401(k) business financing offers a unique way for you to tap your existing retirement account to start or buy a business. The structure has paved the way for thousands of individuals to achieve their entrepreneurial dreams, but the structure does have a variety of requirements and moving pieces. In this chapter, we’ll take you through some dos and don’ts of what’s formally known as Rollovers for Business Start-ups (ROBS) that will help guide you through this complex product.
The 10 Do’s and Don’ts of Rollovers for Business Start-ups
As you may have seen from the previous chapters, ROBS is a unique method of small business financing that has annual, ongoing and legal requirements. In this chapter, we will take you through the dos and don’ts of Rollovers for Business Start-ups. These should help guide you to avoid making errors to your plan that could result in a taxable distribution – meaning you would have to pay taxes on your roll over as if it was an early withdrawal out the gates.
To be clear, a taxable distribution that results because of the ROBS structure almost never happens when you work with an experienced ROBS provider, such as Guidant Financial. A good provider with navigate you through the process and educate you on dos and don’ts to ensure the highest chance of success for you, your plan and your business. Also, if you are working with the Guidant Financial team, rest assured we are always here to help if needed. Just give us a call with any questions.
Below is a list of the dos and don’ts of ROBS, categorized by specific areas of the business. This is not based on hierarchy of importance, but rather a list to reference when thinking about using or changing your ROBS program setup.
Dos and Don’ts
1. Offer Qualified Employee Securities (QES) and the 401(k) Plan to Employees
DO – Offer your employees the opportunity to participate in the 401(k).
DON’T – Create artificial barriers for employees or obstruct employees from participating in the 401(k). The fourth pillar says that the employer must offer the right to purchase stock in the company with their retirement money. Remember when the entrepreneur in our example used her retirement money purchased stock in the C corp and became a shareholder in Chapter 1? Same deal here: she, as the owner of the company, must also offer the opportunity for her employees to use their retirement funds to purchase stock in the company as well.
Note that you are required to make the offer when the employee is hired – but the employee is probably not going to take it. Consider this: an employee is unlikely to remove their money from liquid and more customary investments like a publicly-traded company, where they can cash out at any time, and put it into your privately-held business, where they cannot cash out until you sell the business. (Of the 14,000+ clients Guidant has worked with, all have offered this stock purchase to their employees — and only a handful have accepted.)
2. Maintaining Active Business Status
DO – Maintain an active business/operating company.
DON’T- Shift into a passive business model. This stems from the third pillar of ROBS, which requires your business to be an “active operating company.”
Luckily, most businesses and franchises meet this operating criteria. Business ventures that don’t include lending, investing or single investments in real estate. However, real estate does present a grey area, as you can fund a property management or Real Estate Operating Company, but whether or not it qualifies as “operating” depends on the scale of the venture.
And one more thing: your business must be legal on the federal level. For example, though marijuana is legal in many states now, it still hasn’t been legalized by the federal government. Even if you live in a state where a pot shop is legal, typically you cannot use ROBS to fund it. Some of the more risk-tolerant ROBS providers will move forward with a business like this — but keep in mind that the IRS has not yet given approval of ventures that are not federally legal.
3. Maintain Active/Actual Employee Status
DO – Maintain your position as an active, bona-fide employee who takes a salary.
DON’T – Become a passive employee. This means a couple of things: you must pay yourself a salary, and you cannot be a silent investor. The fifth pillar states that all business owners with qualified employer stock must be active employees of the business. (This isn’t a requirement for any business partners that use funding other than ROBS.) Keep in mind that the active status doesn’t specifically state the type of work you must do. You could work the register, manage inventory or serve on the board of your corporation. However, this does mean you can’t be a passive investor in your friend’s wine bar or use ROBS to buy a franchise location for spouse or child.
4. Corporation Status
DO – maintain your status as a C corp for the life of your business under ROBS.
