Category Archives: Rollovers

More on Using a 401(k) Rollover to Buy a Business

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.

Annuities as an Option in 401(k) Plans

U.S. News & World Report published an article today (Feb. 14, 2012) about annuities in 401(k) plans – “More 401(k)s May Get a Makeover With the Addition of Annuities“. Written by Rachel Konig Beals, it summarizes the information about annuities in defined contribution plans which the DOL tucked in at the end of the press release on Feb. 2, 2012 about the Final Final Fee Disclosure Regs.

The IRS has also been busy in this area. On Feb. 2, 2012, the IRS released two new Revenue Rulings on this topic.

Rev. Rul. 2012-3 is the Application of Survivor Annuity Requirements to Deferred Annuity Contracts Under a Defined Contribution Plan. In eight pages, it addresses the issue of how the qualified joint and survivor annuity (QJSA) and the qualified preretirement survivor annuity (QPSA) rules apply when a deferred annuity contract is purchased under a profit sharing plan in three given situations.

In two situations, participants are permitted to direct investment of their elective deferral and matching contributions accounts to a deferred annuity contract that is issued by an insurance company which pays benefits in one of several life annuity forms that can be elected during the 180-day period ending on the annuity starting date. The difference between the two scenarios is in the first situation, a participant who invests in a fixed deferred annuity contract may subsequently transfer those amounts out of the contract and elect to take those amounts in the form of a single-sum payment. The third situation addresses amounts attributable to matching contributions if the participant dies before the annuity starting date and spousal consent.

Rev. Rul. 2012-4 discusses Rollover from Qualified Defined Contribution Plan to Qualified Defined Benefit Plan to Obtain Additional Annuity. In eight pages, it addresses two different issues.

First – does a qualified defined benefit pension plan that accepts a direct rollover of an eligible rollover distribution from a qualified defined contribution plan maintained by the same employer satisfy Code sections 411 and 415 in a case in which the defined benefit plan provides an annuity resulting from the direct rollover that is determined by converting the amount directly rolled over into an actuarially equivalent immediate annuity using the applicable interest rate and the applicable mortality table under Code section 417(e).

Second – how does the result vary if the defined benefit plan applies different conversion factors for purposes of calculating the annuity resulting from the amount directly rollover over.

The holdings of Rev. Rul. 2012-4 are specifically limited to rollovers made on or after Jan. 1, 2013 pursuant to Code section 7805(b)(8) but the IRS states it will permit plan sponsors to rely on the holdings of this ruling with respect to rollovers made prior to Jan. 1, 2013.

IRS Debunks Another 401(k) Urban Myth in New Guidance on Rollovers as Business Startups

ROBS, or Rollovers as Business Startups, have been bouncing around the employee plans arena for a couple of years. I first hear an IRS official mention ROBS during the 2006 Cincinnati Benefit Conference as part of the presentation on tax avoidance transactions. This week, the IRS finally released a Memorandum of Understanding, or MOU, addressing ROBS.

In a nutshell, ROBS are plans designed to permit an individual to buy a business, such as a fast food franchise, using their retirement account from a previous employer without taking a distribution from their retirement account so they do not pay tax on the distribution. The individual sets up a corporation, that corporation adopts a qualified plan, the individual rolls their retirement account from a previous employer into the new qualified plan (hence the “Rollover”), and the qualified plan does some one-time-only stock transactions which result in the corporation owning a business, normally a fast food franchise or a frozen yogurt shop (this is the “Business Startup” part).

The MOU on ROBS provides some interesting discussion on some of the theories and concepts which are the underpinnings of employee plans, such as prohibited transactions, the permanency requirement, benefits, rights, and features, exclusive benefit, and promoter fees. One urban myth of qualified plans that this MOU may finally put to rest is the myth of the “inactive CODA”. CODAs, or cash or deferred arrangements, are commonly known as the elective deferrals in 401(k) plans. The Myth of the Inactive CODA is invoked to explain why a 401(k) has an unusually low number of participants actually chosing to make elective deferrals into the plan. When asked why so few employees are availing themselves of the 401(k) plans, the plan sponsor will provide say that the plan’s CODA provision is “inactive”.

