Pros and Cons of Cashing Out Your 401(k) to Start a Business

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September 09, 2010 11:36 am by paulag01 in Money
The combination of a bad lending environment, the economy, and the uptick in people starting businesses have made tapping retirement funds a very tempting business financing option.  Is it right for you?
If you listen to any of the financial experts, the message "never touch your 401(k)" gets repeated over and over.  …  Yet it is happening more frequently than you think, it is legal (if certain tax code provisions are followed), and it doesn't have to be the all-or-nothing doomsday scenario.
A recent article in Inc. Magazine details "How to Finance a Business with your 401(k)".  Here's how it works.  Essentially you establish a C corporation for your new business that has been created but has not issued stock.  The new corporation adopts a retirement plan.  You roll over your 401(k) to the new corporation's plan. The new corporation issues all of its stock and transfers it to the new profit-sharing plan in exchange for the cash.  Voila, instant cash flow.
The process of using a rollover as business start-up is often referred to as "ROBS." You can read more about this in Tapping Retirement Money for Your Business? Be Careful.  It is particularly appealing for franchise opportunities:

But an article published in Franchise Times cited compelling figures from franchise-data firm FranData that showed more than 4,000 businesses started using ROBS funding last year. More than 60 percent of those businesses were franchises.

Back in 2008, the IRS did express its displeasure about the ROBS plans in a retirement-plan newsletter, so Uncle Sam may not be as enthusiastic about this approach as some entrepreneurs.
So is it right for you or not?
The Franchise King had this to say about using your 401(k) to fund your franchise business.  Bottom line?  Get educated, make an educated decision ... for you.
Here are some pros and cons to consider:

Pros

• Relatively quick and easy access to potentially large sums of cash without having to qualify for a loan.
• You leverage your own cash to build something of value, essentially becoming your own venture capitalist (needless to say, this is only a positive if the business thrives).
• Up to 100 percent of your retirement funds can be used, but you can diversify and use only a portion to fund your business venture leaving the rest of your retirement assets intact.

Cons

• You put your future retirement and financial security at risk should the business fail.
• Must hire a tax attorney or CPA to handle the formation of the corporation and retirement plan.
• These provisions may be under scrutiny (or that is the picture some paint) by the IRS.

Paula Gregorowicz, owner of The Paula G. Company, offers life and career coaching for women to help you figure out what you want to do with your life and career and cultivate the confidence to be the person you most want to be so you succeed on your own terms. Learn more about The Life Alchemy Success Formula™ and Get the free eCourse "5 Steps to Move from Fear to Freedom & Experience Greater Confidence" at her website.

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Tapping 401(k) Funds Can Open your Business to Tax Problems

Small Business Trends
August 3, 2010
By Rieva Lesonsky

Did you use 401(k) funds to start your business, or are you tapping into your retirement to get you business through the current credit crisis? BusinessWeek recently drew attention to a possible trap:  The IRS is starting to pay more attention to entrepreneurs who finance their businesses using money from their 401(k) funds.

Here’s how such moves typically work: A business owner creates a new corporation, sets up a 401(k) plan for it and moves his or her 401(k) monies into the new plan. The money is used to buy shares in the business, giving it an infusion of capital but still retaining the tax advantages of the 401(k).

Monika Templeman, acting director of employee plans at the IRS, told BusinessWeek that the process “is open to abuse.” If the entrepreneur’s 401(k) funds weren’t rolled over in this fashion, but just withdrawn, the business owner would be subject to income taxes, as well as penalties of 10 percent of early withdrawal if he or she is under age 59 ½.

Templeman says the IRS has seen money used to buy stock whose valuation was questionable or even to buy personal assets such as cars.

The rollover strategy has grown in popularity during the credit crisis; BusinessWeek says some 4,000 people are expected to use the tactic this year. Typically, the transaction involves $100,000 to $200,000 in retirement funds. Financial advisers charge clients an average of $5,000 for the paperwork, plus annual fees of about $1,000 to manage the new 401(k). One financial advisor cited compares the fees favorably to the 15 or 20 percent interest rates banks charge on business loans — that is, if you can get a loan.

With the IRS planning increased scrutiny of such plans, it may be a good idea to review your plan with your advisor and your accountant to make sure it’s not raising any red flags. If you do use 401(k) funds to finance your business, make sure the money is put to good use and don’t use it for any expense for which you can’t make a clear business case.

The IRS website has lots of resources that can help your accountant and advisor clarify the issues. A closer look at the issues with these plans can be found in “Guidelines Regarding Rollovers as Business Startups (ROBS).” This publication is for IRS agents, so it’s pretty dense, but will give you some insights into the issues with the rollover concept.

About the Author

Rieva Lesonsky is President and Founder of GrowBiz Media, a content and consulting company that helps entrepreneurs start and grow their businesses. A nationally known speaker and authority on entrepreneurship, Rieva has been covering America 's entrepreneurs for nearly 30 years. She blogs at SmallBizDaily.

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.

Look Before Rolling Over a Business Startup

WebCPA.com

(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.



Logo of Internal Revenue Service, USA (Photo credit: Wikipedia)

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. …

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.



Pension (Photo credit: Frederik Seidelin)

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:
“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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