If you want to start a business that requires a lot of capital, like a restaurant or buying a franchise, you’ll need to qualify for a small business startup loan, find an investor, or come up with cash to invest.
What if you have savings but they’re tied up in retirement savings?
For aspiring entrepreneurs, it’s a realistic possibility: According to the Empower Personal Dashboard, more than 885,000 401(k) plans have at least $1 million committed to their employer-sponsored plans (such as 401k or 403b plans) and their personally managed IRA savings and investment accounts.TM Data current as of March 2024.
Even if you don’t have a million-dollar retirement savings account, you may still want to use your retirement accounts to fund your business.
One way to do this is through a Rollover Business Startups (ROBS) account. Here we explain how it works and how to decide if it’s right for you.
Pro Tip: This information is for educational purposes only. Always consult with legal and tax professionals for advice.
What is ROBS 401k (Rollover at Start-Up)?
Rollover-as-Business-Startup (ROBS) offers a way to use retirement savings to start a business without cashing out your IRA, 401(k) or 403(b) savings.
Typically, if you want to use your retirement savings in a 401(k) plan, you’ll need to do one of the following:
- When you withdraw funds from the account, you may incur taxes and, depending on your age, early withdrawal penalties.
- You take out a loan from your 401(k) or 403(b) account and pay it back monthly over five years. (Many plans require you to pay the loan back immediately if you separate from your employer.)
ROBS plans can avoid these concerns. Typically, they work like this:
step 1Form a C Corporation. A business owner forms a new C corporation, a type of business structure that can issue stock.
Step 2Establish a Retirement Plan: Next, establish a new retirement plan with the company, such as a 401(k), profit sharing, or defined benefit plan.
Step 3Retirement rollover: An employer rolls over existing retirement benefits from an existing retirement account, such as a 401(k) or IRA, from a previous employer into a new retirement plan.
Step 4Invest in company stock: Retirement plans use the rolled-over funds to purchase stock in new companies.
Step 5Use of capital. A company uses the capital it receives from selling stock to pay for the start-up costs of a new business.
That might sound a bit complicated, and it can be. Setting up these accounts isn’t cheap, and you have to be very careful to avoid running afoul of the IRS. One wrong move could cost you money, including unexpected income taxes and penalties.
Benefits of using ROBS to raise business capital
The main benefits of using a ROBS account are:
- There are no loan eligibility requirements, such as a good credit score or business revenue.
- Avoid taxes when you withdraw funds from your retirement accounts to start a business.
- There’s no need to borrow or make payments from your retirement accounts.
Disadvantages and risks of using ROBS to raise business funds
The disadvantages of ROBS funding are:
- Can be costly to set up and manage.
- There are ongoing steps that need to be taken to stay in compliance with the plan.
- The IRS has issued warnings about these schemes, and compliance is crucial to avoid an IRS audit that could result in taxes and penalties.
When the IRS studied these plans in its Employee Plan (EP) ROBS project, it found that many businesses funded through ROBS ultimately went bankrupt and lost their retirement savings. It also found high rates of bankruptcies, foreclosures, and business dissolutions.
How to know if a ROBS plan is right for your business
First, it’s important to be realistic about retirement savings. Most Americans don’t have enough retirement savings. What happens if your business fails? Not only will you lose the money you need for retirement, but you’ll probably end up paying thousands of dollars in fees.
Second, you need to be realistic about the chances of your new business succeeding. ROBS loans are most commonly and successfully used by individuals with substantial retirement savings who are investing in franchises and relatively low-risk businesses.
Third, it’s important to work with a trusted ROBS provider to set up your plan — vet providers carefully and consider getting a second opinion from your own advisor.
Rollover Alternatives for Small Business Financing
While raising capital can be more difficult for startups, there are some options that prospective business owners can consider.
SBA Loans
The U.S. Small Business Administration oversees the SBA loan program. There are several types of SBA loans, including 7(a) loans, SBA microloans, and 504 loans. These loans are made by SBA-approved lenders and guaranteed by the SBA. Some lenders make SBA startup loans, but you usually need good credit to qualify.
Online Loans
A variety of lenders offer small business loans, including business lines of credit, term loans (loans for a fixed amount, usually repaid within a set period of time), and business cash advances, which are usually based on business revenue. Typically, you must have business revenue to qualify.
business credit card
Most business credit cards offer a line of credit with funds readily available. Even better, they’re often available to startups, as long as the owner has good personal credit and qualifying income from all sources. Plus, most small business credit cards can help you establish a business credit score if you make payments on time.
Crowdfunding
One advantage of crowdfunding is that you don’t have to start a business to raise funds. A good idea combined with good marketing can make a business fundable. The main types of crowdfunding for small businesses are reward-based crowdfunding, investment-based crowdfunding, and loan-based crowdfunding.
How to Configure ROBS
Many small business owners will need to hire someone to set up these plans. Choose your partner carefully. Research the company’s experience setting up and managing ROBS plans. Make sure you get ongoing support to keep your plan compliant.
It’s also a good idea to get a second opinion from an attorney or accounting professional.
How to avoid the ROBS 401K nightmare
There are many actions that can get you in trouble with the IRS. In 2008, the IRS issued a memorandum outlining some of the issues it identified, which still apply today.
It warns of two main issues.
- “Because ROBS transactions generally benefit only the principals involved in establishing the business and do not allow rank-and-file employees to acquire stock in their employer, we believe that some of these plans, on a case-by-case basis, violate the anti-discrimination provisions of the Code and Rules.
- In all ROBS arrangements, aspiring entrepreneurs create capital stock with the intent of exchanging it for tax-deferred accumulated assets. The value of the stock is set as the value of the available assets. Appraisals may be created to substantiate this value, but supporting analytics are often lacking. We believe this could create prohibited transactions depending on the true enterprise value.”
Elsewhere in the memorandum, the IRS points out common “disqualifying operational deficiencies.”
“We have investigated several of these plans… and found significant and unqualified operational deficiencies in most of them. For example, in some plans, employees were not informed of the existence of the plans, did not participate in the plans, and did not receive contributions or allocable employer shares.
“Furthermore, it was found that scheme assets were either not valued or were valued at an insufficient valuation.
“Some plans have not filed required annual reports, and in some situations we have found that the entities created by ROBS exchanges have not continued to exist or have used the resulting assets to make purchases for personal, non-business purposes.”
How do we avoid these problems?
As mentioned above, it’s important to work with a reputable company to ensure your plan is set up properly.
It’s also important to understand what these plans do and don’t do. For example:
Your company must be a C corporation and must maintain that status.
This type of plan cannot be used to fund a passive business, such as certain types of real estate investments, nor can you be a passive employee in that business.
A ROBS plan is not meant to be used as a personal piggy bank: You must avoid using funds for personal purposes and cannot overcompensate yourself for working for the company.
They offer eligible employees the opportunity to participate in their retirement plan and are required to pay fair market value for their company stock.
Annual reporting is required.
Nabis’s verdict
ROBS is a viable financing option for new business ventures, but it requires careful planning and compliance with IRS regulations.
Before selecting a ROBS agreement, you should consult with a qualified tax advisor or attorney to fully understand its implications and ensure you comply with all legal requirements.
Also, consider other financing options to determine if you can fund your business without using your severance pay.
Doing your due diligence can help protect your retirement savings and position your business for success.
This article was originally written on June 21, 2024.
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