Finding the cash to start-up a business can often times be the greatest challenge for new business owners.
Most new business owners don’t realize that there are special programs that allow you to use your balance in your 401(k) account or IRA to fund your start-up business without having to pay income taxes or early withdrawal penalties on the distributions.
These are called ROBS plans. Rollovers for business start-ups. The strategy involves setting up a new entity, establishing a new 401(k) plan for the company, processing rollovers into your new 401(k) plan, and then your 401(k) plan buys shares of stock in your new company as an investment.
This can be a great funding strategy but you have to know the rules and the compliance surrounding this funding strategy.
One of the most challenging aspects of starting a new business is finding the capital that is needed to support your expenses as you begin to build up a revenue stream since it’s not always easy to ask friends and family for money to invest in a startup business.
Luckily, for new entrepreneurs, there are some little-known ways on how you can use retirement accounts as a funding source for your new business.
However, before you cash out your 401(k) account to start a business, you have to fully understand the pros and cons of each option.
ROBS stands for “Rollover for Business Startups”. ROBS is a special program that allows you to use the balance in your 401(k) or IRA account to fund your new business while avoiding having to pay taxes and the 10% early withdrawal penalty for business owners under age 59.5.
Unlike a 401(k) loan that has limits, loan payments, and interest, ROBS plans allow you to use your full retirement account balance without having to enter into a repayment plan.
Why do business owners use ROBS plans?
The benefits are fairly obvious.
First off, by using your own retirement assets to fund your new business, you don’t have to ask friends and family for money.
Secondly, if you were to embark on the traditional lending route from a bank for your start-up, most would require you to pledge personal assets, such as your house, as collateral for the loan.
Doing this puts an added pressure on the new entrepreneur because if the business fails you not only lose the business, but potentially your house as well.
By using the ROBS plan, you are only risking your own assets, you have quick and easy access to those funds, and if the business fails, worst case scenario, you just have to work longer than you expected.
Is this too good to be true?
When I explain this funding strategy to new business owners, the question I usually get is, “Why haven’t I heard of these plans before?”, and here are a few reasons why.
To begin, you are using retirement plan dollars and accessing the tax benefits, and in doing so there are a lot of complex rules surrounding these types of plans.
It’s not uncommon for accountants, third-party administrators, and financial advisors to not know what a ROBS plan is, let alone understand the compliance rules surrounding these plans; thus, it’s rarely presented as a viable option.
Of course there are the pros and cons of this funding mechanism.
How do ROBS plans work?
The concept is fairly simple, your retirement account essentially buys shares of stock in your new business which provides the business with the cash needed to grow. You do not have to be a publicly traded company for your retirement account to buy shares, however, you are required to establish your new company as a C-Corp in order for this plan to work.
This process entails incorporating your new business, as well as establishing a new 401(k) plan within that business, that contains the special ROBS features. Then, you can transfer assets from your various retirement accounts into the new 401(k) plan allowing the 401(k) plan to then buy shares in your new company. While this sounds easy, I cannot stress enough that you must work with a firm that fully understands these types of plans and the funding strategy. These plans are perfectly legal, but there are a lot of rules to follow. Since this funding strategy allows you to access retirement account dollars without having to pay tax to the IRS, the IRS will sometimes audit these plans hoping that you did not fully understand or comply with the rules surrounding the establishment and operations of these ROBS plans.
The steps to set up a ROBS plan
Here are the steps for setting up the plan:
1) Establish your new business as a C-Corp.
2) Establish a new 401(k) plan for your new business
3) Process direct rollovers from your 401(k) accounts and IRA accounts into your new 401(k) plan
4) Use the balance in your 401(k) account to purchase shares of the corporation
5) Now you have cash in your business checking account to pay expenses
You must be a C-Corp
The only type of corporate structure that works for a ROBS plan is a C-Corp because only a C-Corp can sell shares of the business to a retirement account legally. That means that LLCs, sole proprietorships, partnerships or even S-Corps will not work for this funding option.
Establishing the new 401(k) plan
ROBS plans have all the same features and benefits of a traditional 401(k) plan, profit-sharing plan, or defined benefit plan, except they also have special features that allow the plan to invest plan assets in the privately held C-Corp.
You need to work with a firm that knows these plans well because not all custodians will allow you to hold shares of a privately held corporation in a qualified retirement account. For many investment firms and custodians, this is considered either a “private placement” or an “alternative investment”. There is typically a special approval process that you must go through with the custodian before they allow your 401(k) account to purchase the shares of stock in your new company. Be ready, there are a lot of mainstream 401(k) providers that will not only not know what a ROBS plan is, but they often times limit the plan investment options to mutual funds; to avoid this, make sure you are aligning yourself with the right provider.
