The Truth about Using Retirement Funds to Start Your Own Business
Published on February 17, 2016
Current clients and prospective clients routinely ask us how they can start or buy their own business using retirement plans. More often than not, they have heard about this particular structure from a franchise seller or from companies that heavily promote this technique.
If you don’t have the personal savings or credit line necessary to fund a new business, can’t get or don’t want a bank loan, or you’re not tapping friends or relatives for the money, it is possible to fund a new business using funds from a self-directed IRA or 401(k); it’s called a Rollover Business Startup, or ROBS.
The ROBS structure was the subject of a recent article in Forbes that explained how and why this is all possible as well as some concerns the IRS has about businesses that are funded from a self-directed retirement plan.
ROBS at a glance
It takes more than a glance to really understand ROBS but basically, it takes advantage of an exception in the tax code under IRC Section 4975(d)(13) by which a C Corporation adopts a 401(k) plan and the 401(k) plan uses rollover retirement funds to purchase stock in the Corporation (qualifying employer securities). The Corporation would then use the funds to purchase the business assets. Sounds simple? Well, here are the steps required to set up this arrangement:
- An individual sets up a shell corporation that would sponsor a qualified retirement plan. This corporation typically has no employees, operations or assets at this point.
- The plan document put in place states that all participants in the plan may invest the entire account balance in company stock.
The individual who set up the plan becomes the only employee and participant. Usually at this point there is no ownership or equity interest in the company.
- The individual rolls over or transfers current retirement plan funds, either from a previous employer plan or IRA, into the newly created plan. Any taxes that might ordinarily be owed by taking a distribution are avoided as the assets go directly into another tax-deferred vehicle.
- The only participant of the new plan then directs the purchase of his assets into company stock, which is then valued at the amount of the plan assets invested.
- These funds are then used by the individual to purchase a business/franchise or initiate a different type of business.
Next Generation’s Take on ROBS
As our clients know, we at Next Generation Trust Services do not give investment advice, but we do provide guidance and education regarding self-directed transactions, including our take on the IRS regulations regarding the purchase or structure of certain investments within retirement plans.
Regarding the ROBS “strategy,” we have always advised that it is a much more complicated arrangement than many of its promoters would lead clients to believe (as you can see from the steps outlined above). Our advice has been to contact an attorney well versed in ERISA (Employee Retirement Income Security Act) and setting up employer-based retirement plans such as 401(k)s.
The Potential Trouble with Using Retirement Funds to Buy a Business
The Forbes article states that the ROBS structure is the only legal way a business owner can use retirement funds to buy or finance a business that the owner or another “disqualified person” will be involved in personally. However, it has drawn the scrutiny of the Internal Revenue Service as its implementation has grown, and the IRS and the Department of Labor are looking into the operation of many of these arrangements for prohibited transactions and non-compliance issues.
In October 2008, the Tax Exempt and Government Entities Division of the IRS issued the only real administrative guidance on rollovers of retirement plan assets to fund business start-ups, the ROBS Memorandum. The memorandum covers several potential problem areas that we have discussed with our clients: issues of non-compliance regarding the 401(k) plan, lack of plan activity, inadequate valuation given to the purchase of the “qualifying employer security,” permanency of the plan, and whether the arrangement was established for the exclusive benefit of employees or for if personal assets were being purchased.
While we know that many people are seeking ways to capitalize a new business by alternative means, violating IRS regulations is an avoidable risk (and your precious retirement fund can be invested in many other ways). Having a qualified attorney, intimately familiar with the nuances of crafting these arrangements, conduct a thorough review of such an arrangement is a wise step.
Alternative Ways to Invest through Self-Direction
Researching the many alternative assets that you can include in you self-directed retirement plan is another wise move. Self-directed investors make all their own investment decisions, based on what they know and understand, and the allowable nontraditional assets span a very wide range (including private placements and unsecured loans). As the plan administrator, Next Generation Trust Services will conduct the transactions, hold the assets, and manage all the reporting and paperwork associated with the account.
If you are considering using your self-directed IRA to fund a new business, and would like a copy of the entire IRS memorandum, please e-mail us your name, postal address, e-mail address and request to firstname.lastname@example.org.