BawldGuy Here: Though this post doesn’t in any way apply to or address real estate investing via IRAs/401Ks, there are many who’ve wondered about using some of their funds to start up a business. I thought this post would serve those readers well. Enjoy the post.
I have done many a blog posts over time that have dealt with the benefits of one self-directing their own retirement accounts (e.g., IRAs, 401Ks) . . . and I still will. However, there comes the occasional time where, while emphasizing the benefits of self-direction, caution needs and must be provided regarding potential pitfalls with how some of these plans are established. This isn’t to scare one into not self-directing, but to educate all of us on some legitimate concerns.
If you are an individual who wants to start up your own business (rather than self-directing your investments with your retirement accounts) with your retirement account funds…you may want to keep reading.
The IRS and ROBS
This recently came to light when the IRS addressed concerns they had with ROBS (Rollovers as Business Start-Ups) plans. The IRS penned an article titled “IRS compliance project scrutinizes potentially abusive ROBS retirement plan arrangements” as part of their Retirement News for Employers (Fall 2010). ROBS are designed to allow individuals to convert their existing retirement accounts into seed money for funding new businesses without first paying taxes on the distributions. Quite simply, the IRS stated “While conceding that ROBS are not considered abusive tax avoidance transactions, IRS has branded such arrangements as “questionable.”
Folks, why is this a BIG statement?
Well, there are companies that are actively promoting these plans. While these companies are ensuring their clients that the plans are established in compliance with IRS regulations (and they very well may be), let’s take a closer look at what and how ROBS works and if you should consider them for your self-directed retirement investments.
The IRS went a step further and explained their concern in writing by stating: “Promoters have been aggressively marketing ROBS arrangements to business owners. A ROBS plan is an arrangement in which business owners use their retirement funds to pay for new business start-up costs. ROBS plans, while not considered abusive tax avoidance transactions, are questionable because they may solely benefit one individual — the individual who rolls over his existing retirement funds to the ROBS plan in a tax-free transaction. The ROBS plan then uses the rollover assets to purchase the stock of the new business.”
In IRS parlance, the transactions related to benefitting only one individual is self-dealing…a concept I have done much blogging about.
A ROBS plan
So, let’s take an example of a typical ROBS plan (as explained by the IRS): “A new business owner first creates a shell C corporation, with created — but not issued — stock. After incorporation, the newly created shell corporation adopts a retirement plan (typically a pre-approved specimen plan), with a provision allowing 100% of the plan assets attributable to rollovers to be invested in employer stock. Next, the business owner either rolls over or executes a direct transfer of the proceeds from an existing tax-deferred account, such as a 401(k) plan account with a former employer, to the newly created ROBS plan. Once the rollover or direct transfer is complete, the business owner directs the shell corporation to issue all of its capital stock, and then transfer the stock to the ROBS plan in exchange for the proceeds held in the rollover account. After the transfer, the shell corporation has adequate capital to pursue business opportunities and the ROBS plan has capital stock in the corporation equal in value to the amount of the funds transferred. And, because all of the shell corporation’s stock has been allocated to the business owner’s ROBS plan account, any future employees or beneficiaries will not be able to invest in employer stock, barring a recapitalization (see Federal Taxes Weekly Alert 11/20/2008).”
Ah, I get what you are now saying — REALLY interesting stuff, John! But, it is important to keep reading if you have or are considering a ROBS plan. The IRS continues by stating in their newsletter:
“Thus, the business owner has used rollover proceeds to indirectly start up or acquire a business while avoiding taxes (income and penalties, if any) on the transaction.”
Now, in establishing these plans, individuals are going to companies who specialize in establishing these them. In many circumstances the individuals will ask for, or be provided, a favorable IRS determination letter to assure the clients that the IRS approves the ROBS arrangement.
However, as the IRS continues in their newsletter:
“Even a favorable determination letter—based on the plan’s terms meeting Code requirements—does not give plan sponsors protection from incorrectly applying the plan’s terms or from operating the plan in a discriminatory manner. When a plan sponsor administers a plan in a way that results in prohibited discrimination or engages in prohibited transactions, it can result in plan disqualification and adverse tax consequences to the plan’s sponsor and its participants.”