In unequivocal terms, the IRS states:

    There being no such thing as an “inactive” CODA, examiners should consider whether all the procedures for allowing employees to participate in the CODA were followed, whether new employees just chose not to defer, or whether employees were not even offered salary reduction elections. If it is established that employees were not permitted to make elective deferrals, the plan would violate IRC section 401(k)(2)(D) in that it did not permit eligible employees to elect salary deferral contributions.”

[tag]pension protection act, ppa, memorandum of understanding, IRS, ROBS, rollovers, business startups, CODA, ERISA[/tag]

Revisiting Rollovers to NonSpouse Beneficiaries Before 2008

When the House of Representatives failed to act on the Pension Protection Technical Corrections Act of 2007 last week, it created a terrific end-of-the-year PPA question.

The question: Are plans required to provide rollovers to nonspouse beneficiaries?

The answer: Yes No Yes

The reason behind changing the answer from “Yes” to “No” to “Yes” is the revised interpretation the IRS, with a little help from Congress, has provided regarding the plan document impact of new Internal Revenue Code section 402(c)(11).

Effective December 31, 2006, Section 829 of the Pension Protection Act added new Internal Revenue Code section 402(c)(11), which states:

    ‘‘(11) DISTRIBUTIONS TO INHERITED INDIVIDUAL RETIREMENT PLAN OF NONSPOUSE BENEFICIARY.—
      ‘‘(A) IN GENERAL.—If, with respect to any portion of a distribution from an eligible retirement plan of a deceased employee, a direct trustee-to-trustee transfer is made to an individual retirement plan described in clause (i) or (ii) of paragraph (8)(B) established for the purposes of receiving the distribution on behalf of an individual who is a designated beneficiary (as defined by section 401(a)(9)(E)) of the employee and who is not the surviving spouse of the employee—
        ‘‘(i) the transfer shall be treated as an eligible rollover distribution for purposes of this subsection,
        ‘‘(ii) the individual retirement plan shall be treated as an inherited individual retirement account or individual retirement annuity (within the meaning of section 408(d)(3)(C)) for purposes of this title, and
        ‘‘(iii) section 401(a)(9)(B) (other than clause (iv) thereof) shall apply to such plan.
      ‘‘(B) CERTAIN TRUSTS TREATED AS BENEFICIARIES.—For purposes of this paragraph, to the extent provided in rules prescribed by the Secretary, a trust maintained for the benefit of one or more designated beneficiaries shall be treated in the same manner as a trust designated beneficiary.’’.

The IRS provided guidance in Notice 2007-7, including how to accomplish a rollover to a nonspouse beneficiary. Q&A 14 of Notice 2007-7 stated that a plan was not required to offer a direct rollover of a distribution to a nonspouse beneficiary. Thus, Q&A 14 of Notice 2007-7 provides the “No” answer to the question on whether a plan is required to provide rollovers to nonspouse beneficiaries.

On February 13, 2007, the IRS released a special edition of Employee Plan News devoted to clarifying the provisions of Notice 2007-7 relating to rollovers to nonspouse beneficiaries. It states that:

There has also been a question whether a plan is required to offer a direct rollover of a distribution to a nonspouse designated beneficiary. Pursuant to section 402(c)(11) of the Code and Notice 207-7 Q&A-14, a plan may, but is not required to, offer a direct rollover of a distribution to a nonspouse designated beneficiary.

Congress answered this interpretation of IRC section 402(c)(11) in August of 2007 with the Pension Protection Technical Corrections Act of 2007. Specifically, section 9(e) of both S. 1974 and H.R. 3361, which prompted the IRS to reverse their “No” position back to “Yes” on rollovers to nonspouse beneficiaries.

The IRS then released the 2007 List of Interim and Discretionary Amendments, which included this statement:

§ 402(c)(11) [Discretionary]: PPA ’06 § 829(a)(1) added § 402(c)(11) to allow nonspouse beneficiaries to roll over distributions from a qualified plan to an individual retirement plan. Nonspouse beneficiary rollovers are an optional plan provision for 2007. See, Notice 2007-7. Pursuant to an impending technical correction, nonspouse beneficiary rollovers will be required for plan years beginning on or after January 1, 2008. See, section 9(e) of S. 1974, the Pension Protection Technical Corrections Act of 2007, as introduced in the Senate on August 2, 2007 and section 9(e) of H.R. 3361, the Pension Protection Technical Corrections Act of 2007, as introduced in the House of Representatives on August 3, 2007.

