Various promoters have suggested to entrepreneurs that they use the assets in their 401(k) plans or IRAs to finance a new business. These programs are sometimes known by the acronym ROBS, or Rollovers as Business Start-ups. The basic structure involves the entrepreneur’s rollover from a prior employer of the amount in his or her qualified plan to an IRA or a 401(k) plan to be established by the new business. The IRA or qualified plan then uses the rollover money to purchase the business, such as a franchise operation. The IRS has cautioned taxpayers that there are many requirements that must be met for this structure to work and also emphasizes that it is risky for business owners to invest all their retirement savings in a start-up business since new businesses fail at a high rate and any failure will result in the loss of both the business and the employee’s retirement assets.
A recent tax court opinion highlights the importance of meeting all legal requirements with these arrangements. The tax court decision involved two individuals who formed a corporation and directed their IRAs to use amounts rolled over from a prior employer’s plan to purchase 100% of the corporation’s newly issued stock. The cash was then used to purchase the assets of a business. The cash in the IRAs was not sufficient to finance the transaction so the company borrowed money from various sources, one of which was a note to the seller, personally guaranteed by the individuals whose IRAs owned the stock of the company. After the transaction was complete, the individuals owned the IRAs and the IRAs owned 100% of the stock of an employer that was now operating a business. The business owed money to the seller of the assets used in the business and the individual IRA owners had personally guaranteed that debt.
The individuals later converted their IRAs from traditional IRAs to Roth IRAs. The business was sold a few years later and the individuals assumed that the gain on the sale would be tax free when received by the Roth IRAs and tax free when distributed to the individuals who owned the Roth IRAs. (If appropriate holding periods are met, amounts distributed from Roth IRAs are not subject to income tax.)
The IRS challenged the tax treatment, claiming that the personal guarantees by the IRA owners of the note to the seller constituted an indirect loan to the IRA itself. Under the tax code, any extension of credit “directly or indirectly” between an IRA and its owner constitutes what is known as a prohibited transaction. An IRA that engages in a prohibited transaction is treated as having lost its IRA status in the year in which the transaction occurs. The IRS claimed that the IRAs lost their status as tax free IRAs in the year in which the personal guarantees were given and that that status continued for every year in which the personal guarantees remained outstanding. Thus, at the time the business was sold, the IRAs no longer qualified as IRAs and the owners of the IRAs had to recognize the capital gain incurred on the sale.
In addition to having to pay the capital gains taxes, the owners were also hit with penalties for failure to properly report their income. The owners claimed that they relied upon their business advisors regarding the structure of the transaction and the appropriate tax treatment. The IRS noted that the promotional materials from the advisor warned the owners to avoid engaging in prohibited transactions with their IRAs. The tax court noted that the owners did not discuss the personal guarantees with the advisor and in any case the advisor was the promoter of the arrangement so was not an independent advisor upon whose advice the owners could rely to avoid penalties.
ROBS can also be structured using a rollover to the 401(k) plan of the new business. Those arrangements too are subject to the prohibited transaction rules. With 401(k) plans, however, instead of the plan losing its tax exempt status, those responsible for the prohibited transaction are required to pay excise taxes. The amount of the excise tax is 15% of the amount involved for each year or part of a year that a prohibited transaction is not corrected. Ultimately, an uncorrected prohibited transaction can be subject to a 100% excise tax.
Taxpayers wanting to use their qualified plan or IRA assets to fund a new business must be especially careful in arranging financing for that new business. In light of this case, taxpayers may need to avoid personal guarantees of additional funding sources. Taxpayers should work closely with qualified advisors and may find that a different source of financing is ultimately a better choice than a ROBS.