Hopeful small business owners are often surprised to learn they can avoid taking a loan or risking their home as collateral by using their retirement funds through Rollovers for Business Start-ups (ROBS). But are ROBS legal? Short answer – yes! For the long answer and tips on how to stay in compliance, read on.
Obtaining adequate financing can be one of the most frustrating challenges for an aspiring business owner. The application for small business loans take at least a couple months and few people qualify; many entrepreneurs struggle with low credit scores and coming up with a down payment or collateral to secure debt-based funding can be difficult. This is why when hopeful business owners learn about Rollovers for Business Start-ups (ROBS), which provides fast, debt-free funding that’s easy to qualify for, it can seem to good to be true — even prompting the question of whether or not ROBS are legal. Let’s take a closer look at the details, legality and benefits of the ROBS structure.
How are Rollovers for Business Start-ups (ROBS) legal?
First, let’s address the biggest question: Yes, ROBS are legal and ROBS funding is not a tax loophole. Also know as 401(k) business financing, the ROBS structure involves rolling funds out of an existing retirement account, such as an IRA or 401(k) and then using that money to buy a franchise, or existing business, or as start-up capital. Many entrepreneurs and business advisors aren’t familiar with ROBS, and because it’s not a loan and the transaction is tax-free, some are lead to question the legality of the structure.
However, ROBS funding has been legal since 1974 when Congress passed the Employee Retirement Income Security Act (ERISA). This law passed the responsibility of retirement saving from the employer to the employee — giving individuals the right to direct their retirement funds as they see fit.
As long as funds from the rollover are used for small business funding, the correct process is followed, and a few minimal requirements are met, 401(k) business financing is legal.
What does a legal ROBS process look like?
It’s important to note that when new entrepreneurs ask if ROBS are legal and if 401(k) financing is legal, what they really might be trying to understand is whether it’s possible to take money from a retirement fund for small business financing without paying taxes and penalties.
An essential element of ensuring that 401(k) business financing is legal (and not taxable) is completing the funding transaction according to the correct structure. ROBS funding is complicated but working with an experienced 401(k) funding provider will make the process easy and let you focus on what’s important — your business. It’s generally a bad idea to attempt to complete ROBS funding on your own due to the complex process, and if you work with an independent CPA or tax attorney, always inquire about their experience with ROBS.
Here’s an overview of the complete ROBS process:
- A new business is established as a C corporation. Funding any other type of business entity will cause a taxable event. In other words, a ROBS transaction when funding an S corp, LLC, etc. is not legal (and is not a proper ROBS transaction). The reason a C corp must be established is because the following steps require a company stock purchase.
- The newly created C corporation establishes and sponsors a new 401(k) plan that can purchase private stock. Setting up the retirement plan correctly is also essential to meeting the ROBS structure requirements.
- Funds from the existing retirement account are rolled into the new 401(k) plan without triggering a taxable distribution. This step is the ‘rollover’ in Rollovers for Business Start-ups. Done correctly, it’s considered a qualified rollover and is not taxable. Think of it as rolling retirement funds from an old employer account to a new employer account — this is exactly what you’re doing.
- The 401(k) plan purchases stock in the C corporation. As a result of this transaction, your 401(k) plan becomes a shareholder of the new company. The 401(k) plan is the owner of the shares, but it’s recorded on the stock certificate “on behalf of” you, the owner.
- The new business is now cash-rich. Because of the stock purchase, the new company is now funded and can use the capital for almost any business purpose including start-up cash, acquiring an existing business, purchasing a franchise, and even the down payment on a small business loan.
Is it legal to use ROBS funding for the down payment on a loan?
Qualifying for a Small Business Association (SBA) loan can be difficult. There are a lot of requirements to meet including a large down payment, great credit score, business history, and sufficient collateral. For many well-qualified borrowers, pulling together enough cash for the down payment is the most difficult part of obtaining a loan, which is where ROBS comes in.
One of the greatest advantages of 401(k) business financing is that it’s debt free. However, some people need more money than what’s available in a retirement account to fund their small business project. In this case, ROBS can still help. It’s perfectly legal to use the funds from a ROBS transaction as the down payment on a small business loan. In fact, many of our clients regularly obtain SBA loans this way.
Combining these financing methods can prove to be extremely helpful for entrepreneurs — not only does having a large down payment help you qualify for more financing, but it can help you get better loan terms, and as a result, more manageable monthly payments.
What are other considerations for a legal Rollovers as Business Start-ups (ROBS) transaction?
