Say you have a client who is tired of working 9 to 5, five days a week, and comes to you with a plan to open the café they've always dreamed of running. However, instead of financing the new venture with a small business loan, they want to use their 401(k) plan.
Most advisors will instinctively pump the brakes as soon as they hear clients mention cashing in a qualified retirement account to capitalize a new business, but a rollovers-as-business-startups (ROBS) transaction allows a prospective business owner to use his or her retirement savings without incurring a tax penalty.
It should come as no surprise that there are caveats to these types of transactions.
First is that while they aren't expressly prohibited, the IRS doesn't exactly look on them favorably.
The Employee Plans Compliance Unit of the IRS studied ROBS in 2010 and found that while they are "not considered an abusive tax avoidance transaction," they were "questionable in that they may serve solely to benefit one individual."
Second, obviously, is that if the business fails in its first two years, as a third of new businesses do, the client is facing an uncertain future with a significant dent in his or her retirement savings.
David Nilssen, co-founder and CEO of Guidant Financial, which facilitates ROBS transactions, acknowledges that the strategy sounds inordinately risky. "A lot of people when they first hear about ROBS, they'll say, 'You let people do what with their retirement plan?'" he told Investment Advisor. Individuals and their advisors have to decide if a ROBS is appropriate, he said, "but that doesn't eliminate the risk" of starting a business.
How ROBS Work
"What we do is dependent on specific exemptions in both tax and ERISA law that were put in place to effectively encourage investments in small business; similar laws to what you'll see with regards to ESOPs, with similar intentions," Nilssen said.
The first step is to establish the new business as a C corporation with a retirement plan. Nilssen said that's usually a 401(k) plan. Funds from the original retirement plan are then rolled into the new C corp's plan, which invests in stock in the new company, Nilssen said. The "401(k) sends money to the corporation and in exchange becomes a shareholder."
Any employees at the new corporation must also be allowed to purchase company stock if they wish. Among the ROBS concerns the IRS identified in 2010 is that some plan sponsors might amend the plan to prevent other participants from purchasing stock. Sponsors that do so could violate qualification requirements for the plan.
Other concerns the IRS listed included sponsors' failure to file Forms 5500, 1120 or 1099-R. Plans with one participant (which may include a participant and a spouse) that have less than $250,000 are exempt from filing Form 5500. ROBS plan sponsors still have to file a Form 5500 because even if the new plan only covers the business owner, "the plan, through its company stock investments, rather than the individual, owns the trade or business," according to the IRS.
Nilssen recommended advisors who assist clients on ROBS transactions work with an experienced tax professional. "By default, most professionals will steer their clients to an S corp or an LLC. It is a different taxable animal," he said.
The investment itself is tax deferred, Nilssen said, although "there could be taxes on the sale of that investment, trying to get money back in the 401(k) plan, but there are strategies to minimize that."
Once the new plan is in place, the client will have an active 401(k) plan with the ongoing costs and administrative responsibilities associated with that, Nilssen pointed out. "They do have to make sure that the plan stays open, and that they're continuing to provide that as an employee benefit to the future staff."
Another thing to keep in mind: When they have no other shareholders, small business owners can generally pay themselves whatever they want. That's not the case in a ROBS plan, as there are two shareholders: "the individual and the individual's retirement plan," Nilssen said. "The individual has to do what is in the exclusive benefit of their retirement plan. They are the fiduciary on that plan."
Who Should Use ROBS
While there are clear risks associated with ROBS, Nilssen said they can be beneficial to clients and advisors, too.
For one, they give investors more freedom to do something they love without incurring a lot of debt. "Some of the most common things we hear [from customers] are, 'I wanted to invest in something that I had direct control over,'" he said.
If they choose to use a traditional loan to finance their new venture, "in that case, I'm going to put a 25% down payment down to satisfy the bank's need for liquidity and that's money I've already paid taxes on," Nilssen said. "I'm going to have to collateralize my home and other assets to utilize credit to get that loan, and at the end of that, I still have debt that I have to service on a monthly basis."
With a ROBS transaction, "there's no underwriting procedure, and the transaction can happen in as little as 21 days." Because they're using cash instead of debt, "they don't have the corresponding overhead that a traditional business would take on," which Nilssen said leads to "higher success rates among our customers."
Nilssen said about 80% of his customers are still in business five years after starting their own company. Using data from the Bureau of Labor Statistics, the Small Business Administration found that between 1995 and 2010, two-thirds of businesses with employees survive at least two years, and about half last five years. A Dun & Bradstreet report found 39% of small businesses last five years, Nilssen said.
Three-quarters of Guidant customers are in their 40s and 50s, he said. "If someone expects that they're only going to work for the next five years, this may not make a lot of sense." He added that over half of his customers are using other sources of financing to start their new business in addition to the ROBS transaction.
Franchising is a popular choice for boomers who want to start their own business, he said. Over a third of Guidant customers are using their retirement savings on a franchise. "There's a huge draw to franchising by baby boomers because not only do they want to invest in a business, but they want to invest in a business where they're not by themselves. Having a franchise system that's already predefined plays into their strength as a business manager who's now starting a business," Nilssen said.
