“Is a Rollover as Business Start-up (ROBS) a good strategy for funding a business?”
ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.
A recent call with a financial advisor from California is representative of a common inquiry related to rollovers. The advisor asked: “Is a Rollover as Business Start-up (ROBS) a good strategy for funding a business?”
Highlights of Discussion
- “Good,” may not be the right word to use when describing a ROBS. According to the IRS, ROBS plans, while not considered an abusive tax avoidance transaction, are questionable …” (Rollovers as Business Start-Ups Compliance Project [1]). Anyone considering a ROBS transaction should consultant with a tax and/or legal advisor before proceeding as there are several issues the IRS has identified that must be considered on a case-by-case basis in order to determine whether these plans operationally comply with established law and guidance. These issues and guidelines for compliance are detailed in a 2008 IRS Technical Memorandum [2].
- Here is an example of a common ROBS arrangement. An individual sets up a C-Corporation and establishes a 401(k)/profit sharing plan for the business. The plan allows participants to invest their account balances in employer stock. (At this point the business owner is the only employee in the corporation and the only participant in the plan.) The new business owner then executes a tax-free rollover from his or her prior qualified retirement plan (or IRA) into the newly created qualified plan and uses the assets from the rollover to purchase employer stock. The individual next uses the funds to purchase a franchise or begin some other form of business enterprise. Note that since the rollover is moving between two tax-deferred arrangements, the new business owner avoids all otherwise assessable taxes on the rollover distribution.
- Every few years, we find promoters in the industry aggressively marketing ROBS as a means for prospective business owners to access accumulated tax-deferred retirement funds, without paying applicable distribution taxes, to cover new business start-up costs. While the IRS does not consider all ROBS to be abusive tax avoidance transactions, it has found that some forms of ROBS violate existing tax laws and, therefore, are prohibited (see Fleming Cardiovascular, P.A. v. Commissioner, and Powell v. U.S., the Court of Federal Claims)
- The two primary issues that the IRS has identified with respect to ROBS that would render them noncompliant are 1) violations of nondiscrimination requirements related to the benefits, rights and features test of Treas. Reg. § 1.401 (a)(4)-4; and 2) prohibited transactions resulting from deficient valuations of stock.
- Other concerns the IRS has with ROBS relate to the plan’s permanency (which is a qualification requirement for all retirement plans, violations of the exclusive benefit rule, lack of communication of the plan when other employees are hired, and inactive cash or deferred arrangements (CODAs).
- The Employee Plan Compliance Unit of the IRS completed a research project that revealed that while some of the ROBS studied were successful, many of the companies in the sample had gone out of business within the first three years of operation after experiencing significant monetary loss, bankruptcy, personal and business liens, or having had their corporate status dissolved by the Secretary of State (voluntarily or involuntarily). The full project summary is accessible
Conclusion
Caution should prevail when considering a ROBS arrangement. Those interested should seek the guidance of a tax and/or legal advisor, and consider the guidance from the IRS’ 2008 Technical Memorandum as well as tax court cases.