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Chapter 6

Retirement Financing

Don really wanted to buy an existing franchise business. His wife Mary was less enthusiastic. Don said they needed $300,000 to get it going. The couple had explored obtaining an SBA loan but they didn’t have the 25 percent down payment required. And their credit was not stellar.

The only source of money they really had was Don’s 401(k) plan. He had managed to accumulate $350,000 for retirement. Mary said their financial planner warned they shouldn’t take their money out for something as risky as starting a business; they would need it to help them pay expenses in their later years.

But Don felt their financial planner just wanted to hold onto their account. Of course he wouldn’t suggest using the money for starting a business. He would lose out on financial planning fees.

So Don went on the internet and found all sorts of promoters claiming that one could easily tap into their 401(k) for business financing. The promoters touted that there were provisions within the Employee Retirement Income Security Act (“ERISA”) and the IRS tax code allowing people to invest retirement savings in a business if they were active employees. (Those seeking passive income through absentee ownership didn’t meet the requirements.)

On the internet it seemed so easy. There were five basic steps to follow:

1. Set up a C corporation. An S corporation, limited liability company or other structure wouldn’t work. You had to set up a double tax C corporation before you created or bought your business.

2. Have the C corporation set up a 401(k) plan. The new plan must specifically provide for the acquisition and holding of qualified employer securities (meaning stock in the business).

3. Roll your existing 401(k) plan into the new plan. So your old plan gets rolled into the plan you just set up for the new C corporation.

4. Have the new 401(k) invest in the new C corporation. The new plan (which is specifically authorized to do so) then invests directly into the business. The plan is now a shareholder of the new C corporation.

5. The 401(k) money is now in the corporation. With cash in the corporate bank account you can now start doing business.

Don reported all this back to Mary. He said the unique strategy was called Rollover as Business Start-Ups or ‘ROBS.’ Mary was not convinced, noting that all she saw was a risky business that ‘robs’ their retirement monies.

Don said the promoter offered all sorts of benefits to this strategy. A key, he said, was that there was no debt service on the business like there would be with an SBA or bank loan. Their house and other assets were not exposed. While Mary acknowledged this as true, she noted that their most valuable and asset protected entity—their 401(k) plan—was now completely exposed. If the business failed their retirement monies were gone. Did Don have enough years left to ever accumulate another $300,000?

Don was confident of their future success. He noted another benefit was that all the profits went into their 401(k) plan tax free. And it would be there accumulating tax free until they needed it. Mary didn’t have an answer for this and said she would talk to their CPA about it.

Several days later, Mary reported back. Their CPA was very concerned that any profits made by the C corporation were subject to taxes of between 15% and 34%.

But even worse, Mary said, were the numbers when the business was sold. Because of the double tax C corporation (the corporation being a requirement for a ROBS transaction) a great deal more in tax was paid at the time of sale.

The C corporation paid another 15% to 34% tax on the gain before money went into the 401(k) after a sale and then another hefty 10% to 39.6% personal income tax was paid when the 401(k) distributed the money out to Don. Their ROBS required a double tax scenario which robbed them of any real gains. Don thought about it all. He asked Mary what their CPA thought about ROBS plans. She said he wasn’t a big fan of them. The IRS had never fully endorsed them and the Tax Court was cracking down on them. The recent case of Ellis v. Commissioner (TC Memo 2013-245) questioned the ability of taking a salary from your ROBS entity. The CPA had asked why you would set up such a convoluted structure and then not be able to take a salary from it? All in all, the CPA felt that they operated in a grey area of the IRS rules. And there were complex regulations associated with them, which if not followed, could trigger expensive penalties. Mary showed Don a few of the ongoing ROBS plan rules the CPA wrote down: