure a transaction that is in full compliance with IRS and ERISA rules. The ROBS rules must be adhered to so that your business funding is compliant.

What is ROBS?

Rollover as Business Startup (ROBS) is a structure that allows entrepreneurs to remove funds from a 401(k) or IRA to purchase/fund a new/existing business or franchise. The arrangement often involves rolling over a prior IRA or 401(k) plan into a newly established 401(k). A C corporation business must sponsor the new 401(k). This structure is IRS and ERISA approved.

The ongoing legal requirements of the Rollover as Business Startup structure make it difficult to ensure ROBS compliancy with the IRS. While the IRS does state that the ROBS solution is legal, it is important to receive proper legal guidance from a tax professional. The IRS has witnessed multiple instances where entrepreneurs have not been in full compliance with the IRS and ERISA rules and procedures.

Related: Rollover as Business Startup FQAs

Rollover as Business Startup Compliancy

5 Steps to Keep Your ROBS Structure Compliant

Now that you have established the Rollover as Business Startup, you can use your retirement funds to acquire or finance a business. However, it is imperative that you keep your structure fully IRS compliant. We provide five steps to ensure complete rollover as business startup compliancy.

Step 1 – Fidelity Bond

Acquire a fiduciary bond as trustee of the 401(k) plan. An ERISA fidelity bond is a form of insurance protection. In general, a fidelity bond will insure your business against losses caused by acts of fraud or dishonesty by your employees. It will protect you, as the employer, from any crimes committed by the employee.

Step 2 – Payroll

You must be an employee of the business when using 401(k) plan funds to purchase corporate stock. Your next step is to secure a payroll company to make automatic 401(k) plan contributions. Payroll companies include Paychex for HR and payroll solutions, and ADP for payroll, HR and tax services.

Step 3: Offer 401(k) Plan Benefits

If your employees are full-time (work greater than 1,000 hours/year), they should be eligible to receive 401(k) plan benefits. Depending on the features of the 401(k) plan, your company may have to make safe harbor matching contributions to eligible participants.

A Safe Harbor match is a type of 401(k) with an employer annual contribution match. With the Safe Harbor match, you will avoid most annual compliance tests. The employer will make a contribution on behalf of the employee, which is immediately vested. Contact IRA Financial about your company’s Safe Harbor requirements.

Step 4: Year-End Company Valuation

Each year, you must file IRS Form 5500 for the 401(k) plan and report the value of the 401(k) plan. This is a requirement. The C corporation stock (qualifying employer securities) is owned by the 401(k) plan and typically makes up a large portion of the value of the 401(k) plan, therefore the C corporation stock must also be valued.

Consult with a qualified and independent specialist or firm to prepare the annual company fair market valuation for your company.

Step 5: Tax Returns (and other requirements)

  • You must file federal and state tax returns for your C corporation by March 15. 
  • The annual company valuation as of 12/31 must be ready by May 1 of the following year.
  •  You must be on payroll and treated as an employee of the 401(k) plan and you must provide all employees with a W-2 Form.
  • As trustee of the 401(k) plan, make sure you have your fidelity bond.
  • Check with the state your C corporation was formed regarding annual report/fee requirements. A C corp. is a taxable entity which means you must file Form 1120.
  • Have quarterly corporate board meetings and keep proper documentation of the meetings.

ROBS Rules for Clients

October 1, 2008 Memorandum

One of the ROBS rules is the ROBS Examination guidelines. On October 1, 2008, Michael Julianelle, Director of 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. 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.

Internal Revenue Code Section 4975(c)(1 )(A) defines a prohibited transaction as a sale, exchange or lease of any property between a plan and a disqualified person. Internal Revenue Code Section 4975(d)(13) provides an exemption from prohibited transaction consideration for any transaction that is exempt from ERISA Section 406, by reason of ERISA Section 408(e), which addresses certain transactions involving employer stock. ERISA Section 408(e), and ERISA Regulation Section 2550, 408e promulgated thereunder, provides an exemption from ERISA Section 406 for acquisitions or sales of qualifying employer securities, subject to a requirement that 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 Section 3(18). ERISA Section 3(18) provides in relevant part that, in the case of an asset other than a security for which there is no generally recognized market, adequate consideration means the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations.

An exchange of company stock between the plan and its employer-sponsor would be a prohibited transaction, unless the requirements of ERISA Section 408(e) are met (the acquisition or sale of the qualifying employer securities must be for adequate consideration).

Therefore, valuation of the purchase corporate stock is a relevant issue. Since, in some cases, the company may be newly established, there could be a question of whether the stock is indeed worth the value of the purchase price exchanged. If the transaction has not been for adequate consideration, it would have to be corrected, for example, by the corporation’s redemption of the stock from the plan and replacing it with cash equal to its fair market value, plus an additional interest factor for lost plan earnings.

In addition, the IRS asserts that a valuation-related prohibited transaction issue may arise where the start-up enterprise does not actually “start-up.” Many promoters have been advising clients that they do not need to secure appraisal which would seemingly contradict the IRS’ position outlined in the “Memorandum”. In addition, the promoters who have provided clients with a valuation have been providing clients with a single line valuation statement generally approximating available retirement funds, which the IRS considers inadequate.

Compliancy for ROBS – We’re Here to Help

The Rollover a Business Startups Solution may have a few basic steps to get started, but don’t let this trick you into thinking it is a simple structure to navigate. It is highly complex to operate prior to getting started and after you have employed the structure.

IRA Financial is always available to help guide you throughout the process and maintain Rollover as Business Startup compliancy. Don’t hesitate to contact us with any questions regarding the structure. Contact via form or directly at 800-472-0646.

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