Investors Tap Into 401(k) Money Tax-Free for Business Startups

BusinessWeek

May 27, 2010, 6:28 AM EDT

By Amy Feldman

May 27 (Bloomberg) -- Hal Mottet, a Lake Oswego, Oregon, businessman bought a family-owned packaging company for $3.5 million in late 2007, and he and a partner financed 40 percent of the sales price with their retirement money.

Mottet and his partner used a loophole in U.S. tax law to roll over $1.4 million from their existing 401(k) retirement plans to finance the purchase of Carson, California-based Empire Container Corp. The strategy saved them taxes and penalties they would have faced for cashing out the plans.

“If we hadn’t done it this way, we would have had at least $1 million more debt, and we wouldn’t have made it through the recession,” said Mottet, 51, who’s now chief executive of the firm. “It’s been a fantastic investment.”

Transactions like Mottet’s let entrepreneurs access their retirement funds without tax consequences. Withdrawals from 401(k)s are generally subject to income taxes on the proceeds, and cashouts done before age 59 1/2 incur a 10 percent penalty, according to the Internal Revenue Service.

Here’s how it typically works: An investor sets up a corporation, establishes a new 401(k) plan there, rolls over his or her existing 401(k) or Individual Retirement Account, and then uses part or all of the plan’s assets to buy shares of the new company. This funds the new business, while keeping the tax- advantages of the retirement plan.

The transactions have drawn the scrutiny of the IRS, which dubbed them ROBS, for Rollovers as Business Startups, and said in an October 2008 memo that some may run afoul of the law. The IRS is coordinating efforts with the Department of Labor because these rollovers may also raise issues under the rules that govern retirement plans, according to the memo.

Not ‘Home Free’

“Like many other recently marketed tax savings strategies that appear to have been designed to take advantage of the law, ROBS arrangements, designed to fit within existing law and guidance, do not present a ‘home free’ result,” the IRS said in a November 2008 newsletter. “In fact, they may violate the law.”

Among the issues the IRS found were prohibited transactions, questionable valuations of the company stock, and a failure for the rollover retirement plans to be available to employees other than the principal owner. …

Monika Templeman, acting director of employee plans for the IRS, said the agency would be reviewing these rollover transactions, and auditing them on a case-by-case basis over the next few years.

“It can be done just right, but we’re seeing problems,” Templeman said. “It’s open to abuse because of the structure, and the promoters are taking advantage of that.”

‘Saber Rattling’

In cracking down on tax shelters, the IRS generally goes after the promoters of a shelter, she said. She declined to say if the IRS was targeting any rollover promoter.

Stephen Dobrow, president of Primark Benefits, a Burlingame, California-based benefits consulting firm, called the IRS memo “saber rattling,” and said he expected increased IRS auditing of the transactions….

The rollovers are a relatively inexpensive way to finance a new business, said Jeremy Ames, chief executive of Bellevue, Washington-based Guidant Financial Group, which advised Mottet on the process. …

Cashing Out

…Joanna and Frederick Neubert, of Cleveland, South Carolina, used a 401(k) rollover to buy a residential cleaning franchise in 2004, after both were laid off from corporate jobs. The Neuberts used the entire $118,000 proceeds from their 401(k) plans, Joanna Neubert said. Last December they closed the business.

Risking Future

The result for the Neubert’s retirement savings: The business was valued at zero, and their 401(k) savings are gone, according to Joanna Neubert.

Of the rollovers that the IRS has reviewed, many of their sponsors had gone bankrupt, Templeman said.

“Our thinking tends to be that if you can’t raise enough money with friends and family and people who find your business compelling, it may not be a business that should be started,” said Dan Rosen, a principal in the Lexington, Massachusetts, office of venture capital firm Highland Capital Partners.

“There are a lot of ways to get a business funded without risking your future,” he said.

Investors using this strategy also may face risk of an audit. If a rollover transaction is deemed to be a tax shelter, its plan sponsor or manager may be subject to excise taxes, in addition to regular taxes and penalties, according to IRS regulations. …--Editors: Rick Levinson, Rob Urban.

To contact the reporter on this story: Amy Feldman in New York at afeldman16@bloomberg.net.

To contact the editor responsible for this story: Rick Levinson at rlevinson2@bloomberg.net.