ROBS: the benefits and drawbacks of using retirement savings in a tax-free arrangement for small-business funding - Blog - Ki Solutions Financial Advisors

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ROBS: the benefits and drawbacks of using retirement savings in a tax-free arrangement for small-business funding

Published by in Self-Funding ·
Tags: Capital RaisingROBSRollovers as Business Startups401kretirement savingsfundingself-fundingtax avoidance

 

Many existing or aspiring small-business owners see great value in being able to focus time and resources on growing their business without the burden of debt. With limited resources, they generally turn to bootstrapping, a form of self-funding with strict cash flow control, and they can grow and develop their business by reinvesting earnings until they require capital from outside sources. Retirement funds accumulated in plans such as 401(k)s, IRAs and TSPs have been popular options for self-funding of nascent businesses and employed through an arrangement called Rollovers as Business Startups (ROBS). ROBS are technically defined by U.S. tax authorities as proprietary defined contribution plans established in the form of profit sharing plans coupled with a cash or deferred arrangement, designed to allow a newly created business entity to retrieve available tax-exempt accumulation funds from its principal in exchange for its capital stock. Adhering to the Employee Retirement Income Security Act (ERISA) of 1974, it enables tax-free business funding by using employer plan’s permission for the tax-free purchase of employer stock. The process typically requires: i.) incorporation of a new business entity; ii.) opening of a new qualified retirement account plan under it; iii.) rolling existing retirement account funds into the new plan; iv.) issuance of new company shares that are purchased with funds from the retirement account; and, finally, v.) directing the funds to a business investment. Since both accounts are tax-exempt, the new business owner avoids taking a tax hit.


 

ROBS has been common in funding nascent franchise businesses, but it has been employed in all sorts of funding to support the creation or expansion of small-businesses. There are many benefits to choosing ROBS over traditional small-business financing options, such as i.) tax-free funding; ii.) no early withdrawal penalties; iii.) no need for good credit scores; iv.) no need for downpayments; v.) quick and flexible access to funds based on demand; vi.) no personal assets pledged as collateral; and vii) no equity given up. However, there is a downside to employing ROBS. Since there are strict compliance standards to avoid penalties (and audits), if the ROBS arrangement doesn’t operationally comply with established law and guidance there is risk in tax authorities questioning such arrangement and fining the business owner or placing the business under greater scrutiny. There have been several cases of significant disqualifying operational defects in these arrangements that have come to light. On October 2008, the IRS published guidelines on ROBS and hasn’t classified it as an "abusive tax-avoidance transaction" per se but it has called the arrangement questionable. The complexity of setting up and maintaining ROBS can be costly and many small-business owners have contracted advisory firms specializing in ROBS to ensure compliance. Their fees (~US$5 k to set-up and monthly maintenance of ~US$150) can be cost-prohibitive and generally the benefits of ROBS make more sense in deals above US$50 k (the sweet spot has been ~US$150 k). In some cases, business owners are better off withdrawing the retirement funds at the cost of income tax and a 10% early withdrawal penalty. They also have the option of taking out a loan against the retirement funds, capped at US$50 k.


 

ROBS is just one of many funding options available for small-business owners. Our advisory services look at our clients' business plan and capital requirements to design a cost-efficient capital solution, which could include a ROBS arrangement. If this is the case, then we act in our client’s best interest and, given the considerable risk in the tax authorities questioning this arrangement, we will recommend our client in seeking legal and accounting advice from firms that specialize in ROBS. However, we still provide valuable insight in funding and M&A when ROBS is used in combination with other funding options and/or business acquisitions.



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