The IRS continues by addressing how some of the promoters of these plans may have not provided the best information to their clients by stating:
“Many ROBS sponsors do not understand that a qualified plan is a separate entity with its own set of requirements. Some promoters incorrectly advised sponsors that they don’t have to file an annual return because of an exception in the Form 5500-EZ instructions. IRS notes that the exception applies where plan assets are less than a specified dollar amount and the plan covers only an individual, or an individual and his spouse, who wholly own a trade or business, whether incorporated or unincorporated. However, in a ROBS arrangement the plan, through its company stock investments, rather than the individual, owns the trade or business. Accordingly, this filing exception doesn’t apply to a ROBS plan and the annual Form 5500 or 5500-EZ (5500-SF for filing electronically) is still required.”
This is a BIG point as, if nothing else, does an individual really want to specifically ASK the IRS to come calling on their door by not filing the 5500-EZ?!
The IRS then proceeds to address more specific problems that may arise with ROBS arrangements:
1) Amending the Plan — The IRS notes that after the ROBS plan sponsor purchases the new company’s employer stock with the rollover funds, the plan sponsor amends the plan to prevent other participants from purchasing stock.
IRS’s Position – “ROBS plans are designed to benefit only the person involved in setting up the business, and so may violate the “current availability” or “effective availability” requirements of Reg. 1.401(a)(4)-4(b) and Reg. 1.401(a)(4)-4(c).
2) Exclusion — The IRS states that, “If the sponsor amends the plan to prevent other employees from participating after the determination letter is issued, this may violate the Code qualification requirements. These types of amendments tend to result in problems with coverage, discrimination and potentially result in violations of benefits, rights and features requirements.
3) Promoter Fees –- The IRS believes that where fees have been paid to a promoter of such ROBS plans with transferred assets, a prohibited transaction may arise.
4) Valuation of assets -– The IRS takes the position that, “Setting the value of the corporation’s stock at the value of the transferred plan assets may be a prohibited transaction, especially where the stock value was set without an adequately supported appraisal of the stock’s value.”
Finally, the IRS addresses the failure to issue a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., when the assets are rolled over into the ROBS plan (and this is big for individuals who have or are considering a ROBS plan:
The IRS noted: “Last year, IRS’s Employee Plans initiated a ROBS project to: (1) define traits of compliant versus noncompliant ROBS plans; (2) identify ROBS plans that are noncompliant and take action to correct them; and (3) use results to design compliance strategies focusing on identified issues and trends. The IRS initially focused on companies that sponsored a plan and received a determination letter but didn’t file a Form 5500, Annual Return/Report of Employee Benefit Plan, or Form 5500-EZ, Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan, and/or Form 1120, U.S. Corporation Income Tax Return.”
So, what did the IRS find in their review of these plans? Well, the IRS made the following conclusions:
The IRS noted that the “preliminary results from the ROBS Project indicate that most, though not all, ROBS businesses either failed or were on the road to failure with high rates of bankruptcy (business and personal), liens (business and personal), and corporate dissolutions by individual Secretaries of State. Some of the individuals who started ROBS plans lost not only the retirement assets they accumulated over many years, but also their dream of owning a business.”
YIKES!! The IRS continued by stating that:
“Practitioners should counsel clients that ROBS plans pose tax hazards and warn them of the grave risk that retirement funds may be completely lost if the business venture funded through the ROBS plan fails.”
Now, this post is not, in any way, to say that ROBS plans are illegal or do not potentially follow IRS regulations. However, as what can be seen here, the majority of these plans (in the opinion of the IRS) have not been established correctly and have potential, serious flaws in both design and execution. But, this post is simply educating people on the concept of ROBS plans as only a few companies/individuals will establish these plans. As the ‘ole saying goes, “buyer beware.”
Now, saying that, this won’t affect many of you, especially, those individuals who are self-employed with no employees (other than a spouse). Further, it will not affect most of you on this valued educational site (go Jeff Brown) who are certainly interested in investing in non-traditional assets such as real estate. BUT, the reason I wanted to visit this point of interest is that these types of plans have been heavily marketed and may have disastrous impacts on individuals who employ this method.
For more detailed information related to ROBS, feel free to visit:
Retirement News for Employers, Fall 2010 “Rollovers as Business Start-Ups Compliance Project” is on the IRS website at http://www.irs.gov/pub/irs-tege/rne_fall10.pdf.