June 18, 2019

Funding a Small Business with Retirement Funds? Think Twice

AlexWenzelBy Alexander Wenzel

If you have listened to AM radio in the last three years, you may have heard advertisements for arrangements by which small business owners could use tax-deferred funds to inject some capital into their small business from their retirement funds. The IRS refers to these arrangements as Rollovers as Business Start-Ups (or “ROBS”), although the scheme is not limited to start-ups.

Structure of ROBS

One may be able to understand how the IRS feels about these arrangements by the acronym it has chosen for them. The ROBS arrangement is a fairly simple tax work-around that takes funds from an existing tax-deferred retirement account, rolls-over those funds to a new tax-deferred retirement account (the “ROBS Plan”) that has but one client (the business owner) and one investment (the small company). The ROBS Plan would acquire shares of stock in the company as an “investment”by making a nice tax-deferred injection of capital into the company. While this arrangement may be acceptable to the IRS in a narrow set of circumstances, there are some dangers to this type of funding.

Items of Concern

The IRS is most concerned with two aspects of these arrangements: (i) violations of nondiscrimination requirements of retirement plans; and (ii) faulty valuations of the small business stock traded for the capital injection.

Non-discrimination Issue: The Internal Revenue Code prohibits contributions or benefits provided under a qualified retirement plan from discriminating in favor of highly compensated employees—those who either own at least 5 percent of the company, or receive more than $80,000 in salary. The Treasury Regulations also provide that the benefits, rights, and features of a qualified retirement plan (including, in this case, the ROBS Plan) cannot be discriminatory in effect. That is, employees must be able to invest in the ROBS Plan, not just the business owner.

As is often the case, employees may not even know of the existence of a ROBS Plan, much less be able to participate in it. If either the business owner or the ROBS Plan holds more than 5 percent of the company’s equity and employees are not permitted to participate in the ROBS Plan, the ROBS Plan is in danger of violating the non-discrimination requirement.

Valuation Issue: The IRS is also concerned that the valuation of the stock issued to the ROBS Plan may be inflated. The business owner may not want to lose control of the business ownership to the ROBS Plan and may seek to sell a small percentage of the shares to the ROBS Plan at a high price not supportable by the company’s operations or financial condition. Any such transaction should be supported by a well-documented appraisal. Additionally, if the company’s only asset is the capital injected, the investment may be characterized as a “prohibited transaction” which may result in a 15 percent tax on the transaction, or even 100 percent tax if not promptly corrected.

Dangers abound with ROBS Plans, and it may be wise to pursue other avenues of funding a small business before using those hard-earned retirement funds.

Alex Wenzel is an associate attorney at Burns, Figa & Will, P.C. His practice focuses on real estate transactions and litigation, securities, and corporate formation and transactional work. Prior to becoming an attorney, Mr. Wenzel was a Presidential Writer for the White House in the Office of Special Letters and Responses. A native Ohioan, he earned his B.A. at the University of Cincinnati and his J.D. at the University of Denver.

The opinions and views expressed by Featured Bloggers on CBA-CLE Legal Connection do not necessarily represent the opinions and views of the Colorado Bar Association, the Denver Bar Association, or CBA-CLE, and should not be construed as such.

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