If you’re working with an experienced third-party provider to complete your ROBS funding transaction, you won’t have to think too hard about keeping everything legal and avoiding a taxable event. The right provider will guide you through the process and keep you aware of any red flags. Guidant even provides time with an outside counsel attorney, as a part of the initial fee, who represents you and your business’s interests. However, it’s always wise to be aware of all possible considerations when deciding if 401(k) business financing is right for you.
Here are things to keep in mind that could affect you, your business, and the legality of ROBS.
- Bona fide employee requirement. As the owner of a ROBS funded company, you’ll be required to maintain an active role in running the business. Whether you’re doing business development, sales, or sweeping the floors, you should plan to be an active employee of the company. As a rule of thumb, we recommend you work at least 1,000 hours at the business every year. You don’t necessarily need to pay yourself right away and this time can certainly include sweat equity. One of the main reasons for this requirement is you’re not allowed to use ROBS to fund a business for someone else, even for your spouse — though you can absolutely partner with family and friends. In short, your retirement money is invested in the new business and you need to be actively working toward to success and health of that investment.
- 401(k) plan requirements. One of the greatest benefits of funding your business with ROBS is your business’s new 401(k) plan. Sponsoring a retirement plan means you can automatically begin to build up your nest egg and it’s a wonderful recruiting tool for bringing on new talent to your business. As the business owner, it’s important to know that you do have responsibilities. And as the owner of a ROBS funded business the requirements to properly maintain the plan must be met to keep the legal structure in tact. The best way to maintain your plan is first to offer it to employees so they know about it and secondly to work with a 401(k) plan administration team who is familiar with the ROBS structure.
- Filing an Annual IRS Form 5500. Another important element of maintaining the 401(k) plan, and as a result, the ROBS funding structure, is filing an Annual IRS Form 5500. This process is a bit like filing taxes (but it’s NOT the same as filing your corporate taxes), and it reports on your 401(k) plan’s activity, which is review by the IRS and DOL. Even if no one is participating in your company’s retirement plan, a Form 5500 is required each year as long as the 401(k) plan owns company stock. Again, this process can be made much simpler when working with a plan administration team, but it’s important to know that you or someone you delegate will be responsible for collecting the necessary information and paperwork.
Keep your ROBS transaction legal by avoid these mistakes.
As we discussed earlier, when done correctly, ROBS are perfectly legal and tax penalty-free. And there are a bevy of benefits to funding a business with your retirement funds — it’s debt free, funding can be completed in as a little as three weeks, and there are very few requirements for funding approval. There are no down payment or minimum credit score requirements, which is often a huge hurdle for entrepreneurs. However, there are a few cases where ROBS funding may not be a good fit for you and using your retirement money in these scenarios would be taxable. If any of these scenarios describe you or your business, ROBS is likely not a good fit.
- Passive investments. ROBS funding is only legal when the money is used to fund an active, operating business. This does not include passive investing. For example, if you want to start a business to make financial investments in other businesses, this would likely not qualify for ROBS. Another example – it’s not legal to use ROBS money to purchase one rental property, but it is legal to fund a company that manages multiple rental locations.
- Non-qualified businesses. Most entrepreneurs find that their business plan is perfectly well suited for ROBS funding, however a limited number of business structures do not qualify. For example, because 401(k) business funding uses retirement funds, which are regulated at the federal level, it’s not legal to use ROBS funds to open a marijuana dispensary, even if it’s legal in your state, because it’s not legal at the federal level.
- Using ROBS money for anything other than a business. This one seems obvious, but it’s not legal to use ROBS funds for anything other than funding a business. Using the money from a ROBS transaction to access your retirement funds for personal use, such as purchasing a home, boat, or funding travel, is not legal and is not a valid loophole to avoid paying an early withdrawal fee.
Keep in mind, if you work with Guidant, any of these red flags should quickly become apparent in your private conversation with your assigned outside counsel attorney or even in early conversations with our experienced business consultants.
Every year, we help current and aspiring small business owners access 401(k) financing, as well as a full suite of additional funding options. Our team of experts knows the ins and outs of the ROBS structure and can help you move forward confident that you’re protected legally and won’t meet any unexpected tax penalties. In fact, we provide our 401(k) administration clients with ongoing audit protection. Don’t let the fear of the lesser-known keep you from accessing fast, affordable small business funding. Learn even more about ROBS with our Complete Guide to 401(k) Business Financing.