What is it about Rollovers as Business Start-ups, better known as ROBS, which have made them the whack-a-mole of the plan community. No matter how many times the IRS raises a red flag about ROBS arrangements, they keep popping up in the popular press. Yesterday, Barbara Taylor wrote an article in the New York Times about Using Your 401(k) to Buy a Small Business. It is about Rollovers as Business Start-ups (ROBS), also known as Business Owners Retirement Savings Accounts (BORSA), and includes story of a couple who used their retirement funds to buy an existing manufacturing company.
Earlier this year, the IRS completed a Employee Plans Compliance Unit (EPCU) project on Rollovers as Business Start-ups. The IRS began the project examining ROBS in December of 2009 and finished it in September of 2010.
The IRS said that while some of the ROBS were successful, many of the companies studied by the IRS had gone out of business within the first 3 years of operation, with the owners experiencing significant monetary loss, bankruptcy, personal and business liens, or had their corporate status dissolved by the Secretary of State, either voluntarily or involuntarily.
One issue the IRS found during the compliance project was that many plans had failed to file Form 5500s due to an incorrect interpretation of one of the filing exemption for Form 5500. The claimed filing exemption is for plans with assets less than $250,000 where the plan provides deferred compensation solely for an individual or an individual and his or her spouse who wholly own a trade or business. The IRS said that this exemption does not apply to ROBS because, with ROBS, the plan owns the trade or business, not an individual as required to claim the filing exemption.
If you are wondering how a ROBS arrangement is structured, Michael Julianelle, the Director of IRS Employee Plans, issued a 15-page Memorandum on Guidelines Regarding Rollovers as Business Start-ups in 2008. It describes a ROBS transaction as:
- An individual establishes a shell corporation sponsoring an associated and purportedly qualified retirement plan. At this point, the corporation has no employees, assets or business operations, and may not even have a contribution to capital to create shareholder equity.
- The plan document provides that all participants may invest the entirety of their account balances in employer stock.
- The individual becomes the only employee of the shell corporation and the only participant in the plan. Note that at this point, there is still no ownership or shareholder equity interest.
- The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created qualified plan. These available funds might be any assets previously accumulated under the individual’s prior employer’s qualified plan, or under a conduit IRA which itself was created from these amounts. Note that at this point, because assets have been moved from one tax-exempt accumulation vehicle to another, all assessable income or excise taxes otherwise applicable to the distribution have been avoided.
- The sole participant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.
- The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise. Note that all otherwise assessable taxes on a distribution from the prior tax-deferred accumulation account are avoided.
- After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment options. Future employees and plan participants will not be entitled to invest in employer stock.
- A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to the promoter.
The Memorandum says that the IRS found some ROBS with significant disqualifying defects. One issue the IRS identified was that, because ROBS transactions generally benefit only the principal involved with setting up a business, and do not enable rank-and-file employees to acquire employer stock, the plan can violate the anti-discrimination provisions of the Code and Regulations since the only benefit, right or feature (BRF) of the plan is provided to the owner.
According to the IRS, ROBS transactions may also create a prohibited transaction due to the valuation placed on the stock. In all ROBS arrangements, an aspiring entrepreneur creates capital stock for the sole purpose of exchanging it for tax-deferred accumulation assets. The value of the stock is set as the value of the available assets. An appraisal may be created to substantiate this value but, the IRS says, the appraisal is often devoid of supportive analysis. Depending on the true enterprise value, the ROBS arrangement is a prohibited transaction.