Rollovers as Business Start-Ups (ROBS): What to Know When Financing a Business Using Your 401(k), IRA or Other Retirement Funds

The COVID-19 pandemic resulted in widespread layoffs and closed hundreds of thousands of businesses across the country. Despite the economic downturn and one of the worst global health catastrophes in modern history, start-up businesses in the United States have grown from 3.5 million in 2019 to 4.4 million in 2020, a 24 percent increase. While it may be difficult to pinpoint an exact cause of this increase, the more limited opportunities in the wage sector may have incentivized entrepreneurship by necessity and encouraged many individuals and families to search for more independence and control over their financial futures. For most prospective business owners, the biggest financial challenge is often finding sufficient funds to pay for new business start-up costs, acquisition costs or to refinance an existing business. Historically, many new business owners have relied on a home equity line of credit or traditional bank loans to kick start their new business ventures.

However, for those who are reluctant to assume additional debt or may not qualify for a traditional business loan, there is an alternative option. A Rollover as Business Start-Ups (ROBS) is an alternative form of business financing that can be used without having to borrow the cash to start, acquire, or grow a business. A ROBS arrangement is not a withdrawal from a retirement plan account or a loan against it. Instead, is a rollover fund that enables the use of retirement funds to purchase stock in the new company, with the proceeds from the sale of stock then used to fund the new or purchased business without incurring tax penalties or early withdrawal fees.

ROBS have been around for decades. ROBS came into existence when Congress provided American workers another option for growing their retirement assets. In 1974, Congress passed the Employee Retirement Income Securities Act (ERISA), which works in conjunction with specific sections of the Internal Revenue Code (IRC) to allow for the use of a 401(k) plan to invest in Qualified Employer Securities (QES) — which then allows the individual to fund a business.

Establishing a ROBS

Due to the financial risks described below, a ROBS is best suited for individuals with larger amounts of money saved for retirement. There are five steps to establishing a ROBS to invest in the new business.

Forming a C-corporation: The first step in setting up a ROBS requires creating a C-corporation (C-corp). Since a C-corp can issue stock and have shareholders, it is the only business structure for a ROBS arrangement that can legally sell the business' share to a retirement account. Other businesses such as a sole proprietorship, LLC (limited liability company), S-corp, or LLP (limited liability partnership), would not work for a ROBS arrangement under IRS rules. If a current business is operating as an entity other than a C-corp, it can typically be converted to a C-corp to take advantage of the ROBS.
Creating a retirement plan for the new C-corp: The second step in setting up a ROBS is to establish a retirement plan for the C-corp. There is significant flexibility when choosing a retirement plan for the C-corp. The type of retirement that is most appropriate for the new business will depend on factors such as the number of employees or the types of retirement benefits that are provided to employees. For instance, a new business may wish to establish a new 401(k) plan, profit-sharing plan, defined benefit plan, or other type of defined contribution plan. To establish a new retirement plan, the services of a third-party record keeper, a trustee, and an asset custodian are typically required to manage the investments in the retirement plan.
Transfer funds from prior employer’s retirement plan to the C-corp's new retirement plan: The next step in establishing a ROBS is for the existing retirement funds from a prior employer’s 401k plan or a personal IRA to be transferred to the new retirement plan sponsored by the C-corp. The new 401(k) plan can then invest in the new business and become a shareholder in the C-corp.
New retirement plan purchases stock of the new C-corp: In this next step, funds from the ROBS are then used to buy the stock in the new C-corp at fair market value. Specifically, the C-corp issues shares that the new retirement plan and any potential outside investors will purchase.
Funds are available to invest in the corporation: Once the retirement plan has purchased the stock in the new C-corp, those funds can then be used by the C-corp to invest in the business. When using these ROBS funds, the IRS and United States Department of Labor (DOL) require that all contributed funds are used for business purposes related to the new C-corp and not for any personal activities.

Fees to Establish a ROBS

Typically, a ROBS provider can assist prospective business owners with the steps described above. In most cases, there is a one-time initial fee of approximately $5,000 to set up a ROBS. The initial fees often cover the formation of a C-corp, setting up the new retirement plan and preparing the initial required IRS filings. There may also be an ongoing monthly administrative fee of approximately $100-$150 to cover the cost of administering the new retirement plan and submitting annual IRS filings such as the Form 5500.

