In this tough job market, more people are opting to start businesses instead of seeking employment. To help fund those businesses, they often look to their qualified retirement accounts (401(k)s and IRAs). It can be a great financing strategy, but it’s also one fraught with potential tax traps and that the IRS is closely examining.
The strategy the IRS is most concerned with now it calls ROBS, for rollover as a business startup transaction. There are variations, of course, but it basically works like this.
A person starts a new company, which creates a new retirement plan. The company initially might not issue much stock or have any capital. The retirement plan is permitted to accept rollovers from other plans of its employees and to allow investments in the new company’s stock. The owner takes assets he or she already had in an IRA or 401(k) and rolls them over into the new plan. The new plan purchases shares of the new company’s stock.
The company ends up with the owner’s retirement assets as its capital, and there was no tax cost. No distributions were taken to get the assets in the new company. In addition, it is not a loan, so the company doesn’t have an interest expense and doesn’t have to pay back the money. The business can use the assets to conduct its operations.
There are several firms that package and promote these transactions. (The IRS developed the name ROBS.) The transactions frequently are used to finance franchises, though they also are used to buy existing businesses or start new ones. The Small Business Administration even considers the proceeds to be a good down payment when qualifying for an SBA loan.
The IRS hasn’t determined that ROBS are invalid, and apparently has approved a number of them for taxpayers who asked for opinions. It issued a 2008 document explaining when the transaction is valid. But there are some issues to be wary of, and the IRS appears to be taking a fresh look at them.
Before looking at the tax issues, you also need to be careful about using your retirement savings to finance a small business. These are risky investments, even when the business is an established franchise. You’ll have to start saving all over if the business doesn’t work.
The IRS says it’s looking at several key issues when it encounters the transactions in audits. It’s also following up with transactions it previously approved to ensure they are complying with all the rules.
? Some owners use the business funds to pay purely personal expenses. That disqualifies the transaction and makes it taxable. The funds must be spent only for the business.
? The retirement plan must not discriminate between employees. All employees (including futures hires) must participate in the plan and be able to buy company stock through the plan. When the retirement plan is a profit-sharing plan, all employees must receive their share of plan assets, contributions, and employer stock.
? Valuation of the corporate stock is a key issue, both before and after the purchase. No valuation or a superficial valuation could trigger a charge that there was an improper transfer of wealth from the retirement plan to the business owner. The stock also must be valued each year for the retirement plan’s annual report.
? Follow all retirement plan rules after the purchase. That means filing the plan’s annual report, having a valuation done, and ensuring all eligible employees are properly informed of and allowed to participate in the plan.
It’s important to avoid prohibited transactions. These are transactions between a retirement plan and a related or disqualified person. The important characteristic of a prohibited transaction is that it doesn’t matter whether or not it was conducted at fair market value. The transactions are prohibited at any price.
Prohibited transactions include a sale, exchange or lease of property; a loan of money; furnishing goods, services, or facilities; and a transfer of or use of the income of the retirement account. Also prohibited are any transactions in which the related party deals with IRA assets or income as his own. Another prohibited transaction is the receipt of any benefit by the related party in connection with a transaction involving income or assets of the retirement account.
You can see the list is quite broad and basically prohibits any deals between a related party and a retirement account. The Department of Labor is allowed to grant exemptions to prohibited transactions. It’s granted exemptions that allow business owners to use their IRAs or other retirement accounts to fund their businesses or engage in transactions with it. But you need to qualify for an exemption and be sure to follow the guidelines precisely.
We’ve discussed the prohibited transactions in some detail in past visits, and those are available on IRA Watch section of the members’ web site Archive. You can find a more detailed discussion of prohibited transactions and other unconventional uses of retirement accounts in my report IRA Investment Guide: A Road Map for Avoiding the Tax Traps and Penalties for IRA Investments. You can purchase a copy for immediate download on the Retirement Watch web site under the “Bob’s Library” tab.
It’s important to follow the rules precisely when a retirement account is involved. The penalty can be complete disqualification of the retirement plan, making the entire amount taxable immediately. There also are lesser but still substantial penalties for improper transactions with retirement plans.
RW April 2011.
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