The IRS is increasing scrutiny into a complex practice for using retirement accounts to fund a business. The practice may trip up business owners who take advantage of it. In the end, it could cost them not only their retirement nest eggs, but open them up to paying back taxes and large penalties to the IRS.
The practice is called Rollovers as Business Startups (ROBS). The business owner takes his or her tax-deferred retirement funds and uses them to start or buy a business or franchise. The practice is being pitched by several financial companies toward Baby Boomers and others who are looking to start or buy businesses after leaving corporate jobs where they may have amassed 401(k)s and IRAs.
By using a ROBS plan, the would-be business owners are able to tap into their own retirement monies to fund their businesses, without paying taxes or early-withdrawal penalties. The business owner simply forms a new corporation, and rolls the retirement funds over into a new 401(k) in the new corporation. Then the new 401(k) invests in stock in the business owner’s own corporation. The 401(k) money then goes into the business in payment for the stock, giving the business the use of the funds.
As far as the original retirement account is concerned, it is treated as a rollover. Therefore, no taxes or early-withdrawal penalties need to be paid by the business owner.
It’s all perfectly legal.
And clever, right? You use your own money, you don’t have to incur the expense of a bank loan, and you avoid early withdrawal penalties and taxes.
Not so fast. . .there are specific compliance rules for handling ROBS retirement accounts and how you can use the money. Those rules are easily violated and can trip up business owners. For example, the new retirement account must remain a qualified retirement account, which involves administrative responsibilities. If the plan gets disqualified, penalties and taxes could be owed. Also, the funds may not be used to pay a business owner a salary.
The IRS points out in a memo that ROBS aren’t exactly a violation of tax law, but the IRS is making clear that it considers the plans questionable:
“ROBS plans, while not considered an abusive tax avoidance transaction, are questionable in that they may serve solely to benefit one individual’s exchange of tax-deferred assets for currently available funds.”
Two pending lawsuits highlight the disastrous consequences if ROBS plans fall out of compliance. In Peek v Commissioner (PDF), two Colorado entrepreneurs used ROBS retirement funds to guarantee a business loan. The Tax Court said using the funds to guarantee a loan is prohibited, and claims they owe over $500,000 in taxes and penalties. In Ellis v Commissioner (PDF), a Missouri entrepreneur used ROBS money to rent space and pay himself a salary. The IRS says those are also prohibited uses for ROBS funds.
One CPA calls the lawsuits “ticking time bombs.” In an article in The Franchise Times, Steve Hamilton, a certified public accountant with Schmidt and Associates in Cincinnati, is quoted as saying:
“The lawsuits show that the Internal Revenue Service is looking deeply into these transactions. If it blows up, participants can be looking at millions in back taxes and penalties.”
Another concern is that the practice may put entrepreneurs’ retirement security at risk simply because of the high failure rates of businesses. According to the IRS memo issued in January:
“Overall, the research we conducted and the responses we received to the compliance checks indicated that while some of the ROBS were successful, many of the companies in the sample had gone out of business within the first 3 years of operation, experiencing significant monetary loss, bankruptcy, personal and business liens, or had their corporate status dissolved by the Secretary of State (voluntarily or involuntarily).”
Younger entrepreneurs may have enough years to recover from business failure and rebuild their retirement funds. But the ROBS technique is especially risky for older entrepreneurs who face losing their retirement savings at a time when they may no longer be able to recover, if the business fails.
The IRS wants business owners to understand what is involved with complying with ROBS funding plans — and the risks. More at the IRS site.
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Source: Small Business Trends
Using Retirement Accounts to Fund a Business Startup Draws IRS Scrutiny