(December 15, 2009)
By William Brighenti
Promoters have been marketing on the Internet the use of 401(k) funds to purchase franchises or startup businesses, which normally require up-front material sums of monies to launch.
The procedure typically involves the creation of a C Corporation by the business owner, then the setup of a retirement plan for its employees, followed by the rollover of the new business owner-employee's 401(k) funds into this new plan, and ultimately the exchange of corporate stock for the funds in the plan.
Hence, the acronym ROBS: roll-overs as business startups. … A recent memo issued by the Internal Revenue Service characterized the rollover for a business startup as a "scheme" in the marketplace to access retirement funds to evade income taxes and the withdrawal penalty of 10 percent on their premature distribution. …
Logo of Internal Revenue Service, USA (Photo credit: Wikipedia)
If your clients are already sold on this procedure and nevertheless wish to pursue it, here are a few recommendations that may help them:
1. Hire an appropriate attorney to prepare the new retirement plan document. Avoid using the M&P (master and prototype) plan provided by the franchise seller. A number of promoters of ROBS transactions are on the IRS's watch list.
2. Have an objective valuation of the stock of the new corporation prepared with supporting detailed analysis. … The lack of a bona fide appraisal would raise a question as to whether the entire exchange is a prohibited transaction.
3. Before purchasing a franchise through promoters charging fees out of the proceeds of the stock purchase, consider whether they can be construed by ERISA or the IRS as "fiduciaries" rendering "investment advice" or administering the plan. If a fiduciary receives a payment from the plan assets, it may constitute a violation of the Tax Code.
4. Enable future employees to acquire employer stock. … In order for the plan to not discriminate in favor of highly compensated employees, an extension of the stock investment option must be afforded to non-highly compensated employees to be hired in the future.
5. Establish the plan as permanent; do not discontinue it within a few years after its adoption.
6. Never pay purely non-business expenses from the plan.
7. Communicate in writing the existence and availability of the plan to all new employees; otherwise, your plan will be in violation of Treasury regulations and may result in its failure.
The consequences of entering into any prohibited transactions and of carelessly setting up a ROBS are staggering penalties of 110 percent or more of the amounts involved in the transactions or the roll over itself. On Nov. 5, 2008, the IRS issued the following warning to all business owners contemplating the implementation of a ROBS arrangement:
Pension (Photo credit: Frederik Seidelin)
“For these reasons, we intend to scrutinize ROBS arrangements. … We believe that ROBS arrangements may endanger the qualified status of otherwise tax-qualified employee plans and may be prohibited transactions, requiring complete undoing of the transaction, and imposition of excise taxes.”
So tread carefully, and your clients should obtain the necessary legal, accounting and other professional advice before adopting a ROBS arrangement. Or perhaps they should even consider other alternatives, such as borrowing from their 401(k) plan.
William Brighenti, CPA, is a Certified Valuation Analyst and Certified QuickBooks ProAdvisor, who operates Accountants CPA Hartford in Hartford, Conn. He writes the blog Accounting and Taxes Simplified.
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