Entrust Learning Center > Keyword: invest > Look Before You Roll Over: Rollovers as Business Start-Ups (ROBS) Arrangements

Look Before You Roll Over: Rollovers as Business Start-Ups (ROBS) Arrangements

The IRS does not consider ROBS arrangements to be abusive tax avoidance transactions, however it does consider them to be fraught with potential flaws that could hurt investors if they are not aware.

By: Hugh Bromma, CEO of The Entrust Group

IRA & 401(k) Insights

ROBS arrangements allow individuals to convert their existing retirement accounts into a capital source for funding new businesses. The business asset becomes an asset of the retirement account, to which funds are rolled over from another retirement plan. The IRS does not consider ROBS as abusive tax avoidance transactions, however the service does consider them to be potentially fraught with fatal flaws. First, let’s examine a ROBS transaction from start to finish.

Case Study: A ROBS Transaction

• Jason establishes a shell corporation, Mandarin Holdings, Inc. (the corporation), which sponsors a qualified retirement plan for which a favorable determination letter has been received. At this point, the corporation has no employees, assets, or business operations and does not have a contribution of capital to create shareholder equity.
• The plan document provides that all participants (Jason) may invest the entirety of their account balances in employer stock.
• Jason becomes the only employee of the corporation and the only participant in the plan. At this point, there is still no ownership or shareholder equity interest. Jason then executes a rollover and direct trustee-to-trustee transfer of available funds from his prior qualified plan and his IRA into the newly created qualified plan. These available funds are from assets previously accumulated under Jason’s prior employer's qualified plan and from his conduit IRA, which itself was created from these amounts in previous qualified plans. Because assets have been moved from one tax-exempt accumulation vehicle to another, all assessable income or excise taxes otherwise applicable to the distribution have been avoided.
• Jason, the sole participant in the plan, directs the investment of his account balance of $750,000 into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that Jason wishes to access.
• Jason uses the transferred funds to purchase a business enterprise: the corporation. All assessable taxes on a distribution from the prior tax-deferred accumulation account are avoided.
• Once the corporation is established, the plan is amended to prohibit further investments in employer stock. As a result, only Jason benefits from this investment option. Future employees and plan participants will not be entitled to invest in employer stock.
• The corporation now has operating capital to conducts the business interests of the enterprise. The company hires business, accounting, and legal professionals to ensure compliance with all laws and rules, which bear on the conduct of Mandarin Holdings, Inc.

The IRS Findings on ROBS

The IRS initiated an Employee Plans ROBS project in 2009 to:

• Define traits of compliant versus noncompliant ROBS plans
• Identify ROBS plans that are noncompliant and take action to correct them
• Use the results to design compliance strategies focusing on identified issues and trends (for example, Employee Plans Compliance Resolution System, fix-it guides, web-based information, newsletters, and speeches).

The conclusion it reached as explained in an IRS memorandum dated October 1, 2008 is as follows:

“ROBS transactions may violate law in several regards. First, this scheme might create a prohibited transaction between the plan and its sponsor. At the time of the exchange between plan assets and newly-minted employer stock, the value of the capitalization of the entity is equivalent to the value of all plan assets, when in reality, the entity may be valueless and asset-less for an indefinite period of time. Additionally, this scheme may not satisfy the benefits, rights and features requirement of the Regulations. The primary utility of the arrangement may only be available to the business's principal individual.”

“Specific facts will need to be evaluated on a case by case basis in order to make a proper determination as to whether these plans operationally comply with established law and guidance. Technical advice requests may be submitted after consultation with group managers. For this reason, employee plans specialists are directed to resolve open ROBS cases as described herein.”

Within this context, the issues of operating any plan that has received a favorable determination letter out of compliance with the plan remains a big issue. Promoters of ROBS plans may indeed have individuals who are using such plans out of compliance, and therefore are subject to penalties and other tax adverse consequences. Among these issues are:

• Not activating the business for which ROBS capitalization is supposed to be used
• Not following the plan terms regarding employees entry into the ROBS plan
• Using ROBS plan funds to pay the salary of the owner who rolled the funds from his or her previous plan
• Having the ROBS funds as the exclusive source of capitalization of the business
• Unsatisfactory valuation of the business funded by ROBS
• Failure to file the necessary IRS reports, such as 5500s

The IRS states that from its ROBS Project findings, most ROBS businesses:

• Failed
• Were in the process of failing, with high rates of bankruptcy (both of the business the ROBS was capitalizing and personal bankruptcy)
• Business and personal property was subject to legal action of other sorts, such as liens
• In the process of dissolution by governmental agencies

Entrust Conclusions

Entrust’s point of view is that individuals should perform due diligence on the ROBS plan which they intend to use. This consists of having a complete understanding of what the ROBS plan terms are. Promoters may often just provide a document or casually read the terms.

All plans must be functioning in their terms and reality. A good promoter not only provides the plan, but also provides specific business consulting services to implement the plan and business terms. Follow-up is essential.

Business owners have enough to do just running the enterprise they are partially funding with ROBS capital. The IRS experience is not just that ROBS plans were out of compliance, but that the business ventures mostly fail. The business owner, Entrust suggests, should pay attention to the successful execution of their business plan and have sufficient capital, assets, and managerial/entrepreneurial talent to make the business an ongoing concern; insufficiency of any of these do not bode well for an enterprise.

Entrust suggests that in addition to a good plan document, and always being compliant with the Internal Revenue Code, the business owner have the proven talent, or hire that talent before embarking on a plan of business action. All this requires money. Undercapitalization and failure to hire a successful team, added to non-compliance, will lead to disappointment.

Resources:

IRS.gov
Retirement News for Employers - Fall 2010 Edition - Rollovers as Business Start-Ups Compliance Project

U.S. Department of Treasury
October 1, 2008 Internal Revenue Service Memorandum on Employee Plans

Keywords|Tags

Refine your search using these keywords