Acquiring A Small Business Using ROBS Can Meet The IRS Prohibited Transaction Exception
Written by: David Nilssen
An increasing number of entrepreneurs are capitalizing their small business or franchise with their own IRA or 401(k) funds without taking a taxable distribution or getting a loan. Although growing in popularity, this option is still relatively unknown by many dreaming of owning a small business or franchise. In other words, thousands of would-be entrepreneurs are unaware they could be accessing start-up capital that is sitting in their own retirement accounts.
Known as a “Rollovers as Business Start-ups ” or ROBS, this arrangement enables individuals to acquire a business as an investment, inside their retirement plan. Self-directed IRAs and 401(k)s can be used to fund a qualified plan that can legitimately hold both publicly and privately held stock – even one you work for – assuming it qualifies for exemptions found explicitly in both tax and ERISA law. In the case of ROBS, the qualified plan most commonly used is a 401(k). As explained below, an IRA does not qualify.
The principal idea behind rollovers for business start-ups is one in which a C Corporation is created. That new corporation then sponsors a 401(k) plan that explicitly provides for the acquisition and holding of qualifying employer securities. An entrepreneur then rolls all or part of their existing and eligible retirement funds into a new 401(k). This plan, also referred to as an eligible individual account plan, in turn, invests in the stock of the new corporation. The corporation, now flush with funds, acquires a small business or franchise. The process is similar to when an individual purchases stock in a publicly traded company – such as Microsoft. They send money to the company and get to hold shares as collateral (per se) for the investment. Microsoft then gets to use the money to continue building its company. The same result occurs here except the investment is made in a privately held company, not a publicly traded one.
The result is: an aspiring entrepreneur or franchise owner launches his/her new business through a cash investment made by their retirement plan, and, is not responsible for monthly debt payments which accompany interest-bearing small business loans. The business now can (and must) also offer participation in the company’s 401(k) plan to his/her employees-a rare and highly attractive benefit in today’s tight economy.
While the opportunities created by this structure abound, clients can end up in a legally precarious predicament. Sadly, many financial professionals attempting to provide oversight do not properly understand the ERISA and Internal Revenue Code guidelines for this product. Because the newly created business being operated is built on behalf of the entrepreneur’s retirement plan, the structure can be of interest to the IRS since they (and the DOL) are very protective of the use (or abuse) of employee pension plans. And while a relatively rare occurrence, the IRS does occassionally perform audits on these structures. This potential scrutiny is why it is imperative that any individual seeking to enter into a ROBS transaction should retain qualified and independent legal counsel.
One of the areas where the uninformed may stumble in attempting to create a plan such as this is in understanding what qualifies as exceptions to “prohibited transactions”-the acquisition or holding of any employer securities. Fortunately, ERISA specifically permits particular plans to hold employer securities under certain circumstances. Among the required conditions to fit within the prohibited transaction exemption is that the plan must be an eligible individual account plan as defined by ERISA. At the heart of the ROBS transaction is the creation of a 401(k) profit-sharing plan. With a bit of research, the term “individual account plan” can be found defined in §407(d)(3)(A), which includes “a profit sharing, stock bonus, thrift or saving plans.”
Because of this fortunate exemption, the 401(k) plan, its participants and the employer are all exempt from tax on any investment gains; the employee and employer’s contribution to the plan are not taxable to the employee; and the participant is only taxed generally when he/she receives benefits from the plan.
By understanding the many benefits available through ROBS transactions-and by working with experts who understand the guidelines governing them-entrepreneurs will be empowered to launch their small business or franchise with every reason to expect success.
Any individual, who desires to invest their retirement funds into a business through a rollover, should consult a knowledgeable and experienced attorney who is familiar with the ROBS transaction as Nilssen is not a tax or ERISA attorney and readers should not interpret this article as legal advice. He encourages readers of this article to get legal advice before attempting to utilize the strategies discussed.
(originally published in the June 2011 eNewsletter)
About the Author:
David Nilssen is a cofounder of Guidant Financial. Guidant is the nation’s leading provider of rollovers for business start-up transactions. His company has helped more than 5,000 individuals from diverse backgrounds invest their existing retirement assets into a small business or franchise. His company has been included on Inc. Magazine ‘s list of the fastest growing companies in America three years running and in 2007, Nilssen was recognized by the Small Business Administration as the National Young Entrepreneur of the Year.