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IRS Guidance Provides Warning on Funding Business Startups with Retirement Accounts

    Client Alerts
  • November 21, 2008


The IRS recently released guidance on what it refers to as Rollovers as Business Startups or “ROBS,” which have been designed (often by promoters) for individuals to use retirement funds to purchase a business (such as a franchise) or provide business capital to a new corporation.  Based on the IRS guidance, such arrangements will at the very least be closely scrutinized by the IRS.  In many cases, these arrangements may fail to comply with tax laws, with potentially severe tax ramifications.

ROBS typically involve an individual who wants to start up a new business.  The individual sets up a new corporation and has the corporation establish a new employee retirement plan.  The individual rolls over his or her retirement plan assets (either from another plan or from an IRA) into the new plan, and then invests the rollover account in all of the stock in the new corporation.  The plan then owns the stock, for the individual’s benefit, and the business receives the cash it needs.  On its face, the transaction appears to comply with the tax rules and avoid a taxable distribution of retirement plan assets to the individual.  However, the IRS guidance warns that there are many ways for the IRS to find that such arrangements violate the law, such as:

1. Discrimination in “benefits, rights and features”:  Certain features within retirement plans, including the right to invest in particular investments such as employer stock in a ROBS situation, must be available to all plan participants in a non-discriminatory manner.  Often in a ROBS arrangement, the plan covers both highly compensated employees (“HCEs”) and non-highly compensated employees (“NHCEs”), but does not allow NHCEs to invest in the stock.  This structure could result in a violation of nondiscrimination rules and plan disqualification.

2. Prohibited Transactions -- Improper Valuation of Stock:  A plan’s acquisition of the stock of the sponsoring employer is generally a prohibited transaction under the tax rules.  Such an acquisition might qualify for an exemption, but one requirement is that the acquisition be for “adequate consideration.”  In a ROBS arrangement, the inherent value of the entity acquired by the plan may very well be less than the amount of the rollover proceeds invested, resulting in a prohibited transaction.  Prohibited transactions need to be corrected (usually by undoing the transaction) and will generally result in excise tax consequences.

3. Lack of Plan Permanency:  All qualified retirement plans are generally required to be permanent, although there is a “business necessity” exception.  The IRS may scrutinize plans discontinued within a few years after adoption.  Unless a plan with a ROBS arrangement has some form of recurring contributions, the IRS could question the plan’s permanency and, thus, its qualified status.

4. Plan Not Communicated to Employees or Inactivity in 401(k):  The IRS noted that it has found plans with a ROBS arrangement frequently are not communicated to employees, particularly those hired after the business was up and running, and that otherwise eligible employees did not enter the plan as required under the plan terms.  Often such plans will provide a 401(k) deferral feature and eligible employees either were not given information on the ability to defer or were otherwise not permitted to make deferrals.  These violations of the tax rules can result in plan disqualification.

As the IRS notes, ROBS arrangements can also raise ERISA Title I prohibited transaction issues, which are under the jurisdiction of the U.S. Department of Labor.  Based on the IRS guidance, these “Too Good to Be True” arrangements may very well be just that and are best avoided.