An increasing number of entrepreneurs are capitalizing their small business or franchise with their own IRA or 401(k) funds, without taking a taxable distribution or getting a loan. Although growing in popularity, this option is still relatively unknown by many people who dream of owning a small business or franchise. In other words, thousands of would-be entrepreneurs are unaware they could be accessing startup capital that is sitting in their own retirement accounts.
401(k) business funding, also knows as Rollovers as Business Start-ups (ROBS), enables individuals to acquire a business as an investment inside their retirement plan. A ROBS structure starts with the creation of a C corporation. That new corporation then sponsors a 401(k) plan that explicitly provides for the acquisition and holding of qualifying employer securities. An entrepreneur then rolls all or part of their existing and eligible retirement funds into the new 401(k) plan. This 401(k) plan, also referred to as an eligible individual account plan, in turn invests in the stock of the new corporation. The corporation, now flush with funds, acquires a small business or franchise on behalf of the 401(k) plan.
The result is: An aspiring entrepreneur or franchise owner launches his/her new business through a cash investment by their retirement plan. Thus funded, the new business is not responsible for monthly payments which accompany interest-bearing small business loans. The business now can also offer participation in the company’s 401(k) plan to his/her employees — a highly attractive benefit.
Unfortunately, many financial professionals attempting to provide oversight do not properly understand the ERISA and Internal Revenue Code guidelines. 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 the IRS is very protective of the use (or abuse) of employer plans. One of the areas of great concern is that of “owner’s compensation.”
There can be that arise with personal compensation for an individual who establishes a business using ROBS. In a previous article in which we explored whether an appraisal was necessary, I wrote:
The IRS Code classifies certain transactions and activities as ‘prohibited transactions’ under Internal Revenue Code § 4975(c). The rules were created to help individuals avoid transactions that would create a conflict for doing what is in the exclusive benefit of their retirement plan. For example, I cannot buy rental property and let my father occupy it. Why? Well, a conflict of interest would occur if it was necessary to evict him for not paying rent. The personal relationship with “Dad” would make it difficult for me to act as a prudent investor should. Even still, the code (in IRS § 4975(d)(13)) provides an exception to the prohibited transaction rule for acquisition of qualified employer securities.A 401(k), 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 purpose” rule. That 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. Conversely, if they are in desperate need of a salary and make this investment to gain short-term income – the exclusive benefit rule could potentially be violated.
The question then becomes whether the client who provides actual services to the corporation must pay himself or herself a salary to qualify as a bona fide employee. The test that is utilized for qualified plan purposes is the “common law employee” analysis. That test involves an analysis of 20 different factors that are identified in IRS Rev. Rul. 87-41. None of the 20 factors used by the IRS require payment of a salary. While you will often hear companies in our industry assert, “With ROBS, You Must Pay Yourself a Salary,” let me be very clear, because many ROBS providers often assert something different:
There is no legal requirement that a bona fide employee be paid a salary in order to qualify as an employee for qualified plan purposes.
In fact, you might recall that in 1979 Lee Iacocca served as President, CEO and Chairman for Chrysler in exchange for compensation of $1.00. I’m pretty sure he was considered a bona fide employee.
Guidant Financial is the leading provider of ROBS services. For that reason we actively communicate with the Department of Labor, and 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. Their concern is that the individual may not be making the investment to buy the business for the exclusive benefit of the retirement plan, but rather their own need to create income.
To be completely fair, it is hard to understand how the DOL might have such a concern given the prohibited transaction exemption under which the ROBS product is established pursuant to ERISA § 408(e). Nevertheless, informal discussions with the DOL have indicated that they are concerned with the salary issue, and with ROBS promoters that tout “Pay yourself a salary” as a benefit of iFinance or ROBS. The have raised concerns about the indirect use of plan assets for the benefit of the individual. And the prohibited transaction exemption we are talking about does not trump the “exclusive benefit rule.”
Guidant is committed to our clients’ compliance and has established strict protocols to avoid any potential DOL issues. In fact, we advise our clients to take a salary out of the operational revenues generated by the business, not out of the proceeds from their 401(k)’s stock purchase. Despite competitive claims to the contrary, Guidant advises its clients to pay themselves a salary as soon as they begin generating revenues. This simple protocol makes clear that the individual did not enter into the ROBS arrangement for the purpose of receiving immediate compensation and is not therefore taking salary from the plan’s investment. The mere fact that the individual may receive compensation at some point in the future does not cause the plan’s investment in employer securities to potentially violate sections of ERISA 406.
Let me pose a different question as well: Is it fiscally responsible to pay yourself a salary?
Salary is subject to federal employment taxes at a rate of 15.3%, plus state employment taxes in addition to federal income tax. In contrast, a client who takes a taxable distribution from the plan will pay federal income tax plus a 10% early distribution penalty if under the age of 55. Thus, from a tax perspective, it is not optimal for the individual to roll over the distribution and take the plan benefits as salary. Some might argue that taking a taxable distribution isn’t what they would choose because it loses its “tax-deferred status.” Fine. Then why not take a loan from your 401(k) instead? Then you can pay the 401(k) back over time, repaying the principal to your 401(k) plan, plus interest, providing additional profits to the plan. Chew on that!
In summary, it is essential that the client be a bona fide employee in order to roll retirement money into the plan, otherwise a violation of the exclusive benefit rule will result. On the other hand, there is no absolute and inflexible requirement that the client must take a salary in order to be an “employee.” Anyone that tells you otherwise is unfamiliar with the code or trying to earn your business by “fluffing” the facts.
The DOL has informally expressed concern that, depending on the facts and circumstances, an immediate salary paid to the client out of the proceeds from the Plan’s purchase of employer stock might be a prohibited transaction. Guidant’s solution to this situation is to require a ROBS client to take a salary from the operational revenues generated by the business, not from the 401(k)’s investment.
If you are considering using ROBS as a way to fund your business purchase, or if you are referring individuals to companies performing such services, make sure you do your due diligence. Whenever possible, work with an independent tax or legal professional to help you make the right decision. Guidant Financial has helped thousands of individuals to invest in a small business, thereby helping them live the American Dream and create the life they want.