401(k) business financing offers a unique way for you to tap your retirement account to start or buy a business. This structure, also known as Rollovers for Business Start-ups (ROBS), has paved the way for thousands of individuals to achieve their entrepreneurial dreams. 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 ROBS to help guide you through this complex product.
The 10 Do’s and Don’ts of Rollovers for Business Start-ups (ROBS)
ROBS is a unique method of small business financing that has annual requirements. In this chapter, we’ll take you through the dos and don’ts of Rollovers for Business Start-ups (ROBS). This can help you avoid errors with your plan that could result in a taxable distribution – meaning you would have to pay taxes like your rollover was an early withdrawal.
A taxable distribution because of the ROBS structure almost never happens when you work with an experienced ROBS provider, such as Guidant Financial. A good provider will 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. If you’re working with the Guidant Financial team, rest assured we’re 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 list isn’t based on hierarchy of importance. Instead, it’s a reference when thinking about using or changing your ROBS set up.
The Dos and Don’ts of ROBS
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 barriers or obstruct employees from participating in the 401(k). The fourth pillar of ROBS (see Chapter 1) says that the employer must offer the right to purchase stock in the company with their retirement money. Remember the example entrepreneur who used her retirement money to purchase stock in the C corp and became a shareholder in Chapter 1? It’s the same situation 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.
You’re required to make the offer when the employee is hired – but the employee is probably won’t take it. An employee is unlikely to remove their money from liquid and more customary investments like a publicly-traded company where they can cash out any time to put it into your privately-held business, where they can’t cash out until you sell the business. Of the over 20,000 clients Guidant has worked with, all have offered this stock purchase to their employees. 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.”
Most businesses and franchises meet this operating criteria. Business ventures that are eligible don’t include lending, investing, or single investments in real estate. Real estate does present a grey area: you can fund a property management or Real Estate Operating Company, but qualifying 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, it still hasn’t been legalized by the federal government. Even if you live in a state where pot shops are legal, typically you can’t use ROBS to fund one. Some of the more risk-tolerant ROBS providers may move forward with a business like this; but note that the IRS hasn’t given approval to ventures that aren’t 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 can’t be a silent investor. The fifth ROBS pillar states that all business owners with qualified employer stock (QES) must be active employees of the business. This isn’t a requirement for any business partners who use funding other than ROBS. Keep in mind that the active status doesn’t specifically state the type of work you do. You could work the register, manage inventory, or serve on the board of your corporation. But this pillar does mean you can’t be a passive investor in your friend’s wine bar or use ROBS to buy a franchise for your spouse or child and not be involved.
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 who isn’t familiar with ROBS has advised clients to shift to another corporation type. These professionals likely aren’t well versed in ROBS. You should contact your Plan Administration team or outside counsel before making ANY changes. A change to another business entity could result in a taxable distribution. That means all the funds you rolled over could get hit with an early withdrawal penalty – as if you pulled them 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 – Ignore any of the five 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 to exist is through the IRS, so it must follow federal law.
Let’s have a quick recap of those 5 pillars, just for fun:
1. Client’s Duty of Prudent Investment
You have a fiduciary duty to wisely invest your retirement funds. Since any investment is inherently risky, this generally means “sound and prudent investments.”
2. Adequate Consideration for Fair Market Value
Your plan can’t pay more than market value for stock in your business. Simply put, don’t attempt to scam or rip off the 401(k) plan.
3. Corp Must be an Operating Company
Your business must offer goods or services in exchange for money.
4. Employer Must Not Discriminate Against NHCEs
You must offer the option to participate in the 401(k) plan to all employees. Not just highly compensated ones.
5. All Rollover Participants Must Be Bona-Fide Employees
You must be an active employee of the business.
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. Don’t wait until the last minute to complete these essential annual responsibilities. Your Plan Administration service provider won’t 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. Your Plan Administration service provider will walk you through the steps each year.
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’re a trustee of your corporation and your retirement plan is the beneficiary. This means you have a fiduciary duty to wisely invest your retirement funds. Since any investment carries an inherent risk and may or may not turn out to be beneficial to your retirement plan, it’s important to make sure you do 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 than Fair Market Value (FMV) for the stock you buy with the C corporation. This second pillar of ROBS is best described by Guidant’s original Corporate Counsel, Joe Wishcamper, “Thou shalt not rip off the plan.” In other words, the plan can’t pay more than Fair Market Value for the stock it purchases in the C corp. FMV is a price determined between a willing buyer and a willing seller. Both must be familiar with the essential facts of the deal, be under no “extraordinary compulsion” to buy or sell, and can’t be related.
If the buyer and seller are related (familial, or the client is refinancing her own business), it’s crucial to have FMV determined by an independent, third-party appraiser. This was it’s ensured that a fair price is set for both the buyer and the seller. All in all, Wishcamper’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 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 doesn’t 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. They will subject you to penalties if the requirements aren’t appropriately completed. In Chapter 11, we’ll cover what it looks like to close your ROBS structure, so you’ll know what to expect.
For more details on the dos and don’ts of ROBS, please reach out to one of Guidant Financial’s professionals. If you’re already using the ROBS structure, reach out to our Client Services team, your outside counsel, and your CPA to address any changes you’re considering. 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.