Since 1974, 401(k) business financing, also known as the Rollovers for Business Start-ups (ROBS) arrangement, has allowed entrepreneurs to tap their retirement funds to start or buy a business. It can be a complex structure with several moving parts that come together to form a viable small business financing option for many who dream of being their own boss.
What is the ROBS Structure?
The Rollovers for Business Start-Ups structure consists of multiple elements that must each meet specific requirements to make the structure work properly. Here are the five basic steps to set up the ROBS structure:
Through this process, you end up with a business that has cash on hand to function. Here’s a quick example:
An aspiring entrepreneur wants to start a small business or purchase a franchise location. She chooses ROBS as her funding method (perhaps she has a wealth of retirement funds on hand, she doesn’t want to go into debt, and she doesn’t want to collateralize her home).
Now she needs to set up the ROBS structure in order to access her retirement funds without being taxed or penalized by the IRS. She uses a company that specializes in ROBS to form a C corp. Her new C corp sponsors a 401(k) plan that specifically allows the participants in the plan to acquire employer stock in a private business. The plan also allows eligible employees to roll funds over from existing eligible retirement accounts into this new plan – which she now does.
Once her retirement funds have been rolled into the corp’s new 401(k) plan, the plan invests up to 100 percent of those funds into the purchase of company stock. In effect, the money in the owner’s 401(k) plan is transferred to the corporation in exchange for the company’s stock. The transfer is similar to purchasing Microsoft stock. For example: an investor gives Microsoft money in exchange for stock certificates — a form of collateral, per se. Microsoft is then free to use those funds to grow their business.
The only real difference between this example and the ROBS structure is that the investment is made in a privately held business (the C corp) instead of one publicly held, like Microsoft. Once the investment is made, the 401(k) plan owns stock in the business, and the C corp holds the cash from that investment. The corporation then uses that cash to operate a business: rent space, buy equipment and supplies, hire employees, etc.
The Advantages of Using a C Corporation for the ROBS Structure
In the process of using your retirement funds to open a new business or purchase a franchise (formally known as a Rollover for Business Start-up), you must first open a C corporation. While some CPAs and investment firms may recommend that businesses immediately or eventually be converted to S corporations, there are actually many advantages to the C corporation for new business owners. In fact, many tax professionals recommend the C corporation as the business entity of choice.
Consider the following benefits of C corporations:
- Profits from a C corporation do not pass through to the individual owners, and therefore do not have an effect on individual tax brackets. Profits remain in the company and are taxed at the corporate rate – which was reduced from 35% to 21% under the 2018 tax reform.
- C corporations can take virtually unlimited capital and operating losses, which means the IRS will not scrutinize you if you report losses many years in a row. You can carry losses forward or backward and apply them against other tax years, allowing you to substantially reduce your tax bills. This is especially important for a new business start-up that may take substantial losses in the first year but wish to carry them forward to future years.
- C corporations are taxed at a flat rate of 21%, despite how much revenue they generate. By comparison, individuals with taxable income of $50,000 or more see at least part of that taxed at 22%.
- In small, privately held corporations, shareholders may also serve as the corporation’s directors and employees. Employees are entitled to salaries, and the corporation can elect to pay enough in salary and bonuses so no taxable profits remain at the end of the fiscal year. As a result, shareholders will only pay individual income taxes.
- C corporations can deduct 100% of the health insurance they pay for their employees, including employees who are shareholders in the corporation. They can also deduct the costs of any medical reimbursement plans. For a small corporation with a lot of medical expenses that aren’t covered by insurance, the corporation can establish a plan that results in all of those expenses being deductible.
- C corporations can also deduct fringe benefits such as qualified education costs, group term life insurance up to $50,000 per employee, employer-provided vehicles and public transportation passes, pre-paid legal assistance, child and dependent care, discounts on company products and services, and qualified achievement awards.
- Unlike LLCs or S corporations, the fiscal year for a C corporation doesn’t need to correspond with the calendar year. One advantage of this is “income shifting,” which allows the owner to decide which year to be taxed on bonus money.
While some tax advisors advise against C corporations for small businesses based on “double taxation” issues, many small businesses have little left in the way of earnings after salaries and fringe benefits are paid out. Little or no earnings mean little or no corporate taxes or double taxation issues. Additionally, you should weigh the double taxation issue against many other factors, including the fact that you might be able to delay receiving dividends and paying taxes for several years.
As always, if you have specific taxation questions, it’s best to consult your tax professional.
OK, we know that was a lot to take in. You’re doing great! We’re now going to dive into the legality of Rollovers for Business Start-Ups, and how the structure avoids what the IRS calls “prohibited transactions” that would void the ROBS transaction and trigger a taxable event. In other words, prohibited transactions are anything that causes you to be taxed or penalized for touching your retirement funds before retirement.
The Legality of the ROBS Structure: The Five Pillars
Our Senior Counsel, Colonel Joe Wishcamper, has built his career on corporate, federal tax and ERISA pension law. We’re about to take you through a very condensed version of Joe’s ROBS structure training, which will tell you everything you need to know about how, exactly, Rollovers for Business Start-ups work.
