One of the most important factors in the success of a small business is access to funding. Lack of business financing poses serious challenges, simply because the ability to grow or pivot to new opportunities may not exist. In fact, lack of capital/cash flow was the biggest challenge cited by business owners in Small Business Trends:2020.
Two of the most common funding methods are small business loans from the U.S. Small Business Administration (SBA) and Rollovers for Business Startups (ROBS). ROBS is the second most popular funding method cited in Small Business Trends: 2021, used by 20 percent of respondents, while 9 percent used an SBA loan. (The most popular method was cash, used by 30 percent of respondents — but not everyone has the personal savings to finance their business with cash.)
How do SBA loans and ROBs compare with each other? Let’s explore each in depth.
SBA Business Loans
The SBA doesn’t make loans itself, but guarantees loans made by participating lenders (banks, credit unions, and other financial institutions). The guarantee means that the lenders are more willing to extend advantageous terms to small businesspeople who qualify for the loans. The net result is that SBA loans offer some of the best financing deals for small business people, with lower interest rates and longer loan terms than many traditional loans.
SBA loans are also flexible. The most common SBA loan, known as the 7(a), can be used to set up a business, expand a business, acquire another business, refinance existing debt, or for operating capital. Small businesspeople can borrow up to $5 million with SBA loans.
While SBA loans can be an excellent option for funding, they have some downsides a prospective business owner should be aware of. The first is intense competition. A high percentage of SBA loan applications are denied. The competition arises partly from the advantages — many small businesspeople want the lowest interest rates possible and terms up to 25 years, so entrepreneurs face a lot of competition from other entrepreneurs.
The other downside is stringent requirements. SBA lenders will look at the “five C’s” that most conventional lenders look for in potential loan applicants. They are:
- Capital – you will be required to make a minimum 10 percent down payment, and lenders can require up to 30 percent. If you have an existing business, lenders will look at how much capital is in your business.
- Capacity – your ability to repay the loan.
- Collateral – you may be required to collateralize your home or other assets.
- Character – your standing in the community, both business and personal.
- Credit — generally, a 680 minimum credit score is required3
Small business owners should also understand that any type of loan financing is going to leave them with debt costs to repay. It’s important to crunch the numbers and make sure the loan is going to be affordable. The monthly payments for debt service on a $250,000 SBA loan, for example, is $2,775 per month — and $250,000 is a relatively modest size for a business loan.
ROBS, on the other hand, is a funding method that is not a loan. Instead, it taps equity you already have in qualified retirement savings funds such as a 401(k) to fund your business. Since it is not a loan, it doesn’t result in any monthly debt service.
In fact, one of the key advantages of ROBS is that it removes any danger of monthly loan payments imperiling your business. A large percentage of small businesses fail – up to 45 percent in the first five years of operation, according to the U.S. Bureau of Labor Statistics. A substantial percentage of failures occurs because business people do not have enough profit to meet their monthly loan payments. On the other hand, more than 80 percent of Guidant clients who use ROBS are still in business after four years.
ROBS needs to be set up in a very specific manner to avoid taxes and tax penalties on your retirement funds. Briefly:
- You need to set up a C Corporation. (Using ROBS with another corporation type, such as S Corporations or Limited Liability Corporations (LLCs), will cause taxable events.)
- The new C Corporation must set up a 401(k) that can be used for private stock purchases.
- The funds from your existing retirement account(s) are rolled into that new 401(k).
- The new 401(k) plan purchases stock in the C Corporation.
- The cash from the stock purchase now belongs to the C Corporation, and can then be used for any business purpose.
ROBS utilizes 401(k)s commonly enough that it is sometimes known as “401(k) financing.” But in fact, you can withdraw funds from a number of retirement plans using ROBS, including traditional Individual Retirement Accounts (IRAs), Thrift Savings Plans (TSPs), 403(b)s, Keoghs, and Simplified Employee Pension Plans (SEPs). (Roth IRAs can’t be used because the funds in it have already been subject to tax.) Generally, a business owner should have a minimum of $50,000 in at least one retirement plan to utilize ROBS effectively.
And if you’re worried about your retirement account balance, don’t be! You and additional employees can continue to contribute to a 401(k) retirement plan in the new C Corporation. You can continue to fund your retirement.
ROBS funding can be much faster than an SBA loan approval. ROBS can be set up in as few as three weeks, while SBA loan approval can take three months or more.
Tax Advantages: SBA Versus ROBS
SBA loans provide some tax advantages. The disbursed amount is a loan, so it is not subject to taxes. Interest on all business loans is deductible on your taxes, and SBA loans are no exception.
The tax advantage with ROBS is you can withdraw money from qualified retirement accounts completely tax-free using the ROBS method.
This is quite different from trying to tap your tax-advantaged retirement monies to fund a small business without using ROBS. Generally, if you try to withdraw funds from any tax-advantaged plans like 401(k)s and IRAs before you are 59½, the transaction will trigger taxes. You’ll be taxed on the amount in the year of withdrawal at your ordinary rate. In addition, the Internal Revenue Service (IRS) socks early withdrawal penalties of 10 percent on withdrawn amounts if you’re not 59½.
So in other words, if you’re trying to withdraw $100,000 from your retirement accounts without using ROBS, and are in a 30 percent tax bracket, you may end up having to pay $30,000 in taxes plus a $10,000 tax penalty, for a total of $40,000. You’ll end up with just $60,000 in cash to fund your business due to taxes. But with ROBS, you’ll have access to the entire $100,000.
Note that, if you withdraw retirement funds to start a business, they will be taxed in any business structure that isn’t accomplished using the ROBS method. If you tap retirement funds to start an LLC with multiple members, for example, it is usually taxed as a partnership, with any income or loss reported in Schedule E of your 1040. LLCs can also choose to be taxed as corporations, including C Corporations, but that does not shield any retirement funds used in starting or expanding the business from taxation or penalties.
Using SBA Loans and ROBS Together
Is there a way to reap the advantages of SBA loans and ROBS together? Yes! They can be used together as funding sources.
ROBS can be used as a down payment for an SBA loan, for example. That way, you have funds to use for the down payment without tapping other capital needed for the business or your personal funds. Again, you never have to repay ROBS since it’s your own money, and you won’t owe any taxes on it.
Let’s say you want a $250,000 loan. The SBA requires a minimum down payment of 10 percent, and can require up to 30 percent. You need, then, a range of $25,000 to $75,000 down to successfully apply. Having the ability to make a larger down payment can mean the difference between a successful application to the SBA and one that doesn’t succeed this time.
If you need a larger loan size but are encountering challenges getting the down payment together, ROBS can provide flexibility by providing the funds for a larger down payment.
Let Guidant Help You Get Funding for Your Small Business
Both SBA loans and ROBS can be complicated, and choosing which funding option is best for your business isn’t easy. That’s where we come in. Guidant Financial counselors can help you optimize your financing options. We can set up a tax-free ROBS for your small business and provide expertise in the SBA loan process, including pre-qualifying. Contact us to discuss SBA loans, ROBS, and using both together.