In the world of entrepreneurship, finding ways to fund a new business venture can be challenging. One strategy some individuals consider is the “Rollover as Business Start-up” (ROBS) arrangement. This method allows prospective business owners to use retirement funds to pay for business start-up costs, offering a potential solution to financing issues. However, while ROBS arrangements are not inherently illegal, they come with risks and potential compliance pitfalls that should be carefully considered before proceeding.

What Is a Rollover as Business Start-Up (ROBS)?

A ROBS is an arrangement where individuals can roll over funds from their existing retirement account, such as a 401(k), into a new retirement plan created for their business. The funds are then used to purchase stock in the newly formed C Corporation, effectively using retirement savings to finance the new company.

While ROBS transactions allow for a tax-free rollover of retirement funds, they have drawn scrutiny from the IRS. These arrangements often solely benefit the individual rolling over their retirement funds, which can raise compliance concerns. Promoters aggressively market ROBS plans as a way to access retirement funds without the penalties typically associated with early withdrawals, but the IRS cautions that these plans must comply with specific regulations to avoid adverse tax consequences.

The IRS and ROBS Compliance

In 2009, the IRS’s Employee Plans (EP) division initiated a project to examine ROBS arrangements and ensure compliance with the Internal Revenue Code. The project aimed to distinguish between compliant and noncompliant ROBS plans, identify problematic cases, and take corrective action when necessary. As part of this initiative, the IRS has used compliance checks to review companies that sponsor ROBS plans.

Key areas of focus include whether companies sponsoring ROBS plans are fulfilling their obligations, such as filing Form 5500 (Annual Return/Report of Employee Benefit Plan) or Form 1120 (U.S. Corporation Income Tax Return). The IRS sends letters to plan sponsors requesting information on the plan’s operation, including its current status, contribution history, rollover details, and participant information. In some cases, companies are found to be unaware of or incorrectly applying the plan’s requirements.

ROBS Project Findings: Business Failures and Compliance Issues

The IRS’s findings from the ROBS project paint a concerning picture. While there have been some success stories, many businesses started through ROBS plans failed. High rates of bankruptcy, both personal and business, as well as corporate dissolutions, were common outcomes for ROBS plan participants. In some cases, individuals lost not only their business but also their retirement savings, which had been rolled over into the plan.

One of the reasons for the high failure rate is that many entrepreneurs who utilize ROBS may not fully understand the complexities of starting and running a business. Additionally, recurring promoter fees and legal issues often exacerbate financial struggles, draining the business’s resources before it even begins to offer products or services.

Common Problems with ROBS Plans

Several specific issues have been identified with ROBS plans, including:

• Filing Issues: Many sponsors fail to understand that a ROBS plan is a qualified retirement plan with its own set of requirements. Some are mistakenly advised that they do not need to file annual returns, such as Form 5500, due to exceptions that do not apply to ROBS arrangements.
• Plan Amendments: After purchasing the employer stock, some ROBS sponsors amend the plan to prevent other participants from purchasing company stock, which can violate the qualification requirements of the Internal Revenue Code.
• Coverage and Discrimination Problems: Amending a ROBS plan to exclude future employees or prevent them from participating in the plan can lead to coverage and discrimination issues, further jeopardizing the plan’s compliance.
• Valuation of Assets: The proper valuation of the assets, including stock purchases, is another area where ROBS plans can run into trouble. Incorrect valuations can lead to compliance issues and affect the plan’s tax treatment.
• Failure to Issue Form 1099-R: When assets are rolled over into the ROBS plan, plan sponsors are required to issue Form 1099-R (Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans). Failing to do so can result in penalties and tax complications.

ROBS: A Risky Path to Business Funding

While ROBS arrangements provide an alternative method for financing a new business, they come with significant risks. Prospective business owners should be fully aware of the potential pitfalls before pursuing this strategy. Failure to comply with the IRS’s requirements could result in the disqualification of the plan, leading to significant tax consequences for the plan sponsor and participants.

If you are considering a ROBS arrangement to start a business, consult with a qualified tax professional to ensure you are fully informed about the compliance obligations and risks involved. Understanding the complexities of ROBS and seeking professional guidance can help safeguard your retirement savings and increase your chances of success in your new business venture.

If you have questions about ROBS or need assistance with compliance matters, please reach out to us. We are here to provide guidance on navigating this intricate process.