Here’s a not unusual scenario for Baby Boomers who have reached their company’s retirement age but are not quite ready to retire. Why not start a business or even buy a franchise? That can require a large personal investment, but he or she has a sizable 401(k) account. Why not use those funds to start a second career?
Here’s how they work.
There’s a number of websites that provide information on how to do exactly that with some indicating it can be done tax free and debt free. Here’s the method:
- The retiree/investor rolls over his or her retirement funds from an existing 401(k) account or IRA to a 401(k) plan that you set up by a new shell corporation (which should be a C corporation).
- The rollover funds are then used by the new 401(k) plan to purchase the stock of the shell corporation.
- Once the funds are paid to the corporation for its stock, the corporation can then use those funds to pay startup expenses for the new business venture.
But Will It Work?
The IRS calls these arrangements “ROBS”, an acronym for Rollovers as Business Startups, which immediately started the yellow caution light flashing as early as October 2008 when an IRS internal memo, Guidance regarding rollovers as business startups, was published.
Why the need for guidance? The author, Mr. Michael Julianelle, Director Employee Plans, wrote:
Recently, personnel in our examination and determination letter functions have identified a retirement plan design that appears to operate primarily to transact in employer stock, resulting in the avoidance of taxes otherwise applicable to distributions from tax-deferred accumulation accounts.
Although we do not believe that the form of all of these transactions may be challenged as non-compliant per se, issues such as those described within this memorandum should be developed on a case-by-case basis. Those cases currently in process or held in suspense should be worked within the context of these guidelines. Please cascade this memorandum to your managers and technical employee staff as appropriate.
Has It Worked?
The IRS zeros in on two primary concerns it has with ROBS transactions.
First, if the ROBS 401(k) plan is set up in a way that permits only the business owner to invest his 401(k) plan account in company stock, it may discriminate against any rank and file employees who qualify to participate in the plan.
Second, the new 401(k) plan is prohibited by law from paying more for the shell corporation’s stock than the fair value of its business. Is a startup franchise business, for example, really equal in initial value to the amount of its substantial up front franchise fee and other startup costs – before it has generated even one dollar of revenue? Questionable, and remember it’s your burden to establish that value in the unfortunate event the IRS comes calling.
First, despite the blandishments of the many websites that promote ROBS transactions, it is advisable to establish the value of company stock through an independent appraisal before you sell it to your shell corporation. Remember, your plan is prohibited from paying even one cent more than what the business is worth.
Second, make sure you have a viable business that generates earned income for you and any employees. Setting up a 401(k) plan for the sole purpose of implementing a ROBS transaction does not work. It’s a red flag if your 401(k) plan has to be terminated before your business succeeds.
Third, “tax free” is good, but remember that 401(k) and other qualified retirement plans turn potential capital gains into ordinary income. If your business is successful and your 401(k) plan sells it at a profit, your share of the proceeds will be taxed to you at ordinary income rates upon distribution. Make sure you consider that tax cost in a proposed “tax-free” transaction.
Fourth, the IRS recognizes that “there is no inherent violation in the form of a plan containing a ROBS arrangement.” ROBS arrangements can work if properly set up and operated in compliance with law. In other words, be careful, and use an independent appraiser and a third party administrator (“TPA”) or other qualified retirement plan professional to help you mind your Ps and Qs.
Andrew S. Williams has practiced in the employee benefits and ERISA arena since ERISA was passed in 1974. He has been recognized by his peers through a survey conducted by Leading Lawyers Network as among the top 5 percent of Illinois lawyers in Small, Closely and Privately Held Business Law and Employee Benefit Law. He maintains a website, Benefits Law Group of Chicago with additional updates, commentary and analysis on benefits and employment topics.
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