Transferring funds from your retirement accounts to your new 401(k) plan
Your new investment provider should assist you with coordinating the rollovers into your 401(k) account to avoid paying taxes and penalties. Also, if you have 401(K) Roth or after-tax money in your retirement accounts, special preparations need to be made prior to the rollover occurring for those sources.
Purchasing stock in the business
It’s not as easy as simply transferring money into the business checking account since you have to go through the process of issuing shares to the 401(k) account. In most cases, the percentage of ownership attributed to the 401(k) plan is based upon your total funding picture to start up the company. If your retirement accounts are the sole resource to fund the business, then technically your 401(k) plan owns 100% of the company. It’s not uncommon for new business owners to use multiple funding sources including personal savings, funding from friends and family, or a home-equity loan. In these instances, a ROBS plan is still allowed but the plan will own less than 100% of the business.
I don’t want to get too deep in the weeds with this point, but it’s usually advisable not to issue 100% of the shares of the business to your 401(k) plan. This could limit your ability to raise additional capital down the road because you don’t have any additional shares to issue to new investors or to share equity with a new partner.
Using the capital to grow your business
Once the share purchase is complete, the cash will be transferred from your retirement account into the business checking account allowing use those funds to start growing the business.
There is a very important rule when it comes to what you can use these funds for within the new business. First and foremost, you cannot use these funds to pay yourself compensation as the business owner. This is probably the biggest ‘no-no’ associated with these types of plans. The IRS does not want you circumnavigating income taxes and penalties just to pay yourself under a ROBS plan. In order to pay yourself as the business owner, you have to be able to generate revenue from the business. The assets from the stock purchase can be used to pay all of your expenses but before you’re able to take any money out of the business to pay yourself compensation you have to be showing revenue.
Once new business owners hear this, it’s often disheartening. It’s great that they have access to capital to build their business, but how do they pay their bills while they’re building up the revenue stream? Luckily, I have good news on this front. We have additional strategies that we can implement using your retirement accounts outside of the ROBS plan that will allow you to pay yourself compensation as the owner and it can work out better tax wise than paying yourself as a W2 income through the C-corp.
Requirements for ROBS plans
There are a few requirements you have to meet for this funding strategy to work.
1) The funds have to be held in a pre-tax retirement account. This means that money in Roth IRA’s and Roth 401(k)’s are not eligible for this funding strategy.
2) You typically need at least $50,000 in your new 401(k) account for the ROBS plan to make sense since there are special costs associated with establishing and maintaining a ROBS 401(k) plan. If your balance is less than $50,000, the cost to establish and maintain the plan begins to outweigh the benefit of executing this funding strategy.
3) If you’re rolling over a 401(k) plan to fund your ROBS 401(k) plan, it cannot be from a current employer. In other words, if you are still working for a company and you’re running this new business on the side, you are not able to rollover your 401(k) balance into your newly established 401(k) plan and implement this ROBS strategy. The 401(k) account must be coming from a former employer that you no longer work for.
4) You have to be an active employee in the business
There are special IRS rules that define if an employee is actively or materially participating in a business. Since ROBS plans do not work for passive business owners, it is difficult to use these plans for real estate investments unless you can prove that you are an active employee of that real estate corporation. If your new business is your only employer, you work over 1000 hours per year, and it’s your primary source of revenue, then you should not have a problem qualifying as an active employee. If you have multiple businesses however, you really need to consult your accountant and ROBS provider to make sure you satisfy the IRS definition of materially participating.
A ROBS plan can be used for more than just start-ups
While we have talked a lot about using ROBS plans to start up a business, they can also be used for other purposes. These plans can be a funding source to:
1) Buy an existing business
2) Recapitalize a business
3) Build a franchise
These plans can offer fast access to large amounts of capital without having to go through the traditional lending channels.
Cost of setting up and maintaining a ROBS plan
It typically costs $4,000 – $5,000 to set up a ROBS plan and you cannot use the balance in your retirement account to pay this fee. It must be paid with outside funds.
As for ongoing fees, you will have the regular administrative, recordkeeping, and investment advisory fees associated with sponsoring a 401(k) plan which vary from provider to provider. You may also have additional fees charged each year by the custodian for holding the privately held C-Corp shares in your retirement account. Make sure you clearly understand what the custodian will require from you each year to value those shares. If you wind up with a custodian that requires audited financial statements, this could easily run you an additional $8,000+ per year to obtain those audited financial statements from an accounting firm. If you are sponsoring one of these plans, you probably want to try to avoid this large additional cost.
