The IRS acronym for Rollovers Business Startups is ROBS. That name may be more prophetic than intended because many people are finding out that using this questionable method to access 401(k) monies for capital robbed them of their retirement savings. Here's the facts on the risks versus rewards.
slide 1 of 7
What is ROBS?
Rollovers as business start-ups (ROBS) are defined by the IRS thus:
“ROBS is an arrangement in which prospective business owners use their retirement funds to pay for new business start-up costs. ROBS plans, while not considered an abusive tax avoidance transaction, are questionable because they may solely benefit one individual—the individual who rolls over his or her existing retirement funds to the ROBS plan in a tax-free transaction."1
Once the individual receives their payout, the rollover assets are used to set up a one-participant retirement plan. The individual sets up a corporation, establishes a retirement plan, deposits rollover funds into the plan, and exchanges the funds for stock in the company. While this sounds pretty straightforward, there are many ways to make mistakes that could cause the plan to be declared unqualified by the IRS and end up causing the individual to lose their money.
slide 2 of 7
Risk Versus Reward
There are some inherent risks in using 401(k) retirement funds in a ROBS to start up a new business. Where most entrepreneurs get into trouble is in applying the plan’s terms incorrectly or operating the plan in a manner that discriminates.
For instance, if the employer hires additional staff to help him or her run the business but refuses to allow them to participate in the plan, this discriminatory action would disqualify the plan. However, just the simple omission of failing to notify new employees in writing of the availability and existence of the plan can also invalidate it.
What this means in terms of finance is the total amount of the rollover—say you rolled over a million dollars—would now be subject to not only taxes but potentially an additional tax because you withdrew them from another plan before turning 59 ½ years old.
Note: While you may hear this additional tax referred to as a “penalty for early withdrawal or early distribution," it is not a penalty. It is an additional 10 percent tax. Penalties can be abated (reduced in amount) but taxes cannot be abated according to the IRS.
Another mistake that entrepreneurs using the ROBS make that disqualifies their plans is failing to file all the required IRS forms such as:
Form 5500 – Annual Return/Report of Employee Benefit Plan
Form 5500-EZ – Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan
Form 1120 – U.S. Corporation Income Tax Return
Form 1099-R – Distribution from Pensions, Annuities, Retirements, Profit Sharing Plans, IRAs, Insurance Contracts, etc.
While applying for a favorable determination letter (DL) is not required for individually designed retirement plans, it would be a wise idea for those using the ROBS program to make application. While a DL does not give plan sponsors protection or guarantee that the plan will be deemed a qualified plan, it could reveal any problem areas that would prevent the plan from meeting the requirements of Code 401(a).
slide 3 of 7
Minimize Your Risk
Starting any new business is risky. Risking your retirement assets to fund a business start-up adds another layer of risk because of the high failure rate of new business.
According to the IRS, “Preliminary results from the ROBS Project in that, although there were a few success stories, most ROBS businesses either failed or were on the road to failure with high rates of bankruptcy (business and personal), liens (business and personal), and corporate dissolutions by individual Secretaries of State."2
If you are determined to use rollover assets as your capital source for funding your new venture, here are some tips on minimizing your risk:
Hire an attorney and an accountant with specialized knowledge about retirement income plans and taxes.
Get business advice from your local Small Business Association (SBA).
Be sure that the valuation of the stock will meet IRS requirements.
Take a loan against the 401(k) instead of withdrawing and rolling over the funds.
Report the 401(k) rollover distribution via IRS Form 1099-R and file all necessary forms relevant to the plan.
Do not administer your plan yourself. Individuals are not supposed to control the plan; you must have a plan administrator.
Talk to the IRS about your plans. Their employees are qualified to answer your questions and help you quickly find the pertinent information. They are available by phone at 1-800-829-1040 Monday through Friday from 7 to 10 pm, or you can go to your local area IRS office and ask for the pensions and annuities division.
slide 4 of 7
Alternative Business Start-Up Funding Sources
Some better choices for finding the capital to finance your business start-up are non-retirement assets, savings or brokerage accounts. You can refinance your home, apply for a home equity credit line or a reverse mortgage, or solicit a private loan from friends, family or investment angels.
Organizations like the SBA may have seed money available for qualified applicants. It’s a smarter move to finance a new venture by one of these methods than to risk losing your retirement nest egg, losing any future interest those monies would have earned and possibly paying additional taxes.
slide 5 of 7
Share Your Experiences
Do you know someone who has successfully used the ROBS to start a business or have you used this method yourself? I'd love to hear an opposing point of view based on other's experiences. Please share your thoughts with our community by using the comments section below.