For most would-be entrepreneurs, the hardest part is not coming up with a business idea or a potential business to buy, but finding the cash needed to start or buy a business. After taking an inventory of their personal finances, the next step on the financing train is usually family and friends. If the train needs to keep moving, the next stop for potential financing is typically a bank or hard money lender that can provide a small business loan. Often this is where the financing train runs out of track.
The good news for many entrepreneurs is that there are a number of legal ways to use retirement funds to buy a business or franchise, although these opportunities do come with substantial downside that must be well examined. Buying or starting a business is not without risk. The Small Business Administration (SBA) keeps the statistics on business failures and claims that more than half of new businesses will disappear in the first five years.
Here is a look at the most common ways to use retirement funds to buy or start a business:
Take a Taxable Distribution: If the funds are in a individual retirement account (IRA) the funds can always be taken as a taxable distribution. The downside is that a pre-tax IRA would trigger an ordinary income tax on the amount of the distribution and a 10% early distribution penalty if the individual taking the distribution is under the age of 59½. In the case of a Roth IRA (after-tax), the funds can be distributed tax-free if the Roth IRA holder is over the age of 59½ and the Roth IRA has been opened for at least five years. If the Roth IRA holder is under the age of 59½, the 10% early distribution penalty would apply on the Roth earnings. Taking an IRA distribution is certainly not the most tax efficient way to use retirement funds to buy a business, but, based on the amount of funds needed for the business and the age of the IRA holder, it could end up being the wisest decision.
401(k) Loan Option: Many 401(k) qualified retirement plans offer a loan feature, which allows a plan participant to borrow the lesser of 50% of their plan account value or $50,000. The loan does have to be paid back over a five year period, at least quarterly and at an interest rate of at least Prime as per the Wall Street Journal, which as of June 30, 2015 is 3.25%. The advantage of using the 401(k) loan feature is that the plan participant would be able to get tax-free and penalty-free use of up to $50,000 of retirement funds, which can be used for any purpose including for the purchase of a business. The downside is that the loan is capped at $50,000 or 50% of the plan account value and the loan need to be paid back over a five-year period. The 401(k) plan loan feature can work well if one is in need of a small amount of money for the purchase of a business, but for many entrepreneurs, the maximum loan amount available would not be sufficient which makes the loan option an unviable option.
ROBS: The Rollover Business Startup Solution (“ROBS”) is a controversial retirement structure that allows one to use rollover retirement funds to purchase a business tax-free. The controversy stems from the fact that although the structure is based off a provision in the Internal Revenue Code (IRC 4975(d)(13)) and has been confirmed to be legal by the Internal Revenue Service (IRS), it continues to be on the radar of the IRS and Department of Labor (DOL).
The ROBS arrangement typically involves rolling over a pre-tax IRA or 401(k) plan account into a newly established 401(k) plan, which is sponsored by a “C” Corporation and then investing the rollover funds in the stock of the “C” Corporation. The individual retirement account holder can then earn a reasonable salary as an employee of the business. The advantage of the ROBS solution is that it does allow one to use all their pre-tax IRA or 401(k) funds to buy a business that they will be involved in personally as an employee without tax or penalty.
The downsides are numerous. First, the ROBS solution requires the use of a “C” Corporation, which is treated as a completely separate taxpayer from its owners, whereas, a sole proprietorship, LLC, or “S” Corporation are treated as pass-through entities for tax purposes. In other words, a “C” Corporation would impose two taxes on corporate earnings: a corporate level tax and a shareholder tax on the dividends received. In comparison, for a pass-through entity, such as an LLC, the profits bypass taxation at the corporate level and are distributed and taxed at the owner’s level. It is important to note that it can be argued that the double taxation handicap does not impact retirement accounts (i.e. 401(k) plans) as much as individuals, since the dividend from the “C” Corporation to the 401(k) plan shareholder would be exempt from tax since a 401(k) plan is a tax-exempt retirement account. However, the double taxation is not eliminated but simply deferred until the 401(k) plan participant elects to take a 401(k) plan distribution, which would generally be subject to a second tax.
The ROBS solution also requires the use of a 401(k) plan, which brings with it some additional costs and compliance issues. Even though 401(k) plan administration costs have come down significantly over the years, there is still the cost of offering a 401(k) plan to employees, which needs to be balanced with the advantage of offering 401(k) plan benefits to employees. In addition to having to potentially make a minimum 3% safe harbor contribution, as many small business 401(k) plans opt to become safe harbor plans, 401(k) plans cost money to administer because there are many compliance issues that have to be monitored, as well as many ongoing service and administration functions that must be provided. It is not uncommon for a small business 401(k) plan to cost anywhere from $750-$1500 annually for plan testing and recordkeeping.
Third, establishing a ROBS solution could lead to an IRS audit. We know that the IRS and DOL have been looking at the promoters of ROBS plans as far back as 2005 because of some of the abuses they perceived were occurring. The IRS outlined their concerns in a October 31, 2008 memorandum titled, “Guidelines regarding rollovers as business start-ups.” The IRS stated that while this type of structure is legal and not considered an abusive tax avoidance transaction, the execution of these types of transactions, in many cases, have not been found to be in full compliance with IRS and The Employee Retirement Income Security Act of 1974 (ERISA) rules and procedures. In the “Memorandum,” the IRS highlighted two compliance areas that they felt were not being adequately followed. The first area of concern the IRS highlighted was the lack of disclosure of the adopted 401(k) Plan to the company’s employees, and the second area was establishing an independent appraisal to determine the fair market value of the business being purchased. In sum, the IRS was concerned that people were using their retirement funds to buy a business and that ultimately the business was not being purchased and the individual then used the funds for personal purposes, thus avoiding tax and potential penalties. Additionally, the business that was purchased closed, and the retirement account liquidated, thus leaving the IRS without the potential to tax the retirement account in the future.
The IRS did not publicly comment on the ROBS solution again until August 27, 2010, almost two years after publishing the “Memorandum,” when the IRS held a phone forum open to the public which covered transactions involving using retirement funds to purchase a business. Monika Templeman, Director of Employee Plans Examinations, and Colleen Patton, Area Manager of Employee Plans Examinations for the Pacific Coast, spent considerable time discussing the IRS position on this subject. The IRS again aired their concerns about the ROBS solution and the potential for abuse, but did confirm that the structure was not considered illegal or prohibited if done correctly. That being said, the IRS’ primary concern with the ROBS solution is directly tied into the SBA statistics on new business failures. Most people don’t think of the IRS as their partner in their retirement accounts, but that is the reality. For pre-tax retirement funds, the IRS permitted the IRA holder to receive a tax deduction for the amounts contributed, but will force the IRA holder to take a required minimum distribution (RMD) beginning at age 70½ and pay tax on the RMD amount. Imagine how the IRS feels when the IRA holder takes the majority of his/her pre-tax retirement funds and invests it in a business that untimely fails. The IRS has now lost any potential tax revenues resulting from RMDs because the funds were lost. In contrast, if the IRA holder purchased stocks, mutual funds, or even real estate, the account would fluctuate in value, but would likely not be lost.