Complications if you have employees
For start-up companies or established companies that have employees that would otherwise be eligible for the 401(k) plan, there are special issues that need to be addressed. The rules within the 401(k) world state that all investment options available within the plan must be made available to all eligible employees. That means if the business owner is able to purchase shares of the company within the retirement plan, the other eligible employees must also be given the same investment opportunity. You can see immediately where this would pose a challenge to the ROBS plan if you have eligible employees.
However, investment options can be changed which is why ROBS plans are the most common in start-ups where there are no employees yet, allowing the 401(k) plan to setup the only eligible plan participant, the business owner, allowing them to buy shares of the company. Once the share purchases are complete, the business owner can then remove those shares as an investment option in the plan going forward.
The Cons of a ROBS plan
Up until now we have presented the advantages of the ROBS plan but there are some disadvantages.
1) The first one is pretty obvious. You are risking your retirement account dollars in a start-up business. If the business fails, not only will you be looking for a new job, but you’ve depleted your retirement assets.
2) You are required to sponsor a C-Corp which may not be the most advantageous corporate structure.
3) You are required to sponsor a 401(k) plan. When running a start-up business, it’s sometimes more advantageous to sponsor a Simple IRA or SEP IRA which requires less cost and time to maintain, but you don’t have that option using this funding strategy.
4) The business owners can’t pay themselves compensation from the stock purchase
5) The cost to setup and maintain the plan. Paying $5,000 just to establish the plan isn’t exactly cheap. Plus, you’re looking at $2,000+ in annual maintenance costs for the plan. Other options like taking a home-equity loan or establishing a Solo 401(K) plan and taking a $50,000 401(k) loan from the plan may be the better funding option.
6) Audit risk. While it’s not the case that all these plans are audited, they do present an audit opportunity for the IRS given the compliance rules surrounding the operation of these plans. However, this risk can be managed with knowledgeable providers.
7) Asset sale of the business becomes complex. If 10 years from now you sell your company, there are two ways to sell it. An asset sale or a stock sale. While a stock sale jives very easily with this ROBS funding strategy, an asset sale becomes more complex.
Finding the capital to start up a business is never easy. Each funding option comes with its own set of pros and cons. The ROBS plan is just another option for consideration. While I have greatly simplified how these plans work and how they operate, if you are strongly considering using this plan as a funding vehicle for your new business, please reach out to us so we can have an open discussion about what you are trying to accomplish, and how the ROBS plan stacks up against other funding options that you may have available.
Our Current Business Acquisition Program includes Accountants, Financial Planners & Insurance Agencies.
In addition to those professionals we are also looking to recruit consultants in the acquisition process, trainers, marketing agencies, business coaches and consultants, business owners and entrepreneurs interested in acquiring businesses.
The State of Play in respect of ROBS Plans, 401k Programs, Salary Packaging, Financial Planning and Retirement Planning is most Professionals currently involved in the foregoing have a paucity of technical knowledge. Their Plan Designs & Management seriously lack creativity and sub-optimize the wealth creation potentials for clients (Employers and Employees) as well as themselves.
Which is where you might come in when you join us to help remedy the deficiences of small firms and even the larger advisory firms in those areas.
Our knowledge, skills and experience give us a competitive advantage and we welcome expressions of interest from financially astute individuals and firms interested in joining us. There is no licensing requirement or experience needed in the specific areas for you to join us – although that might be a bonus and enable a fast start.
It is expected that applicants will hold a University Degree or Equivalent in a relevant discipline
In addition to initial training in specific elements there is on-going training in each type of program – to first equip you and then upgrade your knowledge and skills.
The Financial Rewards for our Consultants are extremely attractive – with plenty of scope to build trailing income in multiple integrated financial businesses.
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The 401k business financing plan (ROBS 401k) is perfect for entrepreneurs seeking readily available funding capital, especially those looking for interest-free or no hassle business funding sources.
Fund your business start-up with retirement funds
Also known as ROBS 401k, the small business financing 401k plan allows you to fund a business with your retirement funds without taking a taxable distribution.
Not a taxable distribution
Because you directly rollover your IRA or former employer 401k, 403b, Keogh, SEP, SIMPLE, or other eligible account, to your new ROBS 401k plan, which then funds your business, you incur no taxes or early distribution penalties.
Not a loan
Unlike traditional 401k plans that allow for a 401k participant loan, that is, borrow up to 50% of the account balance not to exceed $50,000, our 401k business financing plan allows you to use all of your retirement funds to fund your start-up business.