Top Tips to Avoid Common Prohibited Transactions
- Always act in the 401(k) plan’s best interest.
- Don’t pay yourself an excessive salary. Your wages should be within market for your role.
- Don‘t use any business property for personal use. Don’t let your spouse or family use any business property for personal use.
- Don’t pay your ROBS provider’s fee out of the ROBS transaction.
If you have funds set aside in a retirement account, chances are you’ve heard of prohibited transactions: the use of retirement funds for purposes that don’t meet the criteria set forth by the Internal Revenue Service (IRS). Prohibited transactions can leave you susceptible to pay hefty tax consequences.
Despite the long list of what you can’t do with retirement assets, there’s an exception that lets you use all or part of your retirement funds to start, buy, or grow a business without incurring tax penalties. The IRS calls this arrangement Rollovers for Business Start-up (ROBS). ROBS is a legal way for people to leverage their pre-tax retirement funds to start a business.
Note: ROBS is also often called 401(k) Business Financing, as it most commonly leverages the funds from a 401(k) plan – though more retirement plans than just 401(k) plans are eligible.
However, just like there are prohibited transactions for personal retirement plans, there are prohibited transactions in ROBS.
What are Rollovers for Business Start-ups (ROBS)?
Studies show that lack of capital is the biggest challenge of starting a business. But Rollovers for Business Start-ups gives aspiring business owners access to their pre-tax retirement funds to start, buy, or grow a small business. The major benefit is that when set up correctly, ROBS won’t trigger early withdrawal fees or tax penalties. ROBS uses the “qualifying employer securities” (QES) exception under the Internal Revenue Code section 4975(d)(13). This allows you to use your retirement funds to invest in a privately held C corporation that can then purchase a small business.
Learn more about the ROBS setup process in our Complete Guide to Rollovers for Business Start-ups.
If incorrectly set up or managed, there could be prohibited transactions within the ROBS structure that could void the entire arrangement and make it susceptible to tax penalties. It’s important to understand the requirements that have to be met for the ROBS structure to maintain its tax penalty-free status. We call these the “five pillars of ROBS.”
- Client’s Duty of Prudent Investment
As a trustee and fiduciary of the retirement plan, this individual must act in the retirement plan’s best interest.
- Adequate Consideration for Fair Market Value
The plan cannot pay more than Fair Market Value (FMV) for the stock it purchases in the C corporation.
- Corporation is an Operating Company
The business must be an active, operating company; not a passive investment like real estate property.
- Employer Must Not Discriminate Against Non-Highly Compensated Employees
The employer must offer to each employee the ability to purchase stock in the company with their own retirement funds.
- All Rollover Participants Must Be Bona Fide Employees
The individual(s) 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.
What Are ROBS Prohibited Transactions?
ROBS prohibited transactions are the activities that can void the ROBS arrangement and leave the business owner liable to pay tax penalties and even additional fees.
Most Common ROBS Prohibited Transactions
- Excessive Owner Compensation
- Personal Use of Business Property
- Using Plan Proceeds to Pay Promoter Fees
Excessive Owner Compensation
As stated in ROBS Pillar #5, if you use your retirement funds to invest in a C corporation, you must be a “bona fide employee of the business.” There aren’t any requirements around what work tasks you have to perform to be considered a bona fide employee: you can handle administrative work or act as the company’s CEO. Whatever work you do, you are entitled to be compensated for this work. You just need to keep in mind that trouble can arise if the pay you take is above the normal value of the duties performed or if the salary comes directly from the ROBS transaction funds.
As a fiduciary of your retirement plan, the rule is that you must always act in the plan’s best interest. An inflated salary or taking compensation directly from the ROBS proceeds can be a red flag to the IRS that you’re trying to take advantage of the retirement fund – which could trigger a prohibited transaction. You should ensure your salary amount is in line with reasonable market standards.
Personal Use of Business Property
As the business owner, you can’t use any of the business property for personal use. This includes your spouse and immediate family.
Using Plan Proceeds to Pay Promoter Fees
The ROBS structure can be complex to set up and maintain. You will likely want to work with an experienced ROBS provider to ensure the business is compliant with the rules and regulations set forth by the IRS and Department of Labor.
Many ROBS providers charge an initial fee for setting up the structure, as well as ongoing fees to properly maintain the retirement plan. The IRS calls these “promoter fees” or “professional fees.” Using funds from the ROBS transaction to pay these promoter fees might trigger a prohibited transaction, as a fiduciary can’t use funds from the retirement plan in his or her best interest. To avoid this prohibited transaction, most ROBS providers require business owners to pay their fees out of pocket.
ROBS can be a great solution for aspiring business owners who don’t have enough cash on-hand to start a business or just don’t want to take on debt with a business loan. But since the rules surrounding the ROBS structure can be complex (as seen with the five pillars of ROBS and prohibited transactions), it’s important to work with an experienced ROBS provider who can help ensure your corporation and its retirement plan are set on a strong foundation.