Joe’s coined term for the legal structure that supports ROBS is “The Five Pillars” — and ROBS needs all five pillars intact to be structurally sound. If one pillar is missing, the rest of the structure crumbles. The pillars are:
- Client’s Duty of Prudent Investment
- Adequate Consideration for Fair Market Value
- Corporation is an Operating Company
- Employer Must Not Discriminate Against NHCEs
- All Rollover Participants Must Be Bona-Fide Employees
1. Client’s Duty of Prudent Investment
The basic concept of this pillar is that as a trustee and fiduciary of the retirement plan, you have a duty to act in your retirement fund’s best interest – in other words, you must wisely invest the retirement assets in the plan. Any sort of investment carries an inherent risk, and may or may not turn out to be beneficial to your retirement plan. So how do we determine if you are fulfilling the requirements of the first pillar?
The Department of Labor (DOL) states that fiduciaries of the plan must act prudently and solely in the interest of the plan’s participants and beneficiaries when deciding what investment options are available for the plan assets. The trustee should look at how they think the business will do and the likely growth the business may experience to determine if ROBS is a prudent investment.
2. Adequate Consideration for Fair Market Value
The second pillar can best be described with a direct quote from Joe: “Thou shalt not rip off the plan.” In other words, the plan cannot pay more than Fair Market Value (FMV) for the stock it purchases in the C corp.
FMV is defined as a price determined between a willing buyer and a willing seller, where both parties are familiar with the essential facts of the deal, 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 a 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: if you don’t rip off your retirement account, you’ll meet the requirements of the second pillar.
3. Business Must Be an Operating Company
The third pillar requires that the business you’re starting or buying is, you guessed it, an operating company. Thanks to the good ol’ Department of Labor, we have a very solid definition of said operating company:
Most small businesses and franchises meet this requirement without issue. Types of businesses that run into a problem with this pillar are factoring companies (which the IRS considers to be an investment of capital) or more passive investments like a single real estate property you intend to rent out.
4. Employer Must Not Discriminate Against Non-Highly Compensated Employees (NHCE)
“What is an NHCE, and why would I want to discriminate against one?” Excellent question. NHCE stands for “Non-Highly Compensated Employee.” The opposite is an HCE: Highly Compensated Employee. HCEs are defined as anyone who makes over a certain dollar amount in a given year. The IRS sets this dollar amount, and may change it on an annual basis. In 2016, the line was set at $120,000. Non-highly compensated employees, therefore, are those who made less than $120,000 the prior year — or anyone who owns 5 percent or more of the company.
The fourth pillar says the employer must offer to each employee the ability to purchase stock in the company with their own retirement funds. Remember when our example entrepreneur’s retirement plan purchased stock in the C corp and become a shareholder? Same deal here: she, as the owner of the company, must now offer the opportunity for her employees to use their retirement funds to purchase stock in the company they work for.
“Wait, what? This is my company – I don’t want a bunch of shareholders taking control away from me. What gives?” Another great question, and here’s the thing: it’s probably not going to happen. You’re required to make the offer when the employee is hired, but the employee probably won’t accept. Of the 14,000+clients Guidant has worked with since 2003, all have offered this stock purchase to their employees, and only a handful have accepted.
Why is that? Because it can be challenging for the employee to deal with; the employee may not even have retirement funds with which to purchase stock; and, if the employee has retirement funds, they’re already invested in publicly held companies through an investment firm. Furthermore, the employee would be making a shift from a liquid asset (their publicly traded stock) to an illiquid asset (stock in your privately-owned business). In other words, the employee would have to wait on you to sell your company before they would get their money back. So, while it’s important to make the offer (and thus not discriminate against any of your employees), it’s unlikely they’ll accept.
5. Rollover Participants Must be Bona Fide Employees
The fifth and final pillar of the ROBS structure is simple: 401(k) plans must benefit the employees of the company that sponsors the plan. And so, in order to be able to roll money and participate in the plan, you must be an active employee of the business. This means a couple of things: you must pay yourself a salary as soon as the business is able to support it, and you cannot be a silent investor.
In practice, this translates to the owner of the business participating in the business somehow. This participation can be management, bookkeeping, making coffee, taking out the trash, etc. For example, if you own a Jiffy Lube, you don’t need to be the one to change the oil — the qualified mechanics you employ handle the cars. But we recommend the “bona fide” employee work 1,000 hours per year or more for their company — about twenty hours per week.
A common scenario that does not fulfill the requirements of the fifth pillar is what Joe (with a twinkle in his eye) calls the “deadbeat spouse” or “deadbeat offspring” scenario: when Spouse A wants to purchase a business for Spouse B to help keep them busy, or a parent wants to purchase a business to employ their unemployed offspring. This causes an issue because the spouse and/or parent has no intention of working in the company they own. Since the owner is not a “bona fide” employee, the conditions of the fifth pillar are not met. (But Joe gets to say “deadbeat spouse” and “deadbeat offspring,” which amuses him.)
ROBS and the IRS: A History
In 1974, Congress enacted the Employee Retirement Income Security Act (ERISA), which shifted the burden of building retirement assets from the employer to the employee. This act, in conjunction with specific sections of the Internal Revenue Code (IRC), provided another method for American workers to grow their retirement assets — which is exactly what ROBS allows you to do. Your plan purchases a business, you work for the business and earn a salary, and then you contribute a percentage of that salary back into your retirement plan. What’s more, when you sell your business, the proceeds go to the shareholder: you and your retirement plan.
This can be a complex process, as you are no doubt now aware, but the result is a way to access retirement funds to start or buy a business without being penalized. However, it is important to keep in mind that ROBS only works if every element of the rules and guidelines are met — and even this deep dive chapter doesn’t encompass every aspect. That’s why it is very important to work with an experienced ROBS provider who can guide you through this product every step of the way.