“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). 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.
• 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.

“Why is March 1^st an important date with respect to excess deferrals in a 401(k) plan? I thought a participant had until April 15^th to correct an excess deferral.”

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 Nebraska is representative of a common inquiry related to excess salary deferrals.

Highlights of the Discussion

March 1^st could be a critical notification deadline in the case of an excess deferral. If a 401(k) plan participant makes salary deferrals to more than one plan of unrelated employers during the same tax year, it is possible to have excess deferrals—in aggregate—even though no individual plan reflects an excess. The IRC § 402(g) annual limit on employee salary deferrals is an individual taxpayer limit—not a per plan limit. Consequently, an individual under age 50 for 2023 was limited to deferring 100 percent of compensation up to a maximum of $22,500 (or $30,000 if age 50 or more)—regardless of the number of plans in which he or she participated during the year. For 2024, the respective limits are $23,000 and $30,500.

This annual limit is inclusive of employee salary deferrals (pre-tax and designated Roth) an individual makes to all of the following plan types:

• 401(k),
• 403(b),
• Savings incentive match plans for employees (SIMPLE) plans [both SIMPLE IRAs and SIMPLE 401(k) plans[1]] and
• Salary reduction simplified employee pension (SARSEP) plans.[2]

(Note: A person who participates in a 457(b) plan has a separate deferral limit that includes both employee and employer contributions.)

If a taxpayer exceeds the annual limit—the result is an excess deferral that must be timely corrected. Generally, if a participant has excess deferrals based on the elective deferrals made to a single 401(k) plan or plans maintained by the same employer, then the plan must return the excess deferrals and their earnings to the participant no later than April 15th of the year following the year the excess was created [Treas. Reg. § 1.402(g)-1(e)(1)].

In the case of an employee who participates in more than one salary deferral-type plan of unrelated employers, it may be difficult for any of the plan sponsors to recognize there is an excess deferral. Therefore, the onus is on the participant to determine in which plan the excess was created and notify the plan administrator of the amount of excess deferrals allocated to the plan. Many plan documents include a provision that imposes a plan administrator notification deadline. IRC Sec. 402(g)(2)(A)(i) permits the plan to set the notification deadline as early as March 1^st of the year following the year of excess. That allows the plan administrator to timely distribute the excess and earnings to the participant no later than the April 15th correction deadline [Treas. Reg. § 1.402(g)-1(e)(2)].

If the excess deferrals are timely withdrawn by the April 15th correction deadline, then

• The excess deferrals are taxed in the calendar year deferred;
• The associated earnings are taxed in the year distributed;
• There is no 10% early distribution penalty tax; and
• There is no 20% withholding (since the amounts are ineligible for rollover).

EXAMPLE

Joe, a 45-year-old worker, made his full salary deferral contribution of $22,500 to Company A’s 401(k) plan by October 2023. He then left Company A to go to work for Company B, an unaffiliated company, on November 1, 2023, and was immediately allowed to participate in the 401(k) plan. Not understanding how the 402(g) limit works, he began making salary deferral contributions to Company B’s 401(k) plan. In February 2024, after looking at his Forms W-2 from both employers, his tax advisor informed Joe that he over contributed for 2023.

The obligation is on Joe to report the excess salary deferrals to Company B by the deadline prescribed in the plan document (i.e., March 1, 2024). Company B is then required to distribute the excess deferrals and earnings by April 15, 2024. The plan document also requires forfeiture of any matching contributions associated with the excess deferrals.

Conclusion

The IRC § 402(g) annual limit on employee salary deferrals is an individual taxpayer limit—not a per plan limit. When a worker participates in more than one plan of unrelated employers in a tax year, he or she may unwittingly exceed the annual salary deferral limit. In such cases, the participant is responsible for determining in which plan the excess was created and to notify the plan administrator of the amount of excess deferrals allocated to the plan by the deadline prescribed—often March 1st. Participants should refer to their own plan documents for their particular notification deadline.

[1] The 2023 limit for deferrals to a SIMPLE IRA or 401(k) plan is $15,500 ($19,000 if age 50 or more).

[2] The 2023 limit for deferrals to a SARSEP plan is 25% of compensation up to $22,500 ($30,000 if age 50 or more).