Even though the Pension Protection Technical Corrections Act of 2007 did not become law before the end of 2007, the IRS has not announced a new interpretation of the plan document requirement for rollovers to nonspouse beneficiaries. It remains as last stated by the IRS in the 2007 List of Interim and Discretionary Amendments – rollovers to nonspouse beneficiaries are required for plan years beginning on or after January 1, 2008.

Section 1107 of PPA permits plans to adopt amendments for PPA as late as the last day of the first plan year which begins on or after January 1, 2009, as long as the plan timely operates according to PPA. For rollovers to nonspouse beneficiaries, until the IRS or Congress states differently, plans are required to permit rollovers to nonspouse beneficiaries for plan years beginning on or after January 1, 2008, and can adopt an amendment to include this provision as part of the plan document no later than the last day of the first plan year which begins on or after January 1, 2009.

[tags]Pension Protection Act, ppa, rollovers, nonspouse beneficiary, non-spouse beneficiaries, 402(c)(11), ERISA[/tags]

Amending for the Pension Protection Act

The Pension Protection Act contains a variety of deadlines for applying different provisions. For example, for plan years beginning after December 31, 2006, the faster vesting schedule in Section 904 for employer non-elective contributions must be used.

Even though the plan will apply the different provisions of the Pension Protection Act according to the deadlines contained in the Act, the deadline for amending the plan to incude these provisions is stated in Section 1107 as the last day of the plan year beginning on or after January 1, 2009. For calendar year plans, this means that they will need to amend for the Pension Protection Act no later than December 31, 2009, and the amendment will apply retroactively back to the date the PPA required the provision to be applied. Continuing with the example, for the faster vesting schedule applied to employer non-elective contributions, the amendment must be adopted no later than the last day of the plan year beginning on or after January 1, 2009, but will be effective for plan years beginning after December 31, 2006.

This deadline applies to both the mandatory and optional provisions made by PPA.

Because the plan can wait to amend until 2009 does not mean that the plan should wait until 2009 to amend. For example, Section 829 of PPA permits the plan to make rollovers to non-spouse beneficiaries. The IRS says this provision is optional, and applies to distributions made after December 31, 2006. For small plans who only make one or two distributions a year, the plan sponsor may want to consider amending before the deadline in 2009. Especially if the plan sponsor changes TPA firms every 2 to 3 years.

Assume the plan sponsor decides to apply Section 829 of PPA and permits a rollover to a nonspouse beneficiary in 2007. The plan sponsor decides not to amend in 2007 to memorialize that they have decided to apply this optional provision of PPA, but instead decides to wait until the deadline to amend in 2009. The plan sponsor becomes busy with their business, and doesn’t think much about how their plan is administered. Eighteen months go by, and the plan sponsor decides to change TPA firms. In 2009, the new TPA firm prepares the PPA amendment for the plan, and does not include the provision permitting rollovers to nonspouse beneficiaries in the amendment. The new TPA firm is unaware that, in 2007, the plan sponsor applied this provision to the plan and made a rollover distribution to a nonspouse beneficiary.

The plan sponsor has now failed to operate the plan according to the terms of the plan document. This type of failure is completely avoidable, unintentional, and is the result of poor communication. In 2009, the plan sponsor will possibly remember that they had an employee terminate in 2007. The odds are pretty good that the plan sponsor will not remember the type of distribution made to the participant when the participant cashed out of the plan. The new TPA firm is probably aware that the plan made a distribution in 2007, but the plan sponsor and the former TPA firm probably did not provide them sufficient details about the distribution for the new TPA firm to determine that it was a rollover to a nonspouse beneficiary.

If the plan sponsor amended the plan in 2007, before permitting the rollover to a nonspouse beneficiary, the plan documents would have been clear to the new TPA firm. They would have known in 2009 when they are creating the PPA amendment for the plan that, in 2007, the plan sponsor decided to apply this optional provision of PPA.

[tags]rollover, nonspouse beneficiary, distribution, amendment, deadline, participant, plan sponsor, plan document, pension, retirement, ERISA[/tags]