DON’T – change your entity type, no matter who tells you to. There are horror stories where a CPA or tax attorney not familiar with ROBS has advised clients to shift to another corporation type for various reasons. These professionals are likely not well versed in ROBS, and you should contact your Plan Administration team or outside counsel before making any changes. A change to another corporation type could result in a taxable distribution – meaning all of the funds you rolled over will get hit with an early withdrawal penalty as if you pulled them out directly from your 401(k) plan.
5. Avoid Creating a Taxable Distribution
DO – Follow all the rules of ROBS set forth by your provider and the IRS and DOL.
DON’T – Flout the 5 pillars described in Chapter 1. If even one of the five pillars is ignored, the whole structure becomes unstable. This can result in heavy penalties from the IRS.
6. Its Federal Law that Governs Your Plan, Not State
DO – Follow all federally legal activities in your day-to-day business activities and business in general.
DON’T – Attempt to use state laws in managing and choosing your business. The law that allows ROBS for to exist is through the IRS, so it must follow federal law.
Dos and Don’ts Continued
7. File Your Documents Every Year – Including Form 5500
DO – Remember to file your business taxes every year – federal and state level if applicable. Remember, you must file your corporate taxes on your own.
DON’T – Forget to file your taxes and Form 5500. Even better, don’t wait until the last minute to complete these crucial annual administrative tasks. Your Plan Administration service provider will not sign and file these documents for you — only you can file with the IRS. It’s important to have this ingrained in your annual processes to meet your obligations to the IRS.
8. Always Make Prudent Investment Decisions for Your Business
DO – Make prudent investment decisions as it relates to your business under ROBS.
DON’T – Make poor investment decisions. You are a trustee of your corporation and your retirement plan is the beneficiary, which means you have a fiduciary duty to wisely invest your retirement funds. Of course, any sort of investment carries an inherent risk and may or may not turn out to be beneficial to your retirement plan, so make sure you are doing thorough due diligence.
9. Adequate Consideration for Fair Market Value
DO – Pay Fair Market Value (FMV) for stock purchased by your C corporation for the plan.
DON’T – Rip off your plan by paying more for the stock you purchase with the C corporation than Fair Market Value (FMV).This second pillar of ROBS can best be described with a direct quote from our Corporate Counsel, Joe Wishcamper: “Thou shalt not rip off the plan!” In other words, the plan cannot pay more than Fair Market Value for the stock it purchases in the C corp. FMV is defined as a price determined between a willing buyer and a willing seller. Both people must be familiar with the essential facts of the deal; be under no “extraordinary compulsion” to buy or sell; and are unrelated to each other.
If the buyer and seller are related in some way (familial, or the client is refinancing her own business), it is important to have FMV determined by an independent, third-party appraiser. In this way, it is ensured that a fair price is set for both the buyer and the seller. All in all, Joe’s definition is an excellent rule of thumb: as long as you don’t rip off the plan, you’re fine.
10. Termination of the Program – Closing or Sale of Your Business
DO – Remember that if you close or sell your business, you still need to complete your corporate taxes, Form 5500 and any other state or federal annual requirements. It’s also very important you consult your Plan Administration team and Outside Legal Counsel throughout this process.
DON’T – Think that closing or selling your business is the last step in exiting your ROBS structure. Just because your company’s doors are closed does not mean your 401(k) plan and other aspects of the structure are. You’ll need to complete your taxes and Form 5500, as per usual for that plan year. The IRS takes these things seriously and will hit you with penalties if they’re not completed appropriately. (In Chapter 10 we’ll discuss in depth what it looks like to close your ROBS structure, so you’ll know exactly what to expect.)
For additional details on the dos and don’ts of ROBS, please reach out to one of Guidant Financial’s professionals. If you are already utilizing the ROBS structure, reach out to our Client Services team, your Outside Counsel and your CPA to address any changes you have in mind. This will help ensure the smoothest transition and avoid any penalties from the IRS.
For more information, please refer to the IRS guidelines for ROBS programs.