Succeeding in Your Business - Column by Cliff Ennico

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Using Your 401(K) Plan To Start a Business . . . Revisited

Cliff Ennico

"I was laid off from a corporate job a few months ago. I'm thinking of buying a franchise, but I don't have enough money in my checking account to pay the franchise fee and other upfront expenses. I've heard that there's a way I can tap into my old 401(K) plan for the startup capital I need, but I've also heard the IRS looks at that as an audit trigger. Where's the truth here?"

For some time now, entrepreneurs have been able to tap into their 401(k) plans to start a business using an "Entrepreneur Rollover Stock Ownership Plan" or ERSOP. Here's how these work:

-- The entrepreneur sets up a C corporation;

-- the corporation then sets up a profit-sharing plan for the entrepreneur;

-- the entrepreneur withdraws funds from his 401(k) plan and rolls them into the profit-sharing plan within 60 days; and

-- the profit-sharing plan uses the funds to purchase stock in the entrepreneur's corporation, giving the corporation the startup capital it needs.

Sounds great, right? There's only one catch. The IRS doesn't like ERSOPs. It calls them "Rollovers as Business Start-ups," or ROBS. Now, whenever the IRS gives a transaction an acronym like that (as in "robs the Treasury of revenue"), you know a loophole is about to be closed or at least tightened.

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In October 2008, the IRS released a technical memorandum (the full text of which can be found at ftp.irs.gov/pub/irs-tege/rollover_guidelines.pdf), expressing concern about the proliferation of ROBS transactions and the possibility that they may not comply with federal pension law.

Specifically, the IRS raised concerns about a number of possible violations.

Nondiscrimination: Under federal law, retirement plans must be made available to all employees of a corporation on a nondiscriminatory basis. Because ROBS transactions generally benefit only the founding entrepreneur and do not enable rank-and-file employees to acquire stock in the corporation, the IRS believes that some of these plans are discriminatory. Even if the founding entrepreneur is the sole employee of the business, a ROBS transaction may still be discriminatory if it is set up in such a fashion that other employees would not enjoy the same benefits as the entrepreneur.

Valuation of Corporation's Stock: In all ROBS arrangements, the corporation uses the proceeds of the stock sale to acquire assets (such as a franchise). The value of the stock is set as the value of the assets purchased with the ROBS proceeds. An appraisal may be created to substantiate this value, but often, it is nothing more than a one-page document furnished by the promoter who sold the ROBS transaction to the entrepreneur. The IRS believes this may set an artificially high value on the stock.

Promoter Fees: It may also be a legal violation if the corporation immediately pays professional fees to the ROBS transaction promoter out of the proceeds of the ROBS rollover.

Permanency: Because ROBS transaction benefits are designed to be used only once, the IRS is questioning whether they are truly a "permanent" retirement program. Permanency is a qualification requirement for all retirement plans.

At the time this is being written, the IRS has only begun to scrutinize the ROBS transaction industry; as yet, there are no set guidelines for ROBS plans that will withstand that scrutiny. However, since the IRS's primary concern is that the corporate profit-sharing plan formed as part of a ROBS transaction be a "real" employee benefit plan rather than a one-time investment by the company founder, it is likely to look favorably on ROBS transaction in which:

-- an outside accredited valuation firm (not the ROBS promoter) has established the value of corporate stock at the outset of the plan and each year thereafter;

-- an outside accredited and licensed money manager (not affiliated with the ROBS promoter) is appointed and available to render investment advice to the plan participants as needed;

-- the fees for the ROBS promoter's services in establishing the plan are paid for out of the entrepreneur's personal funds as a part of his personal investment and not reimbursed from the corporation at a later time; and

-- most importantly, that "non-highly compensated employees" other than the founding entrepreneur (for example, a person hired by the founder to serve as the general manager of a franchised business acquired with ROBS proceeds) be allowed to participate in the corporation's profit-sharing plan on an ongoing basis and are offered the same investment options as the founder.

If you are planning to do a ROBS, be sure to work only with a reliable promoter who specializes in these types of transactions and offers resources to perform the necessary legal and tax analysis of each transaction (the industry leaders are Benetrends Inc., www.benetrends.com, and Guidant Financial Group Inc., www.guidantfinancial.com). Insist that the promoter furnish you with a "private letter ruling" from the IRS or other regulatory determination that the transaction complies with tax and pension requirements.

And make sure there will be no other nasty surprises for the IRS to find if and when they audit your ROBS ...

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.

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Copyright 2009 Creators Syndicate Inc.

This news arrived on: 10/26/2009

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