An increasing number of entrepreneurs are capitalizing their small business or franchise with their retirement funds — without taking a taxable distribution or getting a loan. This funding method, Rollovers For Business Start-ups (ROBS), contains important nuances such as how you should be paying yourself a salary.
Though ROBS is growing in popularity (it was used by 22 percent of entrepreneurs, according to our recent small business trends study), it is still relatively unknown by many people who dream of owning a small business or franchise.
Can I pay myself a salary when using ROBS funding?
Yes, you as the business owner can pay yourself a salary for the work you are providing to your business, though it’s not required. If you do choose to compensate yourself, issues may arise depending on where you pull the funds from to pay your salary, and how much you pay yourself. The rules and guidelines that lead to this conclusion can be somewhat complex.
Eligibility Requirements for Rollovers for Business Start-ups
ROBS is a legal and viable funding option for new and existing entrepreneurs, allowed for by the Employee Retirement Income Security Act (ERISA). ERISA passed the responsibility of saving for retirement from employers to employees and gives individuals the freedom to grow their retirement assets by investing in private businesses. However, in order for the ROBS transaction to remain tax penalty-free, there are strict rules and guidelines that must be followed, as set forth in the Internal Revenue Code (IRC).
Because the newly created business is built on behalf of the entrepreneur’s retirement plan, the 401(k) business funding structure can be of interest to the IRS since they are very protective of the use (or abuse) of employer plans. One of the greatest areas of concern is the use of 401(k) plan assets to pay yourself compensation or a salary.
The 5 Pillars of ROBS as They Relate to Salary
There are five pillars of a ROBS transaction that must be met in order for the structure to remain sound. All five pillars must be met or the structure crumbles, meaning it loses it tax penalty-free status. 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
It’s the first and last pillar that have the largest impact on paying yourself a salary.
Learn more about your funding options: Pre-qualify Today.
Client’s Duty of Prudent Investment
This first pillar of ROBS means that you, the business owner, as fiduciary and trustee of your corporation’s retirement plan, must act in the best interest of the plan and its beneficiaries at all times.
According to IRS § 4975(d)(13), a 401(k) plan, which exists in the ROBS transaction, must be maintained for the exclusive benefit of the sponsoring employer’s employees (or former employees) and their beneficiaries. There is a parallel provision in ERISA referred to as the “exclusive benefit rule.” This means the only reason someone should elect to invest their retirement assets into a business is because they believe it’s a prudent and judicious investment for their plan.
If an individual finds themselves in need of a salary and uses the ROBS structure as a means to gain short-term income, the exclusive benefit rule could be violated. In these cases, paying a salary would not be prudent as it is not in the best interest of the plan, but rather solely for the individual’s benefit.
The Bona Fide Employee Pillar
The last ROBS pillar states that the individual who completes the 401(k) rollover must also be a bona fide employee of the business they start or purchase, providing an actual service to the business such as administrative duties or performing the role of CEO. The question then becomes whether the individual who provides services to the corporation must pay himself or herself a salary to qualify as a bona fide employee.
The test used for qualified plan purposes is the “common law employee” analysis. This test involves an in-depth review of 20 different factors that are identified in IRS Rev. Rul. 87-41. None of these factors require payment of a salary.
While you may hear other ROBS providers assert that 401(k) business financing requires business owners to pay themselves a salary, there is no legal requirement that a bona fide employee must be compensated in order to qualify. You might even recall that in 1979, Lee Lacocca served as President, CEO, and Chairman for Chrysler in exchange for compensation of only $1.00. He was still highly regarded as a bona fide employee.
The Department of Labor’s Stance on Paying a Salary
Guidant Financial is the leading provider of ROBS services, performing more ROBS transactions each year than any of our competitors. For that reason, we actively communicate with the Department of Labor (DOL). On many occasions during informal conversations, the DOL has expressed concerns about the payment of a salary to the company’s owner using the plan’s investment proceeds.
While the prohibited transaction rules set forth in ERISA § 408(e) were created to prevent such practice, the DOL has still indicated they are concerned with the salary issue and with ROBS promoters that tout “paying yourself a salary” as a benefit. They have also raised concerns about the indirect use of plan assets for the benefit of the individual.
Guidant’s Approach to Paying Yourself a Salary When Using ROBS
It’s common practice for many entrepreneurs who use ROBS to pay themselves a salary, and Guidant has established strict protocols to avoid any potential DOL red flags when it comes to business owner compensation. We suggest our clients wait to take a salary until their business is generating operational revenue. Waiting prevents any concerns that proceeds from the 401(k) stock purchase were used for individual gain and makes it clear that you did not enter into the ROBS arrangement for the purpose of receiving immediate compensation. That you may receive compensation at some point doesn’t cause the plan’s investment in employer securities to potentially violate sections of ERISA 406.
The final factor in the salary discussion is how much you should pay yourself. The requirement is that any salary taken must be “reasonable,” which translates into a salary that is not excessive given the nature of the business, the responsibilities of you as the employee, and the services provided to the corporation by that employee.
Typically, we don’t encounter problems with ROBS clients taking an excessive salary — instead, some clients are reluctant to take any salary at all. This can also be problematic as we recommend our clients defer a portion of their salary into their corporation’s 401(k) plan. Such salary deferrals confirm that the plan is being used for its intended purpose: as a vehicle to generate retirement savings.
Taking a Salary vs. a 401(k) Distribution
Let’s look at the salary issue in a different light: Is it fiscally responsible and “tax-efficient” to pay yourself a salary using a 401(k) withdrawal (also known as a distribution) rather than waiting for operational revenues to support it?
Salary is subject to federal employment taxes at a rate of 15.3 percent, plus state taxes in addition to federal income tax. In contrast, a client who withdraws funds from their 401(k) for immediate income will pay federal income tax at their tax bracket plus a 10 percent early distribution penalty if under the age of 59 ½. From a tax perspective, it’s not optimal for an individual to take a 401(k) distribution and then use the plan benefits as salary. It’s more advantageous for them to use their 401(k) funds tax penalty-free to purchase a business, and then wait to pay themselves a salary until the business can afford it.
The Final Verdict: Paying Yourself a Salary is Acceptable, But Not Required
Paying yourself a salary is not a requirement of the ROBS transaction, but it is common practice that necessitates ensuring it’s done properly. As long as you are a bona fide employee of your business and operate in your 401(k) plan’s best interest, paying yourself a salary can be an added bonus that offers further financial freedom to individuals looking to grow their retirement assets by investing in a small business. We suggest working with an independent tax or legal professional at all times to help you make the best decisions for you.
Guidant Financial has helped thousands of individuals start or buy the small business of their dreams using their retirement funds tax penalty-free, allowing them to create the life they want while improving their retirement outlook. Want to see if you qualify for ROBS? Take our online assessment now to find out.