Additional ROBS Requirements

To qualify for a ROBS, the business owner must satisfy the following requirements:

Minimum Level of Available Assets to Invest in ROBS: Most ROBS providers require a minimum level of current personal retirement savings to establish a ROBS. While this is not a strict requirement, most ROBS providers will want to ensure that there are sufficient funds for investment in the new venture and to cover the initial expenses of establishing the ROBS. While expenses can vary, many ROBS providers require a minimum of $50,000 or more to establish a ROBS.
An Existing Retirement Account: To comply with IRS rules, rollover funds must originate either from a retirement account of a prior employer or from a self-directed account (e.g., solo 401(k) plan or personal IRA) that is unrelated to a current employer. The source of the funds is important to consider for compliance with the IRS’ rollover rules that impose restrictions and tax penalties on withdrawals and/or rollovers from a retirement plan that is sponsored by a current employer. Roth IRAs and Roth 401(k) accounts are not eligible for ROBS.
An Employee of the New Business: To use a ROBS arrangement, the IRS requires the investor to also be a legitimate employee of the business the funds are invested in. Although the IRS does not define a minimum number of hours to demonstrate active employment, many 401(k) plans require a thousand or more hours per year for initial eligibility in a retirement plan, and this may serve as a useful benchmark. By contrast, it may be difficult to demonstrate active employment if the goal of a ROBS is solely to invest in real estate as a passive business owner.

Pros and Cons of ROBS

A ROBS can be an ideal option for funding a small business or to recapitalize on an existing business. However, it is important to weigh all the pros and cons of a ROBS to avoid potential tax and legal liabilities if the ROBS is established or operated incorrectly.

Pros of ROBS

A ROBS can be used to leverage retirement funds without incurring hefty tax penalties or an early withdrawal fee of 10 percent (for those younger than 59 ½ years old).
A ROBS is not a traditional loan. A ROBS does not require borrowing money from credit cards or a home mortgage lender and therefore, there are no credit score requirements and no need to make loan repayments.
Using a ROBS, a business owner has more control over their investment funds as compared to traditional retirement accounts invested in common stocks, bonds, and mutual funds.
C-corps are ideal for a ROBS arrangement because it is the only entity that allows for the selling of stock ownership for cash, and profits under a C-corp are currently taxed at a flat 21 percent (a decrease from the previous 35 percent rate).
Since the investment funds are held in a tax-exempt retirement fund, there won't be any taxes on the ROBS when it is established.
ROBS can help accelerate business profitability by eliminating any form of debt during the initial formation stages of the new business.

Cons of ROBS

If a business funded with a ROBS fails, there is a much greater possibility that the retirement funds invested are also lost.
Only non-Roth fund sources are eligible for ROBS.
While there isn't necessarily an increased risk of an IRS audit when using a ROBS, the audit process may be more complex for a ROBS-funded business because the IRS will review documentation about the retirement plan along with the business operations and specifically, the steps taken to fund the business using retirement funds.
Since ROBS requires private stock purchase, no other business entity works with this structure. And, C-corps require more paperwork, fees, and ongoing administration than sole proprietorships or LLCs.
The ROBS structure requires the new business to administer a retirement plan and make those retirement benefits available to all eligible employees.
ROBS requirements involve additional administration and government reporting on the retirement plan's activities (filing an annual report). Most often, a ROBS provider can assist with these matters for an additional administrative fee.
If the business is closed or sold, the government reporting requirements for the retirement plan (Form 5500), corporate taxes, and other state or annual federal requirements, still apply.
If the ROBS is not established or operated correctly, there is the potential for the ROBS arrangement to inadvertently experience "prohibited transaction(s)" under ERISA. There can be staggering penalties of 110 percent or more of the amounts involved in the prohibited transactions or the rollover amounts themselves.

ROBS and Prohibited Transactions

Business owners using a ROBS to start or grow a business should be aware of the IRS rules on prohibited transactions to avoid unexpected taxes and penalties under the Internal Revenue Code (IRC) § 4975. The most common prohibited transactions impacting ROBS arrangements are as follows:

Excessive business owner compensation: Business owners have a fiduciary duty to the retirement account that invests in the C-corp stock. As such, the business owner cannot pay themselves excessive amounts in salary or benefits. Additionally, any payments to the owner cannot originate from the retirement funds used to fund the business. Instead, the owner’s compensation must be paid from the operating income of the C-corp.
Personal use of business funds: The IRS restricts business owners that utilize a ROBS from personally benefitting from the use of any related business property. For example, a new business owner that invests in a new factory would likely not be permitted to rent space in that factory to a family member. Internal Revenue Code § 4975 places a 15 percent tax on any transactions involving the sale, lease, or exchange of company property to a disqualified person, including the business owner, their spouse, or immediate family.
Using the retirement plan to pay promoter fees: Raising money for a ROBS sometimes requires a “promoter” to help the business owner raise money and provide administrative and investment advice. However, Internal Revenue Code § 4975 prohibits payment of promoter fees if these promoters also qualify as fiduciaries to the retirement plan.
Using ROBS to avoid the retirement plan distribution rules: In a 2008 IRS Memorandum, the IRS described situations where individuals established a ROBS structure to purchase a business, but then never acted on the purchase. Instead, they used the funds from their retirement plan for personal use and avoided the required tax and penalties on what should have been a retirement plan distribution.

ROBS Compliance and Government Audits

Both the IRS and DOL hold ROBS investments to certain compliance standards. Government audits of ROBS, although relatively infrequent, allow the IRS and DOL to monitor compliance with ROBS rules. Those plans not in compliance with the government regulations could face tax penalties and fines. The topics most likely to be reviewed for compliance include the following:

Whether the new retirement plan was properly established, and the plan documentation complies with IRS regulations.
If the costs/fees were reviewed by the fiduciaries, determined to be appropriate, and timely paid to third party vendors.
All required annual filings, such as the annual Form 5500, were timely filed.
Eligible employees were offered participation in the retirement plan.
All eligible employees are provided the same ability to invest in the retirement plan. Specifically, employees must have the same access and ability to make the same investments as the business owners.

Unwinding a ROBS

Just as the IRS has certain requirements to establish a business using a ROBS, the IRS has specific requirements to unwind a ROBS during a corporate transaction.

Stock Sale: Generally, if the stock of a business is sold, anyone who owns a portion of the business will receive their pro-rata portion of the net sale’s proceeds. Any funds received by the retirement plan in exchange for the stock that it owns in the business are typically rolled into an IRA for the benefit of the owner and employees following a stock sale.

Asset Sale: If the assets of the business established with a ROBS are sold, the funds are typically used to pay any expenses of the sale. Any remaining net sale proceeds are then distributed to the business owners, which includes the retirement plan that was used to fund the business.

Bankruptcy: If the business declares bankruptcy or is otherwise winding down, the retirement plan established with a ROBS must also be terminated, according to the IRS rules for retirement plan terminations. After the company’s assets are liquidated, the remaining assets will be used to buy back as many shares of stock owned by the retirement plan as possible. Any remaining funds in the retirement plan are typically placed into an IRA for the benefit of employees and the business owners. In these cases, the business owner is not obligated to repay the original investment funds to themselves and will typically lose most, if not all, of the entire original investment that funded the ROBS.

Closing Thoughts

ROBS can be an ideal opportunity for motivated individuals to invest in or purchase a new or existing business. However, it is important to thoroughly explore the ROBS requirements and to be aware of the potential pitfalls. Prospective business owners should obtain the necessary legal, accounting, and other professional advice before deciding whether a ROBS arrangement is an appropriate business financing vehicle for their new venture.

For additional information, please contact Gary Blachman, Austin Anderson, Ian Minkin, Melissa Proffitt, Chris Sears, Kathleen Sheil Scheidt, Tara Sciscoe, or the Ice Miller Employee Benefits attorney with whom